The Halfway Point

361 Capital Market Commentary | July 8th, 2019

A standing ovation to anyone who felt maximum investment pain on the last Christmas Eve. Had you stuck to your guns, your portfolio likely had an incredible rip higher during the first six months of 2019. Stocks were inches from a -20% bear market drawdown, energy commodities had pulled in by 40% and the credit markets were in a disorderly, illiquid retreat. The Fed took note (along with a threatening POTUS’ sand wedge) and flipped their policy direction from one of tightening to one of loosening. The markets reacted quickly and any investor who doesn’t look at their fourth quarter statements wouldn’t have even noticed. For trend-following investors however, we welcomed Santa with high fives, but then wanted to shoot both St. Patrick and the Easter Bunny. Hats off to the Buy and Hold crowd, you won this round.

So, what will the second half of 2019 have in store for investors? Well just because the first half was great, doesn’t always mean the second half follows. We still have to size up where we are in the world. Stock prices still tend to follow earnings. And because of the global trade and tariff wars, sales are coming up short, margins are being impacted and companies are more reluctant to want to invest. This has and will continue to pressure earnings as we will see in the weeks ahead. With the S&P 500 trading at about 3,000 and the 2020 earnings estimate for the index at about $180, that place the market’s forward price-to-earnings ratio at about 16.5x. Historically, this is not at a discount. Of course in the other corner, you have the Fed looking to lower interest rates while the Market has already front run them by cutting rates by nearly 100 basis points. Cut the interest rate by 1% in any of your DCF models and what do you get? A much higher value.

So welcome to the newest stock market tightrope that investors are going to walk. Falling economic data and earnings being offset by falling interest rates. This game has been playing in Europe for years. U.S. bond market investors are betting on a 25-basis point rate cut in July and then one in September, followed by another 25-50 over the following six months. If the global economy could stop slowing and the U.S. could keep out of a recession, then maybe U.S. stocks could see a melt up as above 20x multiples take hold. But after 10 years of good times, could a soft landing be that smooth? Animal spirits have definitely run. We see it in the high percentage of loss-making companies going public. We see private equity takeovers at top valuations. We see aggressive non-bank lending on many asset classes, including art! Also, take note of the rapid growth in liquid investment vehicles holding non-liquid assets. It is probably time for a reminder of risk in the world, but the Fed and other Central Banks are also watching the markets closely. Rather than remind investors of irrational exuberance, they appear to be swapping the rum in the punch for moonshine.

If the Fed does soft land this big plane then great for them and all of our risky assets. I am just not sure the downside risk is worth the reach for the upside reward right now. I would rather see growth in sales and earnings to push stock prices higher. I know that I am going to be ‘Fighting the Fed’ but I think that I have the inverted yield curve, trade wars and high valuations in my favor. It also seems that the odds of a market/business unfriendly 2020 POTUS is rising.


First, a reminder that a great first half doesn’t always mean a great second half…

 

SPX Return Jan Thru Jun and June to End of Dec

Here is how the major liquid asset classes fared for the first half of 2019…

 

Large cap, technology, U.S. growth was the place to be. Oil had a big bounce from that ugly Q4 drawdown. Bonds lagged stocks but on a risk-adjusted basis, they did exceptionally well.

Asset Classes 7-5-2019

(thru 7/5/2019)

Onto a look at the major U.S. sectors…

 

A most interesting rank with some major Defensive groups like REITs, Staples and Utilities doing well. But once again, it was the Growth areas of Tech, Semis and Consumer Discretionary which led. Energy wore the Red Lantern for this stage of the race.

Sectors 7-5-2019
(thru 7/5/2019)

The market is moving interest rates ahead of the Fed…

 

Imagine a world where the Fed left the U.S. and decided not to raise interest rates. That would be a bad day for stocks and a great premise for a Netflix mini-series.

fedfundsrate

(J.P.Morgan)

Inverted yield curves happen for a reason and usually not for a good one…

 

@TihoBrkan: The most important of the Treasury yield curves — 3 month & 10 years — remains inverted and the inversion is getting deeper again.

Yield Curve - 3 Month Bonds

The markets sees lower rates continuing under Christine Lagarde…

 

Let’s see just how negative Europe will take their rates.

Tumbling German 10-year Bund Yield

(FinancialTimes)

Inverted yield curves and negative interest rates are happening because global growth is slowing and inflation is following…

 

Commenting on the survey, Olya Borichevska, from Global Economic Research at J.P.Morgan, said:

“The global manufacturing sector downshifted again at the end of the second quarter. The PMI surveys signalled thatoutput stopped growing, as inflows of new business shrank at the fastest pace since September 2012. This impacted hiring and business optimism, with the latter at a series-record low. Conditions will need to stage a marked recovery if manufacturing is to revive later in the year.”

