Equities

Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) Chart 10Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps

Highlights Equities had a wild ride in October, ... : The S&P 500 has bounced smartly off of its October 29th lows, but the decline that preceded the bounce was unusually severe. ... that unsettled a lot of investors, and made us reconsider our constructive take on risk assets: To judge by the November 5th Barron's, and some client conversations, several technically-minded investors are unconvinced by the bounce. Nothing has changed with our equity downgrade checklist, however, ... : The fundamental picture hasn't changed at all - neither corporate revenues nor margins appear to be in any immediate difficulty; though we still expect inflation to surprise to the upside, the latest data will not push the Fed to speed up its gradual rate-hike pace; and the combination of blockbuster third-quarter earnings and October's selloff made valuations more reasonable. ... so we see no reason to downgrade equities now, though we do have the admonition of a Wall Street legend ringing in our ears: If the fundamental backdrop remained unchanged, we would be inclined to upgrade equities if the S&P 500 got back to the 2,600-2,640 range, even though we are operating with a heightened sense of vigilance befitting the lateness of the hour. Feature It has been just four weeks since we rolled out our equity downgrade checklist. We would not ordinarily devote an entire Weekly Report to reviewing all of its components, but the last four weeks have hardly been ordinary. The swiftness of the decline, and the apparent lateness of the cycle, have unsettled investors enough to make several of them reconsider just how long they want to stay at the bull-market party. At times when market action provokes emotional gut checks, it is essential for investors to have a process to fall back on. Process provides a rational, objective haven from noise and emotion, and should help foster better decision-making. Our commitment to process underpins our fondness for checklists. They will never be comprehensive - as usual, we have our minds on other important inputs - but they help to ground our thinking, and we're happy to have them when markets make wild swings. Has The Recession Timetable Speeded Up? We are not interested in recessions for their own sake - we'll let the NBER's Business Cycle Dating Committee tell us when recessions begin and end, several months after the fact - but they're poison for risk assets. Any asset allocator who can recognize them in a timely fashion has a leg up on outperforming the competition. We therefore have been repeatedly monitoring the individual components of our recession indicator (Table 1). They do not betray any more concern than they did four weeks ago. Table 1Equity Downgrade Checklist The yield curve is clearly flattening, just as one would expect as the Fed gets further into a rate-hiking campaign, but it is still a comfortable distance from inverting (Chart 1). We think yields at the long end have a way to go before they stop rising, so we expect the fed funds rate will have to get well into the 3's before the 3-month bill rate can overtake the 10-year Treasury yield. The Conference Board's Leading Economic Indicator is still expanding at a robust clip (Chart 2). Finally, we estimate the fed funds rate is about a year away from exceeding the equilibrium rate, thus signaling that policy has turned restrictive. Chart 1The Yield Curve Is Flattening, But It's Not About To Invert ... Chart 2... And Leading Economic Indicators Are Still Surging The unemployment rate continues to fall. Reversing the trend so that the three-month moving average could back up by the third of a percentage point that has unfailingly accompanied recessions (Chart 3) would require net monthly payroll additions to crater. Assuming annual population growth of 1%, and a constant labor force participation rate, net monthly job gains would have to fall to 100,000 for the three-month moving average to back up to 4% in 2020; if the pace of gains merely held at 120,000, the unemployment recession signal wouldn't be issued until 2021 (Chart 4). We applied the same conditions to the Atlanta Fed's online unemployment calculator to see what it would take for the unemployment rate to cross into the danger zone in 2019 (Table 2). Since the seven-year trend of 200,000 monthly net payroll additions would have to reverse on a dime for unemployment to issue a near-term warning, we do not foresee checking this box anytime soon. Chart 3Investors Should Beware An Uptick In The Unemployment Rate ... Chart 4... But None Is Forthcoming ... Table 2... Unless Hiring Falls Off A Cliff Are Corporate Earnings Coming Under Pressure? As we mentioned last week, we view the labor market as tight and getting tighter. We thereby expect that wages are on their way to rising enough to crimp corporate margins, albeit slowly. The composite employment cost index has been in an uptrend since 2016, but it ticked lower last month, and remains well below its cyclical highs ahead of the last two recessions (Chart 5). Chart 5Snails, Godot, Molasses And Wages October's global upheaval was good for the safe-haven