2018 Fourth Quarter Review


The S&P 500 fell 6.2% last year, not including dividends. Volatility picked up as central banks became less accommodating with both federal funds hikes and balance sheet drain. The European Central Bank also started tapering. Most asset classes struggled while the U.S. yield curve flattened. Equity market volatility intensified in December and consumer confidence fell, partly in reaction to hawkish remarks by the Federal Reserve. Earnings, however, grew an estimated 22% last year, and perhaps a little bit more. The result of these seemingly contradictory factors? A contraction in the market’s price/earnings ratio—the fifth largest decline since World War II.

So far this year the S&P 500 is up 5%—and we expect further increases ahead. An analysis by UBS recently looked at 26 cases since WWII of meaningful price/earnings declines for U.S. stocks in a single year. It found that the median returns the following years were 16%.  Much will depend on the manmade headwinds negatively impacting the major economies. It would appear that the U.S. Federal Reserve has come off autopilot and may slow interest rate hikes. Investors are also starting to predict a possible resolution to the U.S./China trade discussions. No trade war escalation will eradicate a major headwind—though keeping the recent tax cuts in place, along with increased government spending, will more than offset current trade risks.  The removal of the tariffs should improve capital spending, the life blood of future economic growth, which has been hobbled in recent months. Additionally, 2018’s combined incremental benefit of consumer tax cuts and lower gasoline prices could increase in 2019.

While we have a constructive outlook on the future level of equity prices, we don’t think it is time to blow the all-clear signal just yet. A lot of what we have talked about is solvable but the resolutions still lie in the future. If we factor in the host of global economic problems and the disarray in Washington, there is reason for some caution. U.S. economic growth will probably slow to around 2.5% this year and corporate profits to the low single digits. But slowing economic growth and profits should not be confused with negative growth. Historically speaking, the former outcome does not end in a recession or a bear market. Our concern is the damage done to the equity markets in a very short period of time resulting in the worst correction since 2011. After such corrections, it often takes the market several months of volatility before it establishes a base from which to move sustainably forward.

January 2019

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US Strategy Weekly: Davos and Dysfunction

In our January 10, 2019 report, “The Consensus View” we noted that there was broad agreement among strategists regarding their outlooks for 2019. Most forecasts include the concept that global and US economic activity will decelerate this year, the risk of a US recession grows for 2020, the Federal Reserve is apt to be on hold for much of the next 12 months, the dollar will remain stable, interest rates have peaked for the intermediate term, and emerging markets represent better values than US securities. We tend to be wary of strong consensus views since history suggests that they tend to be wrong. Therefore, we believe investors should be on the lookout for positive surprises in 2019.

Davos, Switzerland

This week the 2019 World Economic Forum in Davos is the big financial story and we remind readers that this forum is famous for misjudging the global mood and events. Last year global financial leaders and executives were brimming with optimism about the world economy and the ability of stock markets to continue to rise. This year the mood is much more subdued and is focused on the political paralysis seen in the US, UK, France and Germany, the stress on trading relationships and rising concerns about the concentration of corporate power, especially among large technology firms. Corporate leaders are eyeing global trade, the potential impact of the US government shutdown, the uncertain state of the economy and a volatile political landscape as the major risks of the current year and many are calling these risks unprecedented. However, while forum participants are downcast and glum this year’s Economic Forum is most notable for the people who did not attend. The list includes President Trump who did not attend due to the federal government shutdown, Prime Minister Theresa May did not participate due to the time pressure she faces to get a Brexit deal and Chinese President Xi Jinping was not there as China announces economic growth has decelerated to the slowest pace in decades. Clearly the consensus view among US equity strategists that we described two weeks ago is also a global view. To us, this suggests that we should be looking for what could go right in the US and global environments in 2019.

In our last weekly publication we listed the most likely positive surprises of 2019 to be a trade agreement between the US and China, a smooth Brexit, a quiet and uneventful end to the Mueller investigation and a bi-partisan US infrastructure spending bill. This list is presented in order of likelihood.