(MarkitEconomics)

JPMorgan Global PMI Sectors: Manufacturing PMI


And global manufacturing data is slowing almost everywhere…

 

@adam_tooze: The downshift in manufacturing PMI has been a truly global phenomenon of the last 12 months. Great graphic from @DeutscheBank via @SoberLook

Manufacturing PMI

Speaking of slowing, Italy’s population shrink is putting itself into trouble…

 

Italy registered the lowest number of births on record last year, as well as the highest ever number of emigrants — two demographic trends that are weighing on the country’s weak growth prospects and fragile public finances.

Fewer than 440,000 children were born in Italy in 2018, a 4 per cent drop from the preceding year and the lowest number since the modern state of Italy was created in 1861, according to figures from Italy’s national statistics office, Istat…

Italy is set to be the only major European economy with a shrinking population in the five years to 2020, according to the UN. With 23 per cent of the population aged 65 or above, it has the second-largest share of old people in the world after Japan.

The demographic trends translate into a shrinking number of workers, Italy’s working-age population has fallen by 2 per cent since 2014…

“Italy faces the prospect of a severe demographic crisis,” said Jack Allen of Capital Economics. “This will weigh on the economy’s long-run growth prospects, and is a key reason why we think that Italy’s potential growth rate is around zero.”

(FinancialTimes)

Italy's number of births fall to record low

Back to the U.S., falling mortgage rates have not helped recent new home sales…

 

Does the Fed think that interest rates at zero percent would stimulate buying? We might soon find out.

New homes sold in US decline to weakest in five months

(Bloomberg)

Housing and auto sales are not getting help from low rates as affordability and consumer confidence is in retreat…

 

@lisaabramowicz1: Consumer confidence among younger & poorer Americans has deteriorated significantly in recent months, as pointed out & charted by DB’s Torsten Slok.

Comsumer confidence rolling over, in particular for young people and lower incomes

The track record for fighting the Fed is not good. But maybe this time it will be different?

 

@LeutholdGroup: Don’t fight the “Three-Gun Gooser:” Policy support is now coming from the Fed, the Treasury, and Bond Vigilantes—a rare combination. The simultaneous support of all three major policy guns has historically been productive for the stock market.

Average Annualized Future Six-Month S&P 500 Percent Gain


If you were building a long-term portfolio of stocks, you would be looking closely at value stocks…

 

If you know when the 13-year bull market in growth versus value will turn, please let me know

Growth's longest secular run on record

(NedDavisResearch)

If you were building a long term portfolio of stocks, you would also be looking closely at small cap stocks…

 

You will have to go back 17 years to find Small Cap valuations this cheap versus Large Caps.

Ratio,Leuthold Small Cap to LArge Cap Median Normalized P/E

(Leuthold Group)

You would also be looking closely at high dividend paying stocks to fill out your long-term basket of stocks…

 

High dividend stocks have underperformed both year to date. Probably a good place to dig to find names to replace some of those low yielding fixed income instruments if you can stomach the volatility and want to own the business model.

High Yielders Relative PE to the Market

(WolfeResearch)

But as the Leuthold Group reminds us, you have to be certain that you don’t buy dividend stocks blindly…

 

Needless to say, markets generally do not like companies cutting dividends. Chart 9 demonstrates the performance differential between those cutting dividends and other dividend-paying companies. At each quarter end, we form three portfolios, as in the prior charts: 1) companies cutting dividends (grey line); 2) companies raising dividends (dark line); and, 3) companies with dividends unchanged (dotted line). Cumulative performance is charted based on monthly returns.

From December 1985 to June 2019, companies that cut dividends significantly lagged, with annualized returns only at +2.8%. Companies keeping dividends unchanged recorded +12.1% annualized returns, and companies raising dividends returned +14.4%.

(Leuthold Group)

Cumulative Monthly Returns Of Companies Cutting Dividends versus Others


Greek animal spirits after this weekend’s elections has only been good news for their equity market…

 

@Schuldensuehner: Greeks vote in 1st parliamentary election since bailout end. #Greece’s ruling Syriza party faces a thumping defeat – paving the way for the return of one of the country’s most well-established political dynasties. Greece’s 5y yields trade way below US’s.

Greece 5y bond yields

But maybe just not Greek stocks, as European stocks just set their best first half in twenty-one years…

 

Investors looking away from U.S. valuations towards cheaper equity markets?

