Terry Gardner, Jr., Author at C.J. Lawrence
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18 Dec C.J. Lawrence Weekly – Time to Rotate to Value Stocks?…Not So Fast

The likely passage of the U.S. tax reform bill, a bump up in the U.S. Fed Funds target rate, and better than expected economic data have all contributed to a reevaluation of equity investor sector and style weightings. As discussed in last week’s note, we got a glimpse of rapid sector rotation two weeks ago when the U.S. Senate announced it had the requisite votes to move on tax legislation. The shift from growth to value, or in this case, from less tax-advantaged to more tax advantaged, was fast and furious. But interestingly, much of that rotation reversed itself over the past two weeks, calling into question the permanency of the shift.

Periods of accelerating economic growth have historically been good backdrops for value stocks. The thesis holds that value stocks are more sensitive to changes in economic activity and typically trade at lower valuations, so they can be bought early-cycle at discounts, and outperform during the expansion. For “style box” allocators, the debate centers on whether now is the right time to undertake a meaningful tactical shift and overweight value stocks in equity portfolios. Rules-based investors, who continuously rebalance their portfolios according to preset asset allocation and style weight targets, have underperformed over the past several years as they sought to stay within their style guidelines while growth stocks vastly outperformed. Since 2010, the growth style, as measured by the S&P 500 Growth Index, has outperformed value, as measured by the S&P 500 Value Index, by over 50%. Mean reversion advocates suggest, therefore, that the environment is ripe for a reversal, and for the two styles to come back in balance. Technicians are echoing that call based on what they see as extended price action in many growth stock categories. But the fundamental picture paints a different story.

S&P 500 Growth / S&P 500  Value Relative P/E

S&P 500 Growth / S&P 500 Value Relative P/E

To categorize stocks as either growth or value, Standard and Poor’s uses formulas that score stocks on the following criteria: price/earnings ratio, price/book value ratio, price/sales ratio, three-year earnings growth, three-year sales growth, and price momentum. In some cases, a single stock may show up in both indices, but its weighting is often meaningfully different in each. At this stage in a bull market one might expect that growth stock valuations would far exceed those of value stocks, especially given the price differential experienced over the past several years. But interestingly, growth stocks look cheaper on a relative value basis than they have since 2013. Over the last 15 years, growth stocks have traded at a 1.21 relative P/E to value, having peaked at 1.44 and troughed at .91. That ratio now stands at 1.28 and has been declining since 2013. The same holds true for price/book value, return on equity, and price/earnings growth (PEG) relative comparisons. The technical set up may be giving a green light for a rotation from growth to value stocks, but historical fundamental valuation comparisons are telling growth weighted managers to stay put.


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Terms and Conditions

11 Dec C.J. Lawrence Weekly – Cash Can be King Even When You’re Bullish

Whether it’s the machines at work, or faster fingered traders, when the market shifts, it happens fast. The week after Thanksgiving provides a good example of how quickly sentiment can change, and how dramatically and demonstrably the market reacts to those shifts. For months, pundits have been calling for a market correction based on a variety of technical factors. While the broader market has failed to deliver that correction, the sector rotation experienced during the week after Thanksgiving was fierce. One can debate the catalyst that launched the rotation, but it seems to us that the U.S. Senate’s announcement that it had the requisite votes for tax reform, set the rotation in motion.

 

Within milliseconds of the headlines hitting the newswires, traders and machines bought the tax beneficiaries (domestic companies that would benefit from lower domestic corporate tax rates) and sold less tax-advantaged stocks. The rotation bid up many year-to-date price losers and sold the winners. The biggest gainers during the two-trading day period were Broadcasters, Department Stores, and Food Retailers, all of which had negative year-to-date price performance to that point. Between Friday and Monday those group indices were up 6.3%, 5.8%, and 3.9% respectively. The losers were Software, Semiconductors, and Health Care Suppliers which had all posted 30+% price gains year-to-date.