dollar, which surged to a new year-to-date high (Chart 6). The DXY dollar index is now within 3% of the 100 level that would lead us to check the dollar strength box. Even though we're not checking the box yet, the dollar's 10% advance since mid-February will exert a modest drag on S&P 500 earnings for the next few quarters. Triple-B corporate yields have ticked a little higher since we rolled out the checklist, extending their six-year highs (Chart 7), though we still view them as manageable. Chart 6A Gentle Headwind (For Now) Chart 7Higher Yields Aren't Biting Yet A rising savings rate would cancel out some of the top-line benefits from employment gains. It fell pretty sharply in the third quarter, however, amplifying the self-reinforcing effect of new hiring. It's at the bottom of the range that's prevailed since 2014 (Chart 8), but could go still lower if consumption tracks the robust consumer confidence readings, as it consistently has in the past. Chart 8Consumers Are Well-Fortified EM economies have become considerably more indebted since the crisis, as developed-world savings sought an outlet; corporate profits are falling; and a stronger dollar makes it harder for EM borrowers to service their USD-denominated debt. A credit crisis (or multiple credit crises) could slow global activity enough to pressure multinationals' earnings, even if the U.S. economy is mostly insulated from EM wobbles. EM equities have gotten a respite since global equities put in their year-to-date lows, and Chinese stimulus could extend EM economies a lifeline, though BCA expects that Beijing will disappoint investors hoping for a meaningful boost. We remain bearish on emerging markets as a firm, but EM distress is not anywhere near acute enough to justify ticking the box. Is Inflation Starting To Make The Fed Uneasy? There are two channels by which inflation could pose a problem for equities. The first is the Fed: if it is discomfited by what it sees in realized inflation, or perceives that inflation expectations could become unanchored, it is likely to move forcefully to quash upward pressure on prices. A forceful pace is considerably faster than a gradual pace, and would bring forward a monetary policy inflection. If policy flips from accommodative to restrictive sooner than we expect, the window for risk-asset outperformance will shrink. With all of its talk about symmetric inflation targets, the FOMC has made it clear that it will not make any attempt to defend its 2% core PCE inflation target. It is comfortable with an overshoot, and has indeed openly wished for one for much of the post-crisis era. There are limits to its indulgence, however, and we suspect that the Fed would not be comfortable if core PCE inflation were to make a new 20-year high above 2.5%. With that red line far off (Chart 9), inflation is not yet likely to encourage the Fed to quicken the pace at which it removes accommodation. Chart 9Turtles, Sloths And Inflation Inflation expectations aren't yet pressing the Fed to speed things up, either. Long-maturity TIPS break-evens have retreated slightly since mid-October, and have yet to enter the range consistent with the 2% inflation target (Chart 10). The media and the broad mass of investors don't bother with symmetric targets, or implied break-evens; they take their cues from consumer prices. A multiple haircut driven by popular inflation fears is the second channel by which inflation could halt the equity advance, but CPI remains well below the mid-3% levels that would provoke concern (Chart 11). Chart 10Stubbornly Well-Anchored Chart 11No Reason To Trim Multiples Yet So What's To Worry About? Irrational exuberance is always a concern after an extended period of gains, but there's no sign of it in broad market measures right now. Blockbuster earnings gains have pulled the S&P 500's forward P/E multiple back down to the 15s from its January peak above 18. Secondary measures like price-to-sales, price-to-book, and price-to-cash-flow are well below extreme levels in the aggregate. If the S&P 500 is going to get silly, it will have to surge first. That said, the latter stages of bull markets and expansions can be perilous, and we are on high alert. We continue to actively seek out any evidence that challenges our broadly constructive take on risk assets and the U.S. economy. Though we have yet to find anything compelling, an admonition from legendary technical analyst and strategist Bob Farrell has lodged in our mind. Rule number nine of Farrell's ten market rules to remember states, "When all the experts and forecasts agree - something else is going to happen." It's much more fun to bring novel views and analysis to our clients, but we don't get overly concerned about agreeing with investor consensus. It's inevitable that a lot of people will agree in the middle of extended cycles; we simply strive to be among the first to recognize the major macro inflection points and determine the optimal asset-allocation framework to benefit from them. We get a little antsy, though, when everyone knows that something is either certain to happen, or cannot happen by any stretch of the imagination. The near-unanimity with which the investment community believes that a recession cannot begin