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Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Chart 3Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Chart 12Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Chart 14...But Offsets... Chart 15...Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
The opposing sides of our market- and industry-neutral trade going long the S&P homebuilding index/short the S&P REITs index1 have both been on the receiving end of negative data in the last month. With respect to homebuilders, housing permits, a leading indicator of future starts, fell well short of expectations this week and took the S&P homebuilding index down with it. Meanwhile rising UST yields have been weighing heavily on REIT stocks. The end result is that our trade has given up its early gains. The macro environment tells us that it is too early to throw in the towel on this trade. We continue to believe prices in the residential real estate sector have the upper hand over their commercial real estate (CRE) peers. Existing home inventories have tightened and remain at historically low levels, which should support pricing. On the flip side, our CRE occupancy rate composite is still contracting, warning that already-slowing pricing has further to fall. The divergence in pricing should support homebuilders' returns at the expense of REITs. Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.
Overweight The S&P home improvement retail index (HIR) has historically benefitted from rebuilding efforts following costly hurricanes hitting the U.S. However, these spikes in relative performance largely track the earnings impact of the disasters; that is to say that they are one-off and do not provide much staying power. The impending arrival of Hurricane Florence today appears to have been priced into the index already as the stocks have already spiked. We would recommend against playing into this noise. Rather, we think investors should remain focused on the core profit profile of the index which has shown no sign of let up in its six-year run of earnings growth outpacing the S&P 500. Accordingly, we reiterate our overweight recommendation on the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.
Neutral Despite rising rates, homebuilders remain highly optimistic about the prospects for the domestic housing market, with the homebuilder survey persistently pushing near decade-highs (second panel). The message from Q2 earnings calls echoed this positivity, with the public homebuilders indicating demand was resilient even in a rising price environment. Still, the niche S&P homebuilding index has been moving sideways since our late-May upgrade to neutral. The cue from lumber prices is equally mixed; while the fall from the stratospheric levels of late-2017 is certainly a boon to profits, such a fall may be indicative of declining demand (third panel). At the same time, the tight labor market has seen wages in construction accelerating at the fastest rate since the rebound coming out of the financial crisis (bottom panel). The margin implication is thus unclear; we remain comfortable on the fence and reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
Underweight (Upgrade Alert) Auto components stocks found a rare bit of relief this week on the back of news of a trade deal with Mexico and hopes that a similar deal can be made with Canada. Importantly, the scant details gleaned about Mexico are better than had been feared. Of particular note are the increase in regional value content from 62.5% previously to 75% and a 40-45% auto content made by workers earning at least $16 per hour requirement. Both of these should see a diversion of supply chain from overseas to domestic auto parts companies. This makes us reasonably optimistic on the industry's medium-term growth outlook. However, we caution that the situation is highly fluid and the details of final trade deal may be vastly different from the ones thus far released. Further, industry-operating metrics have been deteriorating; light vehicle sales have flat lined, consumer confidence (at least with respect to making a purchase of a new vehicle) has declined and vehicle pricing has fallen back into deflation. Bottom Line: we remain bearish on the S&P auto components index but are cognizant that NAFTA renegotiations could offer a solid tailwind to a beaten-up sector. Accordingly, we are putting this niche index on upgrade alert. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.
Overweight Consumer discretionary giant Home Depot has put together a string of solid earnings reports and outlook improvements that have served to keep the S&P home improvement retail index at its lofty levels for the past several years. We think more is to come. Lumber prices, though off the stratospheric levels they reached earlier this year, remain exceptionally high (second panel). Further, pricing power of household appliances continues to expand, thanks to more expensive imports resulting from tariffs put in place earlier this year (third panel). As home improvement retailers earn a spread on these key products, both sales and earnings should continue to expand; Home Depot's Q2 same store sales growth of 8% certainly underscores this point. While home improvement retail sales growth is likely to trail industry retail sales, we think as long as the six year run of earnings growth beating the S&P 500 continues (as we expect it will, bottom panel) investors should stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.
Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... Chart 9...By Several Measures Chart 10A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) Chart 13Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) Chart 15A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) Chart 17Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) Chart 19Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) Chart 21Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) Chart 23A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) Chart 25Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) Chart 27This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) Chart 29Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) Chart 31The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). 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 nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) Chart 33Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 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 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Chart 35Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.
The long S&P homebuilding/short S&P REITs pair trade is off to a flying start. Already, this market- and industry-neutral trade has generated alpha for our portfolio to the tune of 7% since the early-July inception.1 There is a long runway ahead for additional gains in this pair trade. Importantly, the recent slew of bank earnings releases had a common thread: across the board, banks are pulling in their horns with regard to extending commercial real estate (CRE) loans. This represents a bearish backdrop for the overextended CRE sector (second panel). As the Fed continues to tighten the monetary screws, delinquency rates have nowhere to go but up, especially in CRE that currently enjoys an ultra-low starting point (fourth panel). Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.