8%- 10% performance differentials between winning and losing groups were not uncommon during that two-day rotation. The broader market did not experience a correction, but many sectors and groups did.

 

While the market’s recovery from fundamentally driven corrections, like the recession of 1990-1991, the popping of the internet bubble and subsequent recession in 2000-2001, and the financial crisis of 2008-2009 can take months, and even years, its average response to technical moves can now be measured in days. After the “flash crash” in 2010, the S&P 500 needed only five trading days to recuperate. When Greek banks were closed in 2015 to stave off collapse, the S&P 500 needed just 11 days to recoup the 2.6% dip it experienced during that period. When the Brexit vote was tallied in 2016, the S&P 500 sold off 5.3%. It took just 10 trading days to retrace the decline. Many of the losers in the post-Thanksgiving Day rotation have now regained most or all their declines. The point is that corrections and rotations, and the reactions to them, during periods of economic stability and/or expansion, are happening within increasingly compressed durations. Investors looking opportunistically for attractive entry points to high conviction ideas now have narrow windows in which to execute their strategies. Having plenty of dry power available, and the ability to put it to work quickly, have become strategic imperatives in today’s fast-moving market.

 


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Terms and Conditions

04 Dec C.J. Lawrence Weekly – Improving Earnings Growth Forecasts Suggest the Bull May be Sharpening His Horns

Friday’s stock market roller coaster ride ended on a down note, but finished well off the lows of the day. Speculation about what former National Security Director, Michael Flynn, might say to the U.S. Special Prosecutor investigating his pre-inauguration activities, reversed the equity market’s previous risk-on posture, sent U.S. Treasury bond prices higher, the U.S. dollar lower, and gold higher. Then, around midday, reports circulated that the U.S. Senate had gathered the requisite votes to pass their version of tax reform legislation, and stocks quickly found a bottom and retraced their losses. The uncertainty surrounding the forthcoming Flynn testimony injects increased market risks and volatility in the coming weeks and months. But the economic and equity market backdrop remains positive, and continues to improve.

 

According to Tuesday’s release from the Organization for Economic Cooperation and Development (OECD) the global economy is now growing at its fastest pace since 2010, with the upturn becoming increasingly synchronized across countries. The OECD now forecasts 3.7% global economic growth in 2018. At home, the second estimate of third-quarter gross domestic product showed that the US economy grew at a 3.3% annualized rate, the strongest since Q3 2014. The New York Federal Reserve recently raised their 4Q17 GDP forecast to 3.8%, only a week after raising it to 3.2%. The globally synchronized economic expansion is intact, and that is good news for corporate profits. In the US., corporate tax reform may add additional fuel to what is already a crackling economic flame.

 

Forecasts now suggest that 2017 S&P 500 earnings per share (EPS) will be up over 10% from last year’s level. If that figure holds, it will be the first time that the Index has produced year-over-year double-digit earnings growth since 2011, as the economy climbed out of recession. According to estimates from FactSet, S&P 500 EPS are expected to grow 10.8% in 2018 and 10.0% in 2019. These figures do not include any benefit from corporate tax reform, as far as we can tell. If corporate tax rates are lowered to the 20%-22% range, those growth rates could potentially double. There have been only four periods, since 1960, when S&P 500 earnings grew at a double-digit clip for three consecutive years. With the exception of the 1972-1974 period, when the economy was headed into recession and investors were confounded with an inverted yield curve, stock returns averaged 14.7%, per year, during those periods. Many pundits are pointing to tax reform prospects and deregulation efforts as catalysts for the market’s 2017 rally. But accelerating GDP, at home and abroad, and corporate profit growth are the underpinnings on which durable bull markets are built. This one may be further from the top than consensus believes.

