Highlights

Portfolio Strategy

  • Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives. 
  • Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.  

Recent Changes

  • There are no changes in the portfolio this week.

Feature

The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions.

On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1

Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market.

Chart 1
Capitulation
Chart 1

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Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3

Chart 2
Selling Is Exhausted
Chart 2

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A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5

Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3).

Chart 3
Heed The PBoC Message
Chart 3

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Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4).

Chart 4
Reflating Away
Chart 4

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Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular.

Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4).

With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic.

Double Down On Cyclicals Vs. Defensives

Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception.

Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5).

Chart 5
Full Circle
Chart 5

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Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop?

The short answer is yes.

Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6).

Chart 6
China Flashing Green
Chart 6

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Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6).

Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects.

Chart 7
Capex Remains Healthy
Chart 7

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The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further.

A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8).

Chart 8
B/S Improvement Continues
Chart 8

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Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9).

Chart 9
Oversold And Unloved
Chart 9

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In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9).

Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6

Semi Equipment: Buy Into Strength

In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position.

Chart 10
Buy Into Strength...
Chart 10

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These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11).

Chart 11
...But Expect Heightened Vol
Chart 11

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Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively.

Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry.

Chart 12
Green Shoots
Chart 12

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Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13).

Chart 13
Analysts Have Thrown In The Towel
Chart 13

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Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13).

With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13).

Chart 14
Technicals Remain Depressed
Chart 14

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Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight).

Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.

Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC.

 

Anastasios Avgeriou, Vice President
U.S. Equity Strategy
anastasios@bcaresearch.com

Footnotes

  • 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com.
  • 2      Ibid.
  • 3      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com.
  • 4      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com.
  • 5      Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com.
  • 6      Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com.
  • 7      Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com.

Current Recommendations

SECTOR OVERWEIGHT NEUTRAL UNDERWEIGHT
S&P MATERIALS
Jan 14, 2019
OVERWEIGHT
Steel - Jan 14, 2019
Containers & Packaging - Feb 6, 2017
Gold Miners Index ▼ - Feb 6, 2017
Chemicals - Jul 24, 2017
Agricultural Chemicals - Sep 12, 2016
S&P INDUSTRIALS
October 2, 2017
OVERWEIGHT
Airlines - Nov 19, 2018
Industrial Conglomerates - Oct 31, 2018
Construction Machinery & Heavy Truck - Oct 2, 2017
Air Freight & Logistics - Apr 24, 2017
Defense - Dec 7, 2015
Construction & Engineering - Jan 12, 2015
Railroads - Oct 29, 2018
Industrial Machinery - Jan 29, 2018
Electrical Components & Equipment - Nov 21, 2016
Aerospace - Dec 7, 2015
S&P ENERGY
July 10, 2017
OVERWEIGHT
Oil & Gas Exploration & Production – Jul 16, 2018
Integrated Oil & Gas – Feb 5, 2018
Energy Equipment & Services – Oct 11, 2016
Oil & Gas Refining And Marketing – Jul 16, 2018
S&P FINANCIALS
May 1, 2017
OVERWEIGHT
Investment Banking & Brokerage - May 15, 2017
Banks ▼ - May 1, 2017
Asset Management & Custody Bank Index - Nov 14, 2016
Consumer Finance - Aug 25, 2014
Insurance (Composite) - Jan 9, 2017
S&P CONSUMER STAPLES
February 2, 2015
OVERWEIGHT
Packaged Foods - May 23, 2017
Household Products - Mar 23, 2015
Hypermarkets - Jun 19,2017Soft Drinks - June 12, 2017
S&P HEALTH CARE
July 3, 2018
NEUTRAL
Pharmaceuticals - Jul 3, 2018
Biotechnology - Jul 3, 2018
Managed Health Care - May 29, 2018
Health Care Equipment - May 1, 2017
Health Care Facilities - Mar 6, 2017
S&P TECHNOLOGY
April 9, 2018
NEUTRAL
Semiconductor Equipment - Dec 17, 2018
Technology Hardware, Storage & Peripherals - Apr 9, 2018
Software - Nov 27, 2017
Communications Equipment - May 30, 2017
Data Processing - Feb 27, 2017
Semiconductors - Dec 15, 2014
S&P UTILITIES
October 9, 2018
UNDERWEIGHT
Electric Utilities - Oct 9, 2018
S&P REAL ESTATE
April 23, 2018
UNDERWEIGHT
REITs - Apr 23, 2018
S&P CONSUMER
DISCRETIONARY
March 12, 2018
UNDERWEIGHT
Homebuilding - Sep 24, 2018
Leisure Products - Oct 19, 2015
Internet Retail▲ - Feb 26, 2018 Home Improvement Retail - Dec 3, 2018
Restaurants - Jun 25,2018
Hotels, Resorts & Cruise Lines - Sep 18, 2017
Auto Components - Dec 15, 2014
S&P COMMUNICATION
SERVICES
October 1, 2018
UNDERWEIGHT
Advertising - July 25, 2016 Movies & Entertainment - Jun 25,2018
Cable & Satellite - Jun 25,2018
Publishing - May 14, 2012
Interactive Media & Services - Dec 3, 2018
Telecommunication Services - Feb 12, 2018
▲ DENOTES UPGRADE IS PROBABLE ▼ DENOTES DOWNGRADE IS PROBABLE

Current Trades

TOP HIGH-CONVICTION CALLS FOR 2019 BLOOMBERG
TICKERS
RETURN (%)* SINCE
14 JAN 2019
OVERWEIGHTS
BCA Defense Index / S&P 500 **DEFENSE** / SPX1.3
S&P 500 Air Freight & Logistics / S&P 500S5AIRFX‹Index› / SPX-11.4
S&P 500 Software / S&P 500 S5SOFT ‹Index› / SPX-0.8
UNDERWEIGHTS
S&P 600 / S&P 500 SML / SPX1.0
S&P 500 Interactive Media & Services / S&P 500 S5INMS ‹Index› / SPX-8.7
S&P 500 Consumer Discretionary / S&P 500S5COND ‹Index› / SPX-3.8
S&P 500 Home Improvement Retail / S&P 500 S5HOMI ‹Index› / SPX-2.9

* RETURNS ARE UNIFORM ACROSS OVERWEIGHTS AND UNDERWEIGHTS. A POSITIVE NUMBER INDICATES A PROFIT AND A NEGATIVE NUMBER SIGNIFIES A LOSS.
** Average of (LMT + GD + RTN + NOC + LLL)

OPEN LONG / SHORT POSITIONSBLOOMBERG
TICKERS
INITIATION
DATE
RETURN
(%)
S&P 500 Homebuilding / S&P 500 Home Improvent RetailS5HOME ‹Index› /S5HOMEI ‹Index›22 Jan 20193.2
S&P 500 Materials / S&P 500 UtilitiesS5MATRX ‹Index›/S5UTILX ‹Index›28 Jan 2019-2.1

CLOSED TRADESINITIATION
DATE
BLOOMBERG
TICKERS
CLOSING
DATE
RETURN
(%)
S&P 1500 Steel / S&P 150014 Jan 20192.3

Size And Style Views

Favor value over growth
Favor large over small caps