361 Capital Market Commentary | November 4th, 2019

You can sit and reflect all that you want, but it is easy to see that the markets are continuing to shift right now. We had a lot of news and datapoints hit the market last week, with both good and bad news continuing to reward the markets. Even the Fed sees something happening with their move to a neutral stance after a third rate cut. So are bonds done? It sure feels like it. Just look at cyclical stocks breaking out while value laughs at growth. This wouldn’t be happening if the world economy was going to take another leg lower and break the credit markets. Now even valuation-depressed international equities are leading U.S. stocks higher. Today, Mercedes Benz (Daimler) cut their 2020 earnings outlook today by 10% and the stock finished higher. This is not a bear market signal.

Meanwhile, 50+ P/E multiple growth stocks cannot get out of their own way. Investors don’t want to own Silicon Valley’s promises anymore when they can own 10-15 multiple industrial stocks that have not outperformed in a decade. Low valuation healthcare stocks have also been given life this month while the outlook for Senators Warren and Sanders slip in the Presidential polls. Healthcare for all at a $30-50 trillion price just won’t win an election. Ask Boomer.

The economic data and earnings releases and outlooks were mixed last week but the markets still ended higher. The Chicago PMI was a train wreck but contrarians were tripping over themselves to buy stocks because it has worked in the past. Q3 GDP was only +1.9% and it is still being led by consumer spending which was +2.9%. Non-farm payrolls were better than expected even though 1 out of 3 jobs created was in the restaurant industry. Even China posted some green shoots last week which was very different from the recent trends.

So let’s watch and see how this market move plays out into year end. For once, the hedged investors have an opportunity to make money being both long and short assets. Let’s see if this asset and factor rotation will continue through the rest of 2019, so they can put up some numbers ahead of the long-only crowd.

Finally some new highs after 4 months of rejection…

S&P 500 Large Cap Index

And gone is the outlook for future Fed rate cuts…

“I think we would need to see a really significant move up in inflation that’s persistent before we would consider raising rates to address inflation concerns.”
Fed Chair Powell

Fed Funds Futures

The sentiment for the stock market remains out of favor according to Merrill Lynch…

Merrill Lynch Sentiment Indicator

And we know that long-term profit growth estimates have been crushed…

US long term profit growth forecasts have tumbled

We made it through another volatile earnings period, but this time the “misses” were bought, not sold…

US stock price reaction to quarterly EPS beats/misses

Morgan Stanley thinks the outlook for a balanced U.S. portfolio will be challenging…

A traditional 60/40 portfolio mix of U.S. stocks and government bonds is likely to have returns over the next decade that fall to “close a century low,” concludes a research note by Morgan Stanley…

A 10-year annual return of 2.8% over the next decade for a portfolio that is 60% stocks and 40% bonds is very unsettling.

Back in the early 1980s, when rates were much higher, such a portfolio yielded double-digit returns, according to Morgan Stanley. After declining to around 4% in the early 2000s, returns had been moving up again to roughly 6%. But the returns are expected to diminish going forward.

The report does see higher expected returns in several markets outside the U.S. Those include emerging market equities, which they forecast will have an annual return of 7.9% over the next decade on a real basis. They expect European stocks to return 5.4% annually, and Japanese stocks to reach nearly 6% a year.


Portfolio Return

The Chicago PMI was an ugly datapoint last week…

Tweet from @RBAdvisors

But on a more global basis, have things stopped getting worse?

Global Manufacturing PMIs

RenMac’s data suggests that now is the time to have exposure to the S&P 500…

Bottom line, when the data is at its worst, the market will lead the catalysts and outlooks higher.

Tweet from @RenMacLLC

And credit still has your back…

Credit Spreads
(HSBC/The Market Ear)

For seasonal players, the market has entered the best 6-month window of the year…

Average S&P 500 Index Gain

Also, the stock buybacks will restart now that the bulk of earnings are behind us…

Speaking of buybacks, look at this chart of how buybacks have dented Apple’s shares outstanding by 30%.

Tweet from @TSOH_Investing

A visual glance of the October returns shows the outperformance in international equity returns…

And it was both developing and emerging markets. The stocks are cheap and all they needed was a catalyst. Some would say that it is due to the slowdown in the accelerating declines while others would say it was a reversal in the bond markets. But as long as credit and loan quality doesn’t deteriorate, stocks could keep their bid.

Asset Class Performance Last 12 Mths

Keep an eye on the emerging markets as they look to challenge those last two highs…

iShares MSCI Emerging Markets ETF

The Fed’s Clarida doesn’t think we are in the ‘Late Cycle’…

Tweet from @TheStalwart

The market for cyclical stocks agrees with the Fed’s Clarida…

MSCI Cyclicals/Defensives Ratio

Now, will value stocks finally push around growth stocks?

Large Growth vs Large Value

High dividend stocks also have a score to settle…

Dividend growth pessimism is evident in the valuation of high dividend yield stocks. On a sector-neutral basis, the 20% of S&P 500 companies with the highest dividend yields (median of 4.1%) currently trade at roughly half the consensus forward P/E valuation (13x vs. 24x) of the 20% of stocks with the lowest yields (median of 0%). This P/E multiple gap has recently narrowed but remains close to the widest gap in at least 40 years (see Exhibit 3). Other metrics, such as EV/Sales and Price/Book, also show high dividend yield stocks trade at an unusually large valuation discount relative to stocks with low dividend yields.