 


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

27 Nov C.J. Lawrence Weekly – Sector Watch: Consumer Staples’ Premium Valuation at Risk

The Consumer Staples sector has historically been viewed as a safe port in a market storm and a key component sector to diversified portfolios. The thesis has held that the consistency of sales and relatively high dividend yields of sector constituents are the defensive characteristics sought by investors in “risk-off” environments. After all, consumers don’t stop brushing their teeth or drinking beer during crisis, as the saying goes. In 1990 the S&P Consumer Staples carried the highest weighting among all sectors in the S&P 500 at 14.1%. The onset of Operation Desert Storm, and an ensuing recession, likely contributed to the sector inflows during that period. Today, the Staples sector weighting within the index stands at 8.1%, the lowest level since the 1970s.

The Staples sector consists of six sub-indices including, in descending market weight order; Beverages, Food and Staples Retailing, Household Products, Tobacco, Food Products, and Personal Care. Only the Food Products group is down year-to-date (-5.1%), with the broader sector up 6.1% on a price-only basis. Campbell Soup Company’s dismal earnings report, and subsequent stock sell off, has weighed on the group’s performance this quarter. The company reported a sales decline of 2% and stated that earnings were negatively impacted by higher carrot prices and higher transportation costs in the quarter. An important take-away from Campbell’s and other Staples’ company results may be that their top lines are not as resilient in the modern economy as they have been in the past. The Amazon affect, farm-to-table menu preferences, healthier eating habits, and the proliferation of private label goods are all trends that are chipping away at the incumbents’ once dominant franchises. That vulnerability could call into question the high multiples that investors have awarded Staples companies in the past.

The S&P Consumer Staples sector currently trades at 19.3x 2018 calendar year earnings per share estimates, according to FactSet, for an index whose constituents are expected to generate 3.5% sales growth and 7.5% earnings growth during the period. That compares to the broader S&P 500 trading at a 17.9x P/E multiple for 5% sales growth and 11% earnings growth. Over the past 15 years the S&P Staples sector has, on average, traded at a 12% premium to the S&P 500. That premium now stands at 8%, and risks compressing further as changing consumer preferences and behaviors, and the proliferation of mature industry disruptors threaten incumbent revenue streams. Staples constituent stock prices may continue to see inflows during periods of sector rotation and flights to safety, but it is hard to make a case that Consumer Staples stocks will continue to enjoy the premium valuations they have in the past.

 


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

20 Nov C.J. Lawrence Weekly – Talking Turkey – Deflation at Dinner

The recently released Producer Price Index (PPI) and Consumer Price Index (CPI) diverged in their October readings. The PPI rose to an annual rate of 2.8%, the highest annual rate since February of 2012. The CPI, on the other hand, barely rose for the month, and the annual rate bumped down to 2.0% from 2.2%. Most economists believe the CPI reading was more heavily influenced by the impact of fall hurricanes than was the PPI. The index readings are growing in importance as we approach the December meeting of the Federal Reserve’s Federal Open Market Committee (FOMC). Both are weighed heavily in the FOMC’s calculus of price stability and full employment, and ultimately in their monetary policy decisions. But while the direction of the data tilts towards inflation, Americans are experiencing deflation at the Thanksgiving dinner table!

This week, a vast majority of Americans will join together for the time-honored tradition of the Thanksgiving dinner. While many will disagree on politics, the appropriateness of Uncle Joe’s humor, and the dinner table seating arrangements, the overwhelming consensus is that turkey, with all the trimmings, is the mainstay of the Thanksgiving feast. The cost of that feast is projected to be down 1.5% from last year, according to the American Farm Bureau Federation survey. On average, a dinner for ten, consisting of a 16-pound bird, and all the trimmings comes in this year at $49.12. The cost of the dinner is the lowest since 2013, and the second-lowest since 2011, according the Farm Bureau’s director of market intelligence.