in 2019 is increasingly eating at us. We have been checking and re-checking the data, and checking and re-checking our colleagues' various models, in search of trouble, but to no avail. Even though recessions begin at economic peaks, and the economy nearly always appears to be in fine fettle when the downturn asserts itself, the sizable fiscal thrust on tap for 2019 seems to obviate the possibility of a contraction. When discussing potential risks in face-to-face meetings with clients this week, we most often cited trade tensions, as any material rollback of globalization would erode corporate profit margins and would strike at global trade, on which much of the rest of world's economies rely. A dramatic worsening of the trade picture is not our base case, but we do expect upside surprises in inflation, and an attendant upside surprise in the terminal fed funds rate. We have been considering that view mainly from the perspective of fixed-income positioning: underweight Treasuries and maintain below-benchmark duration. We also have been assuming that the FOMC would lift the fed funds rate to 3.5% at the end of 2019 via four quarter-point rate hikes, and possibly take it all the way to 4% in the first half of 2020. If it were to speed up its pace, and take the fed funds rate to 3.5% by the middle of next year, and 4% by the end, we believe financial conditions would tighten enough to choke off the expansion. Monetary policy impacts the economy with a lag, so a recession may still not begin until 2020 in that scenario, but we'd bet that an equity bear market would begin in 2019. Investment Implications Balanced investors should maintain at least an equal weight position in equities. Although our checklist is a downgrade checklist, we're alert to opportunities to upgrade as well as downgrade. As we first wrote one week before the October selloff ended, we would look to overweight equities if the S&P 500 were to dip back into the 2,600-2,640 range (Chart 12). If U.S. equities wobble again in line with our Global Investment Strategy team's MacroQuant model's near-term discomfort, investors may get another opportunity before the year is out. Chart 12Only One Chance To Upgrade So Far, But There May Be More Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

Special Report

Dear Client, I had the pleasure of participating in the Affin Hwang Capital conference in Kuala Lumpur on November 8th. In addition to sharing my views on today's macro environment, I discussed BCA's recent successes in developing quant-based solutions for bottom-up stock picking and market timing. I have transcribed my remarks on the latter topic below. Best regards, Peter Berezin, Chief Global Strategist Feature The Arithmetic Of Active Management Every active investor wants to outperform the market. Unfortunately, just like everyone cannot be above-average in height, beauty, or intelligence, not every investor can outperform their benchmark. I think very few people in the audience would dispute this assertion. What could be more surprising to some of you is the following claim, which is that active investors as a group will always underperform the market. I say this not because I have any ill will towards active investors. I'm an active investor myself. I say this simply because it is a mathematical tautology. As Bill Sharpe has emphasized, the market return is simply the weighted average of the returns that passive and active investors earn before fees.1 The passive return must, by definition, equal the market return. This necessarily implies that the average active return must also equal the market return. Since active investors incur higher costs than passive investors, the former group will always underperform the latter group on average. That's the bad news. The good news is that not all active investors are the same. Some are better than others, and while it is not easy, it is possible to isolate certain strategies that active managers employ that help them outperform the market. Before I discuss these strategies, let me make a generic point, which is that most so-called active investors are not particularly active. In fact, according to one academic paper, the fraction of truly active investors - those whose returns deviate significantly from the market benchmark - shrank from 60% in 1980 to less than 20% in 2009 (Chart 1). In contrast to active investors whose portfolio returns broadly mimic the market's, genuinely active investors typically outperform their benchmarks (Chart 2).2 Chart 1How Active Are Active Investors? Chart 2Active Stock Pickers Outperform What are successful active investors doing to beat their benchmark? Well, first of all, let me tell you what they are not doing: They are not taking on more risk. Don't Bet On Beta Chart 3 shows that there is no clear relationship between a stock's beta and its expected return.3 To those familiar with the CAPM model, this may be surprising. The CAPM model predicts that higher-beta stocks will earn superior returns because they are riskier. High-beta stocks outperform the market when the market is going up, but underperform the market when it is going down. Since the market tends to go up more often than it goes down, the expected return to