US Strategy Weekly: Initiating an SPX target for 2020

Lowering EPS Estimates but Valuations Remain Healthy

The market hit our 2019 target of SPX 3110 this week and this inspired us to review our price targets, earnings and assumptions for 2019 and 2020. With third quarter earnings results for the SP500 now 90% complete, our second half EPS estimates appear high. Bringing our third and fourth quarter estimates more in line with the S&P Dow Jones consensus benchmark, our calendar 2019 earnings forecast falls from $167 to $160 and our 2020 earnings estimate for the SP500 eases slightly from $186 to $184.

Next, we put our new estimates into our valuation model which is stress-tested for 2020 inflation of 2.6% and a 10-year Treasury bond yield of 3.8%. Despite newly lowered earnings estimates and inflation and interest rates well above our expectations, our valuation model suggests an SPX 2020 range of SPX 2800 to 3450. We prefer to remain on the conservative side and are initiating a new 2020 SPX target of 3300. Should a trade agreement materialize in the next six months, this target would likely be revised. See page 11.

It is worth pointing out that the SPX has been hugging the upper end of our model’s projected fair value range since late 2016. This does not surprise us since an environment of low and steady inflation supports a higher PE multiple. Assuming inflation remains benign, one could expect the SPX to continue to trade in the upper half of the fair value range. The top of this range in late 2020 implies a move to SPX 3450.

Conversely, if the UK fails to solve its Brexit issues, if impeachment investigations wear on investor sentiment, or if unexpected events shock the market, our model suggests equities have substantial valuation support at the SPX 2800 in 2020.

Quarterly EPS Results

IBES Refinitiv is currently forecasting third quarter SP500 earnings to decline 0.4%. However, excluding the energy sector, the earnings growth estimate increases to 2.2%. Of the 461 companies in the SP500 that have reported earnings to date for 3Q19, 74.6% have reported earnings above analyst estimates and 18% missed estimates. This is comfortably above the long-term average of 64.8% and the average of 74.1% seen in the prior four quarters. In a typical quarter, 65% of companies beat estimates and 20% miss estimates. Third quarter revenue is expected to increase 3.8% from a year ago and excluding the energy sector, the revenue growth estimate rises to 5.2%. The healthcare and utilities sectors have the highest earnings growth rates for the quarter at 9.4% and 6.7%, respectively; and the energy sector has the weakest anticipated growth rate at negative 37.8%. Third quarter earnings comparisons for energy help to explain the sector’s underperformance in 2019. However, the good earnings performance by both healthcare and utilities make their price performance less understandable. Both sectors rank just above energy on a year-to-date basis. See page 16.

Economic Reports Support a Dovish Fed

A medley of data was reported this week on retail sales, inflation and trade and overall, it supports a dovish Fed, in our view. Retail sales rebounded modestly in October after falling in September. More specifically, sales rose 0.3% after declining 0.3% the previous month. On a year-over-year basis, total retail sales rose 3.1% In October versus a 4.1% gain in September; however, October sales could have been hurt by Hurricane Dorian, weak iPhone sales and the General Motors (GM – $36.38) strike. October’s sales, excluding motor vehicles, rose 2.8% YOY. See page 3. On the whole, this report was neutral in our view.

The US-China trade conflict has been a major topic of concern for investors, yet it has only made a small dent in the total US trade. The trade deficit is running at an annualized $862.7 billion as of September versus $874.8 billion in 2018. Department of Commerce data shows the trade deficit is currently at an estimated 4% of current GDP, while the Census BOP basis, shows the 12-month running ratio to be 3.1% of GDP. Merchandise trade data is available on both custom-based trade statistics and on a balance of payments (BOP) basis. Note that data on services is only available on a BOP basis, which means the real trade deficit is apt to be closer to the BOP 3.1% of GDP which includes services. See page 4.

While headline trade numbers have not changed dramatically, trade is changing beneath the surface. China is no longer our top trading partner and as of September 2019 fell to third place behind Mexico and Canada. Nevertheless, China continues to have the largest trade deficit with the US at $263 billion year-to-date, which is 3 ½ times larger than Mexico which ranks second with a $76 billion deficit. Ironically, the trading partner with the largest surplus with the US is Hong Kong at $20.3 billion. See page 5.

The inflation backdrop is favorable for monetary policy. PPI final demand prices rose 1.0% YOY in October, while intermediate processed goods prices fell 3.7% YOY. CPI rose a benign 1.8% YOY in October however core CPI rose 2.3% YOY. The rise in core prices was due primarily to services. See page 6. The trade war has not generated the rise in consumer prices most economists predicted for 2019. In fact, import prices, excluding petroleum products, fell 1.5% YOY. The effective fed funds rate of 1.55% is comfortably above September’s PCE index of 1.3% YOY. See page 7.

But we remain bothered by the pace of inflation seen in the medical care sector where prices rose 4.3% YOY in October. All components of healthcare rose, but the 20.1% YOY jump in health insurance is most disturbing. See page 8. This could be a cyclical pricing cycle for insurers, or it could be in anticipation of a new rule requiring more transparency in hospital and insurance pricing. In a new executive order, the Trump administration is requiring hospitals to disclose for the first time the prices they negotiated with health insurers for a wide range of services, as well as the prices they charge patients who are paying with their own money. Hospitals will also be asked to create a list of 300 so-called “shoppable” services that patients can use, targeted to more elective services where customers could have the opportunity to shop around. The Trump administration is hoping a little bit of sunlight could help disinfect the high costs of US healthcare.