The big-ticket item, a 16-pound turkey, will cost American families $22.38 or $1.40 per pound. That’s a decrease of 2 cents per pound when compared to 2016. The shopping list for the Farm Bureau’s informal survey includes turkey, bread stuffing, sweet potatoes, rolls with butter, peas, cranberries, a veggie tray, pumpkin pie with whipped cream, coffee and milk, all in quantities sufficient to serve a family of 10. The Thanksgiving dinner menu has remained unchanged since 1986 to allow for consistent price comparisons. Foods showing the largest decreases this year in addition to turkey were; a gallon of milk, a dozen rolls, two nine-inch pie shells, a 3-pound bag of sweet potatoes, a 1-pound bag of peas, and a group of miscellaneous items including coffee and ingredients necessary to prepare the meal. Despite healthy supplies, prices for cranberries and cranberry sauce (a CJL favorite) rose in this year’s survey. Perhaps Amazon has not yet figured out how to disintermediate a cranberry bog! On behalf of the C.J. Lawrence team, Happy Thanksgiving to all!

 


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Terms and Conditions

14 Nov C.J. Lawrence Weekly – China’s and India’s Economic Growth Prospects are Good for Equity Prices

As the US House of Representatives and Senate work through the machinations of domestic tax reform, President Trump has been visiting the globe’s fastest growing region, discussing trade relations, and meeting with regional heads of state. His visit to China looks to have delivered few tangible new business opportunities for U.S. companies, but despite the challenges of operating there, many are making marked progress in the world’s most populous nation. Despite a relatively saturated smart phone market, Apple reported 40% shipment growth in iPhones to Chinese consumers in the most recent quarter. General Motors’ China business is up 2.1% year-to-date, but accelerated in October to 10%, led by a 36.1% surge in Cadillac sales. Starbucks had soft comparable store sales globally, in its recently reported quarter, but saw same store sales in China expand at an 8% clip. Revenue in the third quarter for YUM China, the spin-out from Yum Brands, grew 8% year-over-year. As expected, China domiciled firms performed even better. The grand-daddy of reports on the state of the Chinese consumer came over the week-end when Alibaba reported results from its “Singles Day.” Gross merchandise volume for the day climbed to $25.3 billion, up 39% from last year.

To be sure, China faces a new set of challenges as it attempts to manage its economy, encourage entrepreneurship and innovation, improve the living standards of a larger portion of its population, and enact reforms that protect the environment, all at once. From 1978, around the time economic reforms began, to 2011, China’s annual GDP expanded at an average rate of 9.9% per year. Between 2012 and 2016 that rate slowed to 7.2% and currently fluctuates between 6.7% and 6.9%, depending on the reporting service. But despite the deceleration in GDP growth, the Chinese consumer economy is still growing at 10% a year. According to a study conducted by the Boston Consulting Group, by 2021, China will add $1.8 trillion in new consumption. That is roughly the size of Germany’s consumer economy today, and more than one-fourth of all consumption growth of major economies.

China’s economic expansion continues despite a stubbornly high “Ease of Doing Business Index” ranking by the World Bank (released in October 2017). This year, China remains the 78th ranked country in the survey, down only eight spots in the past ten years. At the same time, China’s Asian neighbor, India, has made important strides in the rankings, improving 30 spots to rank 100 in this year’s survey. India’s rank has improved from 142 in only three years. Prime Minister Modi’s business, tax, and monetary reforms are given much of the credit for the improvement. Despite downward adjustment to near-term economic growth forecasts, as a result of the reforms, the IMF expects India’s economy to recapture its status as the world’s fastest growing economy in 2018. With a population size that is expected to surpass China’s by 2024, and a potential workforce set to climb from 885 million to 1.08 billion in the next twenty years, India’s economy represents another powerful engine of global economic growth. The prospect of both China’s and India’s economies growing simultaneously at ~7% for extended periods, alongside growing economies in the US and EU, lends considerable support to the global growth thesis, and is bullish for corporate profits and global equity prices.