(Goldman Sachs)

Near-record valuation gap between high and low dividend yield firms

I was surprised to see how long people hang onto their iPhones…

If/when 5G does deliver, that could be one big replacement cycle for all phone owners, not just Apple.

Sanford Bernstein Quote & Chart

Money-losing businesses of any type eventually need to become profitable…

What’s hurting these high-concept, high-valuation tech phenoms is not the global-slowdown and trade-friction themes that pressured the broad market in late summer.

It is a stark reassessment of businesses that purport to be software companies and aspire to software valuations, but don’t enjoy the lush margins and effortless economies of scale that software can achieve. Because they are doing the hard stuff: coordinating meal deliveries, shipping couches across the country, for example.

David Sacks, co-founder of Craft Ventures and a former PayPal COO, notes in a recent Medium post, “When you’re losing money on every transaction, you can’t make it up in volume. In fact, the more revenue that a businesses with negative unit economics generates, the more money it loses… There is now a painful readjustment happening as many of these companies try to fix unit economics and bring their cost structures in line.”


Tweet from @ReformedBroker

The Dem boss lays out her roadmap to take the White House. Senators Warren and Sanders aren’t using it.

“As a left-wing San Francisco liberal I can say to these people: What are you thinking?… You can ask the left — they’re unhappy with me for not being a socialist.”

Speaker Nancy Pelosi is issuing a pointed message to Democrats running for president in 2020: Those liberal ideas that fire up the party’s base are a big loser when it comes to beating President Donald Trump.

Proposals pushed by Elizabeth Warren and Bernie Sanders like Medicare for All and a wealth tax play well in liberal enclaves like her own district in San Francisco but won’t sell in the Midwestern states that sent Trump to the White House in 2016, she said.

“What works in San Francisco does not necessarily work in Michigan,” Pelosi said at a roundtable of Bloomberg News reporters and editors on Friday. “What works in Michigan works in San Francisco — talking about workers’ rights and sharing prosperity.”

“Remember November,” she said. “You must win the Electoral College.”


Meanwhile, Phil Gramm pulls out the facts for Senators Warren and Sanders…

The published census data for 2017 portray the top quintile of households as having almost 17 times as much income as the bottom quintile. But this picture is false. The measure fails to account for the one-third of all household income paid in federal, state and local taxes. Since households in the top income quintile pay almost two-thirds of all taxes, ignoring the earned income lost to taxes substantially overstates inequality.

The Census Bureau also fails to count $1.9 trillion in annual public transfer payments to American households. The bureau ignores transfer payments from some 95 federal programs such as Medicare, Medicaid and food stamps, which make up more than 40% of federal spending, along with dozens of state and local programs. Government transfers provide 89% of all resources available to the bottom income quintile of households and more than half of the total resources available to the second quintile.

In all, leaving out taxes and most transfers overstates inequality by more than 300%, as measured by the ratio of the top quintile’s income to the bottom quintile’s. More than 80% of all taxes are paid by the top two quintiles, and more than 70% of all government transfer payments go to the bottom two quintiles…

Any debate about further redistribution of income needs to be tethered to these facts. America already redistributes enough income to compress the income difference between the top and bottom quintiles from 60 to 1 in earned income down to 3.8 to 1 in income received. If 3.8 to 1 is too large an income differential, those who favor more redistribution need to explain to the bottom 60% of income-earning households why they should keep working when they could get almost as much from riding in the wagon as they get now from pulling it.


How Redistribution Works

At 14:1 odds to win it all, I think Mayor Pete is the best bet on today’s White House Racing Form…

Tweet from @bespokeinvest

The cost to buyout a college football coach’s contract has risen to 918 full ride scholarships…

Imagine what hundreds of additional Seminole college grads could do for both the Tallahassee and Florida economy.

FSU raised about $20 million in private donations to buy out what was left of Taggart’s contract, sources told ESPN’s Mark Schlabach. However, an FSU official denied that the money was raised for Taggart’s buyout.

Under the terms of Taggart’s six-year, $30 million contract, FSU’s athletic department will owe him 85% of his remaining compensation through Jan. 31, 2024, which is between $17 million and $18 million. The Seminoles also paid Oregon a $3 million buyout when it hired him away from the Ducks in December 2017, as well as the remaining $1.3 million of a buyout that Oregon owed South Florida when it hired him in December 2016.

In both seasons under Taggart, FSU significantly underperformed its expected results from the Football Power Index. At the start of 2018, FSU was ranked 18th in FPI; it finished 67th. This season, it was ranked 22nd at the start of the year; the team is currently 46th.


Finally, Waffle House is amazing…

It’s difficult to imagine how Waffle House attracts good managers—let alone operates a viable business. But the fascinating thing is that somehow, it does. The company declined to disclose its financials, but most estimates of its annual revenue exceed $1 billion. Waffle House says the share price of its employee-owned stock, which is based on its audited book value, has increased every year for the last 57. The company says it typically opens about 50 new restaurants a year.

In reality, these statistics attract plenty of managers. And because Waffle House promotes exclusively from within, the good ones are rarely inclined to leave. “It’s probably one of the last places where you seriously have the ability to build wealth,” says Randy Coleman, a former Walmart store manager who defected to Waffle House in 2005…

Beneath the folksiness, however, there’s a strong current of calculated capitalism. Tipped servers know that being a team player helps them land lucrative shifts. And entry-level managers earning as little as $45,000 know that if they persevere for five years, they’re liable to receive stock options and earn as much as $117,000.


Picture of a Waffle House
(Photo: Steve Allen/Alamy)

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