high-beta stocks should exceed the expected return to low-beta stocks. Chart 3Don't Bet On Beta As I will discuss, the reason this theoretical prediction is refuted by the empirical evidence is because the market is rife with inefficiencies. What is more, these inefficiencies reflect pervasive institutional and behavioral biases that are engrained within the market's very own DNA. Active managers who understand these biases can exploit them to outperform their benchmarks. Let me start with the former: institutional biases. The investment industry often encourages a "heads I win, tails you lose" mentality: If a fund manager takes on a lot of risk and gets lucky, he or she will be well remunerated; if the manager is unlucky, he or she may have to look for a new job, but the primary losers will be the clients of the fund. Such an incentive structure encourages managers to take on excessive risk by purchasing, among other things, high-beta stocks. This bids up the price of these stocks to the point where they no longer offer enough additional return to compensate for their higher risk. Size And Value If buying high-beta stocks simply adds more risk without generating more reward, what types of stocks do outperform the market on a risk-adjusted basis? Much of the early academic literature focused on two factors: size and value. Historically, it has been the case that small caps and value stocks have outperformed large caps and growth stocks. Some academics have offered risk-based explanations for the size and value effects. Personally, I find these explanations unconvincing, especially in the case of value stocks. The main problem with risk-based arguments is that they fail to convincingly identify the nature of the risk that investors who purchase value stocks are being compensated for. It is certainly not market risk - value stocks tend to be low beta (Chart 4). Revealingly, companies that do face greater existential risks - those that have high levels of debt relative to equity, for example - tend to underperform the market.4 This is exactly the opposite of what risk-based arguments would predict. Chart 4Value Tends To Outperform Growth When The Stock Market Is Falling The presence of market inefficiencies provides a more compelling explanation for why small caps and value stocks outperform. Consider two companies, identical in every way except that one has a lower market capitalization than the other. Since the only difference between the two companies is the price of their shares, the "cheaper" company will generate higher returns for shareholders over the long haul. The cheaper, smaller capitalization company will also initially trade at a lower price-to-earnings and price-to-book ratio. In other words, it will look more like a small cap value stock. Thus, it is not necessary to invoke complex, risk-based explanations for why small caps and value stock outperform. It is exactly what one would expect if markets are not perfectly efficient. Ignore The Analysts? Of course, some stocks are cheap for a reason. How can we distinguish between hidden gems and fool's gold? Wall Street is populated with thousands of analysts paid to make that determination. But are they any good? For the most part, the answer is no. Chart 5 shows analysts' published earnings forecasts versus realized earnings growth. Analysts have had some success at predicting earnings growth over a one-to-two year horizon, but are almost useless over a five-year horizon.5 In fact, large cap companies favoured by analysts tend to underperform companies that analysts pan. Chart 5A Mug's Game There are two exceptions to this rule. The first applies to small caps. Since many smaller companies are not widely followed, analysts that do follow them often add significant value. Unlike their large cap brethren, small cap stocks with buy recommendations tend to outperform stocks with sell recommendations. Second, changes in analyst recommendations do predict returns. Stocks that have recently been upgraded tend to outperform those that have recently been downgraded.6 Insiders And Short Interest How about insiders? Here, the data suggests that insiders know what they are doing. The shares of companies with a lot of insider buying tend to rise more than those that have experienced insider selling. Short interest also predicts returns. Heavily-shorted companies tend to underperform companies that have attracted few short sellers. Combining data on insider activity and short interest can help supercharge returns. Chart 6 shows the highest returns are earned when insiders are buying and short interest is decreasing.7 The worst-performing stocks end up belonging to companies where insiders are heavy sellers and short interest has risen over the prior 12 months. Chart 6Prefer Stocks Where Insiders Are Buying And Short Interest Is Falling Mo' Money What about technical analysis? The academic literature on this topic is a mixed bag, with some studies deeming it useless and others suggesting it can be useful in certain situations. For most technical indicators, the noise-to-signal ratio is very high. Nevertheless, some technical indicators are worth following. Momentum is one of them (Chart 7). Over short-term horizons of about one