The most plausible positive surprise in 2019 is a trade agreement between the US and China. While the negotiating process has been messy and contentious it seems that President Trump is pressing China for the best possible long-term deal, including the ability for the US to monitor the agreement for compliance. Like many deals, the process can be acrimonious, yet we believe it is in the best interest of both parties to find a solution before additional tariffs are imposed in March. Prime Minister May could be facing a tougher battle to pass a Brexit proposal through Parliament; but the disruption of a hard Brexit could pressure politicians into finding a solution in coming weeks. Of all the items on our list, a bi-partisan infrastructure bill currently seems the least likely. This is a very sad commentary since both sides of the US political aisle actually agree on this concept. The absence of such a bill highlights the dysfunctional state of the US political scene and of the US Congress.

The Economic Backdrop

The current US economic backdrop has its highs and its lows. The most recent low was December’s existing-home sales which fell 6.4% from a revised November number and was down 10.3% from December 2017. This was not due to seasonal factors since both the seasonally adjusted and unadjusted sales figures were down by similar percentages. The median single-family home price in December (SA) was $261,220, down 1.2% from November but still up 3% from December 2017. December’s weakness could be temporary factors since these sales were based on contracts signed one to two months prior to December when mortgage rates were at their peak. Weather was also unseasonably cold and wet in November which hampered potential buyers and the government shutdown may have delayed some transactions which were expected at the end of the year. The good news is that interest rates have moved lower in recent weeks and this could bolster the housing market in 2019. See page 3.

The ISM manufacturing index fell from 59.3 in November to 54.1 in December and is now at its lowest level since late 2016. All components of the manufacturing survey, with the exception of imports and exports were lower in the month. The broadness of this decline depicts a clear slowdown in activity at the end of 2018; however, all components of the ISM index remain above the 50 benchmark which indicates the manufacturing expansion is continuing, albeit at a slower pace. See page 4.

One of our favorite economic surveys is the NFIB small business optimism index and it fell from 104.8 in November to 104.4 in December, the fourth consecutive monthly decline. The decline in optimism was modest and the components of the survey revealed mixed results. Plans to make capital expenditures fell decisively to 24 in December, but a net 23% of small business respondents plan to expand employment. This is better than the 22% reading seen in each of the prior two months. This stability in employment plans is encouraging for the average household. See page 5.

The highpoint of December economic releases was the jobs report which showed payrolls grew above expectations with 312,000 new jobs added during the month. Job growth was strongest in construction, leisure/hospitality and education/healthcare sectors. We were most encouraged by the fact that our favorite indicator, the year-over-year growth rates in both the household and establishment surveys, showed December’s year-over-year growth in employment was above average in both surveys for the first time since September 2016. See page 6.

The key question facing investors is whether the risks seen in 2019 have been fully discounted by December’s decline in prices. Consensus surveys for 2019 show that SP500 forecasted earnings have slumped from double-digit growth levels in October to the current 6.1% YOY growth rate in Thomson IBES data and the 8.1% YOY growth rate in S&P Dow Jones data. These consensus estimates remain above our 2018 SP500 earnings estimate of $156 but have now edged below our 2019 estimate of $172. In our view, the consensus has become too pessimistic about 2019 earnings. See pages 9-10.

Technical Indicators are Favorable

We expect the market to remain in a broad trading range until the geopolitical backdrop improves. Nonetheless, a number of technical indicators indicate that December prices represented the worst of the decline. The most important and bullish feature of breadth data were the 90% up days recorded on December 26 and January 4. These days were reversals of the 90% down days seen in early December and were signals that the decline was both stabilizing and reversing. In addition, the AAII 8-week bull/bear spread is in positive territory for the sixth consecutive week. In sum, both breadth and sentiment are suggesting the market has begun a bottoming phase.




“Overweight”: Overweight relative to S&P Index weighting

“Neutral”: Neutral relative to S&P Index weighting

“Underweight”: Underweight relative to S&P Index weighting

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Rumors of their death are greatly exaggerated… said Mark Twain about the FANG stocks.