 


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

07 Nov C.J. Lawrence Weekly – U.S. Economy is Supportive of Accelerating S&P 500 Top-Line Growth

It was not surprising that the U.S. Federal Open Market Committee decided to leave interest rates unchanged last week, but the pressure seems to be mounting for a December move. The third quarter GDP result of 3.0% was followed, last week, by an impressive ISM Non-Manufacturing Index reading of 60.1%. That was well ahead of the 58.1% reading expected by most economists. A reading above 50% indicates improvement. On Friday, the U.S. government reported that the economy added 261,000 jobs in October, despite the impact of hurricanes, and that the unemployment rate fell to 4.1%, the lowest level since December 2000. The backdrop for corporate sales and profit growth continues to improve.

For the past five years, top line growth for S&P 500 companies has averaged 2.3% while average annual GDP growth was 2.2% over the same period. Corporate managements employed a combination of debt refinance, share repurchases, and corporate efficiency initiatives to grow profit margins and earnings. Average earnings per share growth for the Index during the same period was 3.9%. With margins currently holding at high levels, and the economy increasing its pace, investor focus is returning to top line opportunities and market share growth to help identify portfolio winners.

Reported S&P 500 sales per share growth, for 3Q17, has been encouraging. With over 80% of constituents having reported results, S&P 500 sales are coming in 5.8% ahead of last year’s levels. That figure would be 4.6% if the Energy Sector was excluded. 66% of the sales reports have come in ahead of analyst expectations. That is well ahead of the five-year average of 55%. Leading in top-line growth are the Energy and Materials Sectors, both of which are coming off relatively depressed levels. Not far behind is the Technology Sector which is posting 10.2% sales growth to date. The Internet Software and Services and the Semiconductor and Semiconductor Equipment industry groups are bolstering the Index with 25% and 16% top line growth, respectively. Stocks in these sub-indices have reacted accordingly. Companies with leading edge products and services, serving large markets, and operating at attractive margins, that continue to grow their top lines at a double-digit pace are relative outperformers in any market. The Technology Sector includes companies that possess many, or all, of these characteristics, and should therefore remain a meaningful market overweight sector in growth portfolios.

 


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

30 Oct C.J. Lawrence Weekly – REIT Underperformance Likely to Persist

“Bond proxy” equities struggled last week as the benchmark U.S. 10-Year Treasury Bond yield climbed to 2.42% (from 2.06% in early September) reinforcing fears among bond proxy holders that rising interest rates will compete more competently for income seekers. For the week, the Telecom, Real Estate, and Consumer Staples sector indices were down 3.2%, 1.6%, and 1.5% respectively, versus the broader S&P 500 Index, which was up slightly. Sub-par earnings reports may have contributed to the declines, versus positive surprises across most other sectors. Energy stocks, typically high dividend payors, were also off for the week (-0.5%), despite oil prices that climbed 4.4% (WTI). 46% of REITs have reported 3Q17 results to date and 60% have delivered funds-from-operations (FFO) below street expectations.

Real Estate Investment Trusts were carved out of the Financials Sector Index by S&P Global in August of 2016. Investors in securities that track the Financials Sector Index have been rewarded by the split. Since separation, the total return on the S&P Financials Sector Index is 43.0%. The total return on the new S&P REIT Sector is -3.0% during the same period. Year-to-date, the total return on the Financials Index is 16.6% and the total return on the REIT Index is 7.3%.

The good news for REITs is that as the economy improves so too do real estate fundamentals. Thus, in general, REITs’ ability to grow cash flow and increase pay-outs improves as the economy ramps. The off-set is that REITs tend to be serial issuers of new debt, using leverage to grow, and their cost of capital is now on the rise. According to data provided by FactSet, the REIT Sector Index cash flow per share is expected to grow 5.1% in 2018 versus 12.3% for the S&P 500. Increasing competition from fixed income instruments, sub-market cash flow generation, and a surging sector emphasis on early cyclicals may contribute to continued REIT underperformance. We remain underweight REITs in our model portfolio.