month, mean reversion prevails - stocks that did well over the prior month tend to do poorly during the subsequent month. In contrast, over medium-term horizons of about 12 months, return continuation is the name of the game - stocks that have done well over the last 12 months tend to do well during the subsequent month. Interestingly, at very long time horizons of three-to-five years, mean reversion takes over again: Stocks that have done well over the last five years tend to do poorly over the subsequent month. The implication is that the best stocks are those that have underperformed the market over the past one month and over the past three years, but have outperformed the market over the past 12 months. Chart 7The Three Phases Of Momentum Putting aside the short-term reversal effect which, in practice, is hard to exploit due to trading costs, what are the drivers of the medium-term return continuation effect and the longer-term return reversal effect? I think three factors explain the medium-term return continuation effect. The first is institutional inertia. A large money manager cannot instantly jump in and out of a position. It may take many months to build a position to its desired size and just as much time to liquidate it. Persistent buying and selling generates momentum in equity returns. The second factor is imperfect information. A lot of the return continuation effect occurs around the time of earnings reports. If a company reports better-than-expected earnings, its stock goes up. As others hear about and process the good news, the stock usually continues to advance over the subsequent days. The third factor is behavioral biases. People tend to be quite eager to lock in gains but are usually reluctant to realize losses. When a company reports good news, investors are too quick to sell. This premature selling prevents the stock price from rising to its fair value instantaneously. During the time it takes the stock to reach fair value, the share price displays upward momentum. Conversely, when the company reports bad news, investors avoid taking losses, hoping instead that some miracle will bail them out. The lack of willing sellers prevents the stock from falling to its fair value immediately. In the time it takes investors to come to terms with the fact that a miracle is not forthcoming, the share price displays downward momentum. What about the longer-term return-reversal effect? Ironically, it is probably a function of the medium-term return continuation effect. Upward momentum attracts interest from trend-following investors. People who sold too early or never got in from the beginning kick themselves and look for the slightest dip to buy. All this buying interest eventually pushes the stock price above its fair value, setting the stage for a prolonged period of subpar returns. Anomalies Abound Let me briefly mention a few other factors that predict equity returns. Share turnover is one of them. Investors often presume that high turnover is intrinsically a good thing. Terms such as "healthy volume" abound. The truth is that companies with low rates of share turnover actually outperform the market, all things equal.8 Part of this outperformance reflects a liquidity premium. Part of it may also simply reflect the fact that undervalued companies often hide in the shadows of the market, away from the spotlight. There are also balance sheet and earnings quality factors that are worth highlighting. I already mentioned that companies with high debt-to-equity ratios tend to underperform the market on a risk-adjusted basis. It is also true that companies with high accruals - firms that fail to convert most of their earnings into cash flow - underperform the market. More surprisingly, companies whose assets have been growing very quickly also tend to underperform the market. Such asset growth often ends up reflecting empire building rather than prudent corporate management. Relatedly, a significant dispersion in analyst earnings estimates is often a red flag.9 Companies with something good to say usually say it. Companies that do not have much good to say often clam up, leading to greater uncertainty about their earnings prospects. When analysts have little visibility on what earnings a company is poised to deliver, be careful. Picking Stocks With ETS I have discussed a variety of factors that help predict the performance of individual stocks. There are dozens of others that I could have mentioned but did not. Clearly, successful bottom-up investing requires that one sort through a lot of information. What one would like is a system that distills all this information into a single score that ranks stocks from best to worst. The ideal system should dynamically adjust factor weightings to account for the fact that there is momentum in factor returns. For example, if value stocks have recently been doing well, they are likely to continue to do well. At BCA Research, we have constructed our Equity Trading Strategy (ETS) to do just that.10 Chart 8 shows the backtested returns of the ETS model. As you can see, they are quite impressive. Chart 8ETS Model Back Tested Performance To Date I have been personally trading a variant of the ETS model for the past 18 years and once