European stocks set for the best first-half returns in 21 years

(Bloomberg)

Valuations show that international stocks remain at a large discount to U.S. equities…

 

This chart looks at the Price vs. 10-year Average Earnings to help smooth out the peaks and troughs.

TopdownCharts


Even that one step down from emerging markets, called frontier markets, is putting on a bit of a show…

 

Kuwait moving up to EM status in 202 so Vietnam will take over as the largest component of FM.

@TihoBrkan: Frontier Markets are up 7 weeks in the row. $FM

MSCI Frontier 100 ETF

Away from the markets, I am going to conclude that Germany does not have an opioid problem because their citizens do not feel pain…

 

During the past four weeks, how often have you had bodily aches or pains? Never; seldom; sometimes; often; or very often?

About a third of Americans said they feel aches and pains “very often” or “often”—more than people in any other country. Australia and Great Britain came close, but in the average nation only about 20 percent gave one of those responses. In the Philippines or South Africa, just 11 percent felt pain that often.

(TheAtlantic)

Percent with physical pain often or very often

Grab this book and start paying more attention to your night time Fitbit…

 

I just finished this book and wanted to share it. For me, it is one of those books that will change my life for the better. I, of course, wish that I would have read it when I was 18 years old, but it was only written a couple of years ago and the area of sleep science is fairly new. We have had lots of studies over the decades and centuries that have given us great data points, but no one has tied all of the data together into such a comprehensive area of research. Hats off to the doctors and scientists who are now expanding these studies today. Who would have thought that the single key to being better in so many facets of life could come down to just getting more healthy sleep?

After reading the book this weekend, I went back to look at the reviews to see how others rated it. 4.5 on Goodreads. 4.6 on Amazon. 4.8 on Audible. So I am clearly not the only one who loved the book. This note from the publishers website best highlights the book:

In this “compelling and utterly convincing” (The Sunday Times) book, preeminent neuroscientist and sleep expert Matthew Walker provides a revolutionary exploration of sleep, examining how it affects every aspect of our physical and mental well-being. Charting the most cutting-edge scientific breakthroughs, and marshalling his decades of research and clinical practice, Walker explains how we can harness sleep to improve learning, mood and energy levels, regulate hormones, prevent cancer, Alzheimer’s and diabetes, slow the effects of aging, and increase longevity. He also provides actionable steps towards getting a better night’s sleep every night.

In thinking who I could best recommend this book to, I would include:

• All employees and their bosses
• Parents and especially expecting mothers
• Students, professors, college admissions staff and anyone involved in education
• Athletic coaches and their athletes
• All health care professionals. Especially those who work in ERs or intensive care units
• Anyone trying to master a new skill or study for an exam
• Any investor in the leisure, entertainment, or hospitality industry
• Homebuilders, electricians, HVAC technicians and technology device developers
• And of course investment banking interns

The very large health care company, Aetna, pays bonuses to those employees who get more sleep. I wouldn’t be surprised if someday soon they begin paying their insured customers lower premiums for also getting more sleep. Aetna is an early mover on the advantages of more, good sleep. If you are a customer or vendor to Aetna, go talk to them about why they are doing this.

Hopefully you will find this book as helpful to life as I have. Give it a try along with monitoring your REM and deep sleep on your iWatch or Fitbit.

Why we sleep

And here’s new scientific evidence that starting school later really does help teens get more sleep…

 

Delaying school start times has helped Seattle teenagers get a better night’s sleep.During puberty, circadian rhythm is altered, and sleeping and waking are typically delayed to a later time. This creates a problem: Adolescent wake-sleep patterns do not coincide with those of conventional social life, and teenagers rarely get the recommended eight to 10 hours of sleep each night.

In 2016 the Seattle School District changed high schools’ opening time to 8:45 a.m., 55 minutes later than it had been. Using wrist monitors, researchers tracked sleep onset and duration for two weeks in 10th-graders before and after the change in two schools, one economically disadvantaged.

Before the change, students got an average of six hours and 50 minutes of sleep a night. Afterward, they got seven hours and 24 minutes. Bedtimes before and after were unchanged.

(NYTimes)

And finally, join me for a 2019 Mid-Year Review Webcast…

 

I will be hosting a webcast with a Mid-Year Review of market events next Wednesday, July 17. We will discuss second quarter earnings, how continued trade tensions have affected investors, interest rates, and where I see opportunity in the market for the remainder of the year. We welcome topic suggestions when you register as well. Register Here. I hope you can join.

 

Mid-Year Review with Blaine Rollins

Catch up on past Weekly Research Briefings >