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

23 Oct C.J. Lawrence Weekly – Goldilocks’ Porridge Made With Copper and Gold

A useful ratio in gauging global growth prospects versus global fear is the copper-to-gold price ratio. The ratio has become increasingly relevant over the past fifteen years as China, now the dominant swing factor in the global growth equation, has emerged as a massive copper consumer. At the end of 2016, China was responsible for almost 50% of global refined copper consumption, according to the World Bank. It is often said that “copper is the metal with a PhD in economics” because it is used so extensively in the industrial economy. Its uses include, but are not limited to, electrical wiring and circuit boards, plumbing, coin production, and metal alloy production. Thus, as economic activity increases, so does demand for copper. Reversals in copper price trends can be important signals for economists, as are significant price increases and decreases relative to other commodities.

Conversely, there are not many industrial uses for gold. In fact, about 78% of new gold production is used to make jewelry. The rest is added to stockpiles held by central banks, speculators, traders, and vaults containing trade collateral and bullion associated with gold-backed securities. Despite its’ limited industrial uses, ownership of the yellow metal is still widely viewed as a hedge against inflation and currency debasement, and for safety-seekers, as a safe-haven in times of geo-political and economic crisis.

At peaks and troughs, the copper-to-gold price ratio can identify important inflection points in the balance between growth and inflation, as it did at the trough in September of 1980 and at the peak in September of 2006. More recently, the ratio troughed in August of 2016, signaling a bottom in industrial commodity prices, and higher global economic growth prospects. The fact that the ratio has increased gradually suggests that the improvement in commodity prices has likely been driven by stronger unit demand, rather than broad based price inflation. Over the past forty years the ratio has averaged 5.8, and has averaged 6.3 over the past 17 years. It now stands at 5.4. Higher, but not inflated, copper prices and consumption are important underpinnings to global growth. The current ratio may be signaling that the current Goldilocks environment for stocks (low inflation and steady, moderate economic growth) may stick around.


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

16 Oct C.J. Lawrence Weekly – 2018 Earnings Estimates May Be Too Low

Third quarter earnings season kicked off last week with good reports from most of the big banks. JP Morgan Chase, Citigroup, and Bank of America all topped analysts’ top and bottom line forecasts. Despite the “beats”, the stocks of those companies experienced muted responses to their reports. It appears there may have been some selling of the news to counter the incremental enthusiasm for rising earnings and constructive outlooks. As we suggested in last week’s note, the Financials sector is projected to deliver solid double-digit earnings growth in 2018, and looks attractive on a relative valuation basis.

Earnings season provides a good opportunity to gauge corporate financial progress versus expectations and to revisit forecasts. The 3Q17 results may be a bit noisy due to the recent hurricanes but early indications suggest that corporate profits are on track. But with equity valuations close to the top of most historical ranges (discussed in our “Rule of 20” note on Sept 18, 2017) increased attention is being paid to the macro outlook and the rate of growth in corporate earnings, and what is being incorporated into those earning forecasts. The seemingly daily debate centers around whether the prospects for corporate tax reform and/or accelerating economic growth are baked into analyst projections. Our view is that neither is fully discounted, representing potential upside to current estimates.

On October 31 of 2016 the benchmark U.S 30-year treasury bond yield and the benchmark US 10-year treasury bond yield stood at 2.58% and 1.83% respectively. On Friday, they closed at 2.81% and 2.28%. While not dramatic, the upward moves in rates over the past twelve months suggest, in part, that the bond market believes there are greater prospects for inflation and growth than were expected last October. Yet, over the same period, analyst bottoms-up expectations for 2017 and 2018 S&P 500 earnings per share, as measured by FactSet, declined slightly. At the same time, our rough calculation of a move to even a 25% corporate tax rate, if achieved, could add an additional 9% to the index’s 2018 earnings per share. We’ll leave it to the policy experts to project if/when corporate tax reform becomes a reality, but if it does, and economic growth continues to accelerate, corporate earnings estimates will be revised upwards, putting a dent in the bear’s over-valued market argument.