wrote a blog chronicling the journey.11 I have added a line in the chart that shows my own personal performance on a pre-tax basis inclusive of brokerage commissions and other trading costs. I typically hold about 30 to 50 stocks. Except in very rare cases, I don't let any single stock exceed five percent of my portfolio. I normally hold a cash cushion of about 10%-to-15%, although occasionally, as in late 2008/early 2009, I have bought stocks on margin. I have lost a lot of money shorting stocks, so I rarely do it. I am not sure how lucky I have been over the years or how scalable my results are - I generally invest only in small cap companies that most money managers would not touch. But it does give you a sense of what is possible with this system. Market Timing With MacroQuant Of course, stock selection is only one half of a successful investment formula. The other half is market-timing - knowing when to scale back or increase exposure to the stock market. That's where our soon-to-be-released MacroQuant model comes in. The model uses over 100 variables on the economy, financial and monetary conditions, sentiment, and valuations to predict the direction of the stock market. Chart 9 shows the back-tested performance of the model. Chart 9MacroQuant* Model Suggests Caution Is Warranted What is MacroQuant saying today? The signal from the model moved into bearish territory in the lead up to October's correction and continues to flag downside risks to stocks. This is mainly because the leading economic data has softened outside the United States, and more recently, in the U.S. itself. Financial conditions have also tightened on the back of rising bond yields, wider credit spreads, and a stronger dollar. Sentiment enters our model in both level and directional terms. We have found that the best configuration for stocks is when sentiment is bearish but improving while the worst configuration is when sentiment is bullish but deteriorating. Going into October, sentiment began to slip from very bullish levels, which was a warning sign for stocks. Valuations have improved over the past month, but still remain somewhat stretched by historic standards. We do not believe that we are at the beginning of a bear market in stocks. However, our model does suggest that the correction may have further to run. With that, let me conclude my formal remarks, and open it up to questions. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 William F. Sharpe, "The Arithmetic of Active Management," The Financial Analysts Journal 47:1 (January/February 1991): 7-9. 2 Antti Petajisto, "Active Share And Mutual Fund Performance," Financial Analysts Journal 69:4 (July/August 2013): 73-93. 3 Andrea Frazzini And Lasse Heje Pedersen, "Betting Against Beta," Journal Of Financial Economics 111:1 (January 2014): 1-25. 4 John Y. Campbell, Jens Hilscher, and Jan Szilagy, "In Search Of Distress Risk," The Journal of Finance 63:6, (December 2008): 2899-2939. 5 Louis K. C. Chan, Jason Karceski, And Josef Lakonishok, "The Level And Persistence Of Growth Rates," The Journal Of Finance, Vol. 58, No. 2 (2003): 643-684. 6 Ireneus Stanislawek, "Are Stock Recomemndations Useful?"1741 Asset Management Ltd Research Note Series, (IV 2012). 7 Amiyatosh K. Purnanandam, And H. Nejat Seyhun, "Do Short Sellers Trade On Private Information Or False Information?"Journal of Financial and Quantitative Analysis, Vol.53, 3 (2018): 997-1023. 8 Vinay T. Datar, Naik Y. Narayan, and Robert Radcliffe, "Liquidity And Stock Returns: An Alternative Test," Journal of Financial Markets 1:2, (1998): pp. 203-219; and Charles M.C. Lee and Bhaskaran Swaminathan, "Price Momentum And Trading Volume," The Journal of Finance 55:5, (October 2000): 2017-2069. 9 David Veenman and Patrick Verwijmeren, "Earnings Expectations And The Dispersion Anomaly," (January 2015). 10 Please see Global Investment Strategy and Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach To Bottom-Up Stock Picking," dated December 3, 2015. 11 My now-defunct blog, stockcoach.blogspot.com, discussed my real-time trading progress between 2004 and 2007. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Overweight The S&P consumer finance index, much like their larger financials peers in the S&P banks index, have mostly not participated in the rise in Treasury yields, a relationship that has heretofore been relatively tight (top panel). This is despite credit card interest rate spreads that are pushing close to their post-GFC highs; such moves in the spread have typically heralded bullish sell-side sentiment changes and the current message is no different as earnings estimates have soared (second panel). While rate-driven revenues are climbing, the cost picture remains stable. The credit card delinquency rate has ticked up modestly but remains at severely depressed levels, driven by historically low unemployment (bottom panel). We continue to expect a sector rotation with financials and industrials leading the next phase of the market advance, a result of the bond market selloff gaining steam into year-end and beyond.1 Accordingly, we reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5CFINX - AXP, DFS, SYF, COF. 1 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com.