Technicals Continue to Support Equities

The technical scoreboard has not changed much in the last week, although the NYSE cumulative advance decline line made a new high on November 15 which now confirms the ongoing advance in the popular indices. The Russell 2000 index continues to lag behind the popular indices, but like last week, it is close, but has not yet broken above the top of its recent trading band of 1450-1600. A breakout would be bullish. An uptrend line that has supported the DJIA since the 2016 low was recently tested successfully and this strengthens the longer-term bullish trend. See page 12. The 25-day up/down volume oscillator is 1.76 and neutral after being in overbought territory for five of six trading sessions last week. This was the fifth consecutive overbought reading of 2019 and it followed an overbought condition that lasted for eight of ten trading sessions between September 10 and September 23. Consecutive overbought readings denote steady buying pressure and only appear in a bull market cycle. In sum, this is a positive sequence in this indicator.

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Little things mean a lot… even divergences.

DJIA:  27,782

A year ago last October, it took only three days of higher highs in the Dow and negative advance/declines to unleash the havoc that was last year’s fourth quarter.  The backdrop here, however, seems much different.  The Advance/Decline Index now is coming off a new high just two weeks ago, and we don’t have the divergences in the FANG stocks, which then were the leaders.  You will recall, too, monetary policy then was pretty much the opposite of now.  Still, the reality is that against the backdrop of higher highs in the market averages, the A/D numbers have been negative 6 of the last 8 days through Thursday.  Any negative consequences here would seem short term in nature, given the overall backdrop.  And, a couple of good days—2-to-1 up days—would resolve the problem.  This somewhat sudden change in the A/D numbers seems a function of the weakness in rate-sensitive shares like the Utilities and REITs, and the shift to Cyclicals versus Staples.  That said, we’ve learned not to make excuses for the numbers.

It’s out of habit and a history of some success that we measure divergences in the A/D Index against the Dow Industrials.  Over time, Dow or S&P, it doesn’t much matter.  It is, however, a little more interesting these days given Boeing’s (367) weight in the Dow and its volatility.  With the Dow down 100 points the other day, Boeing news left the Dow unchanged in a heartbeat.  Much the same happened Wednesday when Disney (147) news took it from down a point to up ten points.  While the Dow gained some 90 points on the day, the A/Ds were down all day, by about 300 issues at the close.  The distortion was such that DIS accounted for almost 75% of the Dow’s gain, while only 14 of the 30 Dow stocks were positive.  Divergences are never good, but we would rather see them come about because of some specific stock or two, versus the entire market average, in this case the Dow.  And we weren’t complaining when Boeing was having its problems, helping the A/Ds outperform most days.

The NASDAQ, as it happens, has some problems unique to itself.  To get the laughter out of the way, the problems would be what are affectionately called the Hindenburg Omen and the Titanic Syndrome.  These occurred in mid-July, preceding a pullback then.  At the time, they happened both on the NYSE and NASDAQ, so for this time it’s only the NASDAQ.  As you might imagine, there are guidelines more than rules for these indicators and beauty, or in this case ugly, can be in the eye of the beholder.  The basic tenet, as we see it, is a market at or near its high, showing a large number of both 12-month New Highs and 12-month New Lows.  The concept is that of a market showing strength in the Averages, while underlying that strength is a far less supportive picture in terms of the average stock.  Instead of A/Ds, this is another way of looking at divergences.  Because of noteworthy failures, these warnings rarely are taken seriously, but there have been some noteworthy successes.

Utilities in part are the reason for lagging A/D numbers.  They peaked at the end of September and there are a lot of them.  The stocks, of course, had had a big run and seemed vulnerable both in terms of valuations and technically.  At the end of September, 60% of the Utilities made a new high, typically as good as it gets.  At the other end of the spectrum has been Technology, as measured by the SPDR ETF (XLK-87).  Outside of some lagging Software shares, Tech has performed well.  When it comes to XLK, there’s little mystery—Apple (263) and Microsoft (148) are its two largest positions.  Looking at those charts, it’s a wonder the ETF hasn’t done better.  Then, too, we all have our problems.  When it comes to the XLK, it’s Cisco (45).  Despite a “golden cross,” the Russell 2000 remains in its overall trading range.  What is a bit surprising there, the Russell is somewhat a proxy for Regional Banks, and they still act well.

Sometimes a cigar is just a cigar, and sometimes lagging A/Ds is just rotation.  The S&P is making new highs, but what’s getting it there keeps changing.  Remarkably, there have not been back-to-back down days in the S&P since early October, but making money hasn’t been easy.  If the U.S. and China can’t agree on farm purchases, what can they agree on?  Maybe it’s trade war fatigue, but the market seems focused on other things, most likely what Industrial stocks say is a better business backdrop.  It’s certainly not focused on the public impeachment, leaving that as a possible negative surprise.  That Walmart gave up its breakout and a 4-point gain Thursday makes the market look that much more tired.  For the big deal we’re making out of the lagging A/Ds, you have to remember the Index made a new high just two weeks ago.  The worst day during this period saw 1500 stocks advance, not exactly big-time selling.  Market corrections come in two varieties, price and/or time.  All this could be just the latter.

Frank D. Gretz

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