DJIA: 24,370

From September 20, when the S&P peaked at a record, the FANG stocks on average had fallen 27% through Christmas Eve. Since then, there has been what you might call a resurgence, led by a 52% gain in Netflix (353) from December 24th through Tuesday. This is the most in the S&P and has helped the NAZ to be the first to rise above its 50-day moving average, though that of itself has little forecasting value. Meanwhile, Facebook (148) and Amazon (1693) also have outpaced the gains in the S&P, and Google (1090) has come close. Netflix remains under-loved by the analysts as it reports Thursday evening. Rather than wait to comment, let us just say, does it matter? In the end the movie is a happy one, weakness being another chance to buy. It is, after all, one of those big overall uptrends. As for FANG per se, it strikes us as a positive for the market that confidence in these volatile stocks is back.

Always knew we liked the Banks—just kidding. What we do like are stocks that are sold out. After their 10%+ drubbing in December alone, you might have thought Financials fit that bill. Perhaps the best definition of sold out, however, is an ability to ignore bad news. Citigroup (62) got the earnings ball rolling earlier this week with news that was more dubious than good, but the stock rallied. The telling commentary, however, was JPMorgan (103), where the news was such the stock actually traded down for an hour before its sharp rally. We’re still not particular fans here, but sold out is sold out, there should be more rally. Perhaps the best thing is the implication for the market. If one of last year’s biggest disappointments finally can respond to dubious news, it goes a long way to suggesting the market itself is sold out. Overall market numbers say this is so—the two 95% up-volume days—but it’s also nice to see it in a tangible way.

They all laughed at Christopher Columbus and even more at Hindenburg and his Omen. Then wouldn’t you just know it, last September the thing worked. Divergences of any sort are never good, the Hindenburg being an unusual one. The typical divergence involves one measure up and another not up or not up as much. Think of the Dow Theory, the Industrials up, but the Transports not confirming. Rather than the market averages or the advance-declines, the Hindenburg looks at New Highs and New Lows, and comes about when there are too many of both—a market internally out of sync. The signals only work when they appear in a cluster and, in our experience, even then rarely live up to their name. Since it did work recently, however, it seems worth a mention that the opposite of the Hindenburg now is taking place. With the market still in a downtrend, there are a very small number of New Highs and New Lows, and a cluster of such days. In the past this had led to positive one-to-two month returns, according to SentimenTrader.com.

These sort of washout market lows often see a “test” of the lows, which is a move back to, or even below, the washout low. We’re still within the time parameter of a test and the market is up enough to correct, call it a test or whatever you like. We have our doubts about a test because getting to the December 24th low was itself such a process. And there’s been ample excuse for a test, including even Apple’s hiring freeze announced Thursday, to which even Apple (156) didn’t react. BlackRock’s assets during the fourth-quarter meltdown sank $468 billion and all together, investors pulled a net $48 billion from developed world equity markets in the quarter. That pretty much tells you why we’ve seen the market numbers we have. Impressive is what has happened in the three weeks since the low period. In ETFs, Bloomberg noted that leveraged funds betting on the S&P 500 rally have been seeing an outflow, while inverse funds that bet on a decline have been seeing an inflow. This kind of skepticism seems another reason we may avoid a test.

The “funnymentalists” will tell you the fourth quarter created value. We will tell you stocks sell at “fair value” twice— once on the way up, and once on the way down. For the rest, they’re over or under valued, the trick being will they become more of the one or the other. Stock markets are about supply and demand. What the fourth quarter did was create a vacuum. Stocks are where they are now because the sellers became accommodated. Stretched to the upside, as we are now, is not so difficult when those sellers are out of the way. News on the trade war front is getting better, but when doesn’t the news follow price? Sure the market can correct, but, then too, good markets don’t give you a good chance to get in. Markets can yo-yo between overbought and oversold for months, but there are markets that get overbought and stay overbought, and vice versa. These markets are their own indicators—they tell a story.

Frank D. Gretz

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