Highlights Portfolio Strategy Frenzied software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets suggest that software stocks are a must have for equity portfolios. Rising interest rates along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion all suggest that it pays to remain bearish consumer discretionary stocks. Recent Changes We lifted the S&P Industrial Conglomerates index to overweight in a Sector Insight on Wednesday last week.1 Table 1 Feature Chart 1Stocks Are... The S&P 500 found its footing last week, but the volatility comeback assures more violent oscillations before equities resume their upward trajectory. Crash-prone October lived up to its reputation but it is now over, and once the midterm election uncertainty passes this week, investors will refocus their attention on the U.S./China trade war and U.S. economic growth. Trump's moderating approach on the former was welcome news last week, and any further de-escalation signs in the trade tussle will breathe a huge sigh of relief for equities. On the investment front, the 10% SPX drawdown triggered our "buy the dip" strategy on Friday October 26 (please see the "Time To Bargain Hunt" Sector Insight), when we put to work longer-term oriented capital. Our "buy the dip" view remains intact, as we still do not foresee a recession in the coming 9-12 months. On the volatility front, the CBOE SKEW index, a measure of tail risk,2 is sending a positive message as investors are no longer buying tail risk protection as they did in August. Interestingly, as the nominal level of the SPX has been increasing over the decades so has the price of tail risk protection (Chart 1). We view the recent collapse in the CBOE SKEW index as a positive indication that the worst may be behind the equity market. With regard to global flows to U.S. shores, the Treasury International Capital (TIC) System data revealed that global portfolio managers were not chasing U.S. equities this summer as they had been at the beginning of the year. The likely current trough in net foreign portfolio flows into U.S. equities should, at the margin, underpin U.S. stocks (Chart 2). Chart 2... Likely Out Of The Woods... On the U.S. economic front, the latest GDP release revealed that housing is indeed softening. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters. Tack on decelerating house prices and collapsing lumber prices (Chart 3) and residential real estate confirms the yellow flag from our recently introduced Economic Impulse Indicator.3 Chart 3...But Housing Poses A Risk While house prices are decelerating, corporate pricing power remains upbeat. True, investors focused on anecdotes about input cost inflation this earnings season and all but ignored evidence that companies across different sectors have been able, and will continue, to raise selling prices by more than the rise in wage and commodity costs. Thus, corporate profit margin squeeze fears are overblown; they are likely a risk for the back half of 2019, especially if volume growth suffers a setback. This week we are updating our corporate pricing power gauge. While our overall proxy has ticked down, it is still clocking higher than wage inflation. In fact, our pricing power diffusion index shows excellent breadth (second panel, Chart 4). This firming corporate inflation backdrop suggests that businesses have been successful in passing on rising input costs down the supply chain or to the consumer, and thus suggests that investors are mistakenly fretting about a looming profit margin squeeze. Chart 4No Margin Pressures Yet While labor cost inflation is trending higher, wage growth remains contained near 3% despite a multi-decade low in the unemployment rate. According to our wage growth diffusion index, just over half of the 44 industries we track have to contend with rising wages, a visible fall from earlier in the year (middle panel, Chart 4). In addition, the Atlanta Fed Wage Growth Tracker remains tame and the switcher/stayer index recently nosedived to multi-year lows. The switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses (fourth panel, Chart 4). Put differently, corporate pricing power is rising on a broadening basis while leading indicators of wage inflation suggest an easing in wage pressures in the coming months. As a result, there are rising odds that expanding forward operating margin expectations are likely, extending the two year margin expansion phase (bottom panel, Chart 4). Digging deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 73% of the industries we cover are lifting selling prices, while another ten industries are experiencing only mild price deflation (less than a 0.6% decline). If we include those ten industries then 90% of sectors are maintaining or raising selling prices. One third of the industries are lifting prices at a faster clip than overall inflation. This is lower than our early-July report. Outright deflating sectors increased by four to sixteen since our last update but only six are deflating at 1% or more. On a slightly negative note, fourteen industries are experiencing a downtrend in selling price inflation, twice as many since our most recent report (Table 2). Deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 5). Despite the ongoing global export softness, intensifying trade tussle with China and 5% year-to-date appreciation in the trade-weighted U.S. dollar, the commodity complex's ability to increase prices is impressive especially given that the base effects from the late-2015/early-2016 manufacturing recession have filtered out. On the flip side, tech industries dominate the bottom ranks of Table 2. Chart 5Cyclicals Have The Upper Hand In sum, accelerating business sector selling prices will continue to underpin top line growth into 2019. As long as wage inflation rises gradually and does not gallop higher and the corporate sector sustains its pricing power, then profit margins and earnings will remain upbeat. This week we update a high-conviction overweight tech subgroup and reiterate our below benchmark allocation to an early cyclical sector. Software Is In High Demand Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel, Chart 6). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. Chart 6Software Fever It did not take long for the large CA acquisition to get surpassed by RHT. Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels (fourth panel, Chart 6). The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. Chart 7Capex Gains... Beyond the positive M&A angle that we have been exploring for quite some time in our research, software stocks are particularly levered on capital spending. Chart 7 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits (Chart 8). Chart 8...Say Stick With Software Moreover, industry operating metrics are on fire. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel, Chart 9), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel, Chart 9). Chart 9Operating Metrics Are Firing On All Cylinders With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly (Chart 10). Chart 10Pristine Balance Sheets Nevertheless, all of these positives have pushed several valuation metrics to a premium to the broad market and leave little space for any mishaps. On a forward P/E, trailing P/S, and even EV/EBITDA basis, software equities are pricey, but we think for good reason (bottom panel, Chart 10). This rerating phase will likely continue until there is evidence of an end either to the M&A frenzy, or capex upcycle or business cycle. In sum, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Consumer Discretionary Stocks Are Still A Sell While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. Chart 11 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Chart 11Rising Fed Funds Rates... Last week we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 12). Chart 12...The Volatility Comeback... Money aggregates also corroborate that the time to buy consumer discretionary equities is when the money supply is galloping higher and shed exposure when both M1 and M2 are decelerating as we have shown in previous research. Importantly, the velocity of M2 money stock is inversely correlated with relative share prices and the current message is negative for consumer discretionary stocks as GDP is finally growing faster than M2 money growth (velocity of M2 money stock shown inverted, Chart 13). Chart 13...And Money Velocity Point To More Losses In Consumer Discretionary Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. Chart 14 shows our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices). Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. Chart 14Heed The Message From The Consumer Drag Indicator Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged (Chart 15). Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth north of 30%/annum or twice as high as the overall market. Clearly this is not realistic as it assumes a near quadrupling of EPS in the coming 5 years. Chart 15Bad Breadth... In the near-term, analysts are more cautious (bottom panel, Chart 15). Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (top panel, Chart 16). As a result, the 12-month forward P/E ratio is trading at a 27% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 16). Chart 16...With Poor Technicals And No Valuation Cushion Adding it up, a rising interest rate backdrop along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion, all suggest that it pays to remain bearish consumer discretionary stocks. Bottom Line: The path of least resistance is lower for the S&P consumer discretionary index, stay underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Sector Insight, "A Rout For Conglomerates Opens A Buying Opportunity," dated October 31, 2018, available at uses.bcaresearch.com. 2 "The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew"." Source: CBOE, http://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew 3 Please see BCA U.S. Equity Strategy Weekly Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1