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

09 Oct C.J. Lawrence Weekly – “Financials Add Fuel”

Financial stocks re-exerted leadership last week. After a strong 1Q17, the sector had faded into the middle of the performance pack among the broader S&P sectors. The S&P Financials Index is now up 13.1% for the year, ranking it 6 out of the 11 sectors. As we have noted in previous Weekly Comments, leadership from the financials is an essential ingredient to a meaningful equity market advance. The sector accounts for 14.7% of the weighting of the S&P 500 Index, eclipsed only by Technology, with a 23.2% weight.

The S&P 500 now has two of its top three weighted sectors leading in year-to-date performance. If Financials continue to outpace other sectors from here, and joins the top three, the trifecta could provide the broader index with added octane. Leadership from the heavyweights is important, but market participants should also note that the market’s advance has been, and continues to be, broad.

Nine of the eleven S&P sectors are in positive territory for the year, with six of them delivering double-digit gains. Only Telecom and Energy are in negative territory year-to-date, but Energy posted a positive 3Q17 return. Of the 105 S&P sub-indices, 75 are up for the year. Additionally, strength carries over into small capitalization stocks, which tend to do well when the economy gets in gear. The Russell 2000 is up 11.4% since mid-August. Leadership strength, combined with broad market participation and improving corporate fundamentals is typically a potent mixture for higher stock prices.


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

04 Oct C.J. Lawrence Weekly – “The Great Unwind Begins”

With the arrival of October comes the beginning of the Federal Reserve’s efforts to unwind its’ massive $4.5 trillion balance sheet. The Fed’s chair, Janet Yellen, has expressed her desire to keep the process running quietly in the background. The markets are hoping it plays out that way. Never in the history of the Federal Reserve has such an undertaking been attempted. The plan is for the Fed to stop reinvesting the money that current investments throw off, and then allow $6 billion in Treasury securities and $4 billion in mortgage backed securities to mature every month. At that pace, it would take over nine years to chip off 25% of the Fed’s balance sheet, following only that approach. The pace at which they sell additional securities into the open market will be closely watched for market impact.

On the other hand, household and corporate balance sheets look quite healthy. The recently released Flow of Funds data from the Fed shows household net worth up 1.8% at the end of 2Q17 versus the end of 1Q17, and up 9.3% on a year-over-year comparison. The increase has been driven primarily by higher real estate values and the appreciation in value of securities held by U.S. households. Household debt rose by 3.7% annual rate which is faster than last quarter’s annual rate but slower than the 4.4% pace in 2Q16. Importantly, the Fed’s Household Debt Service and Financial Obligations Ratio, which measures households’ ratio of interest expense to income, held at 15%. This ratio has averaged 16.5% since 1980 and has had peaks above 17.5% in 4Q86, 2Q01, and 4Q07. The current ratio suggests U.S. households are doing a good job keeping borrowing in check.

The Fed’s version of a U.S. non-financial corporate balance sheet shows that asset values of U.S. companies have risen faster than liabilities, creating a higher “net worth” for U.S. companies. Balance sheet cash levels were up 6.8% in 2Q17 from the year-ago period, and debt, as a percentage of corporate “net worth” is now calculated at 37.5%, down from 38.7% last year. While the absolute level of borrowing by U.S. corporations has risen, the interest coverage ratio of the S&P 500 is in-line with its 20-year average, suggesting that managements are doing a good job optimizing their capital structures without getting extended. With corporate and household balance sheets in relatively good shape, the market’s attention will likely stay focused on the Fed’s balance sheet unwind, keeping it in the forefront, rather than in the background, as Chair Yellen had hoped. So far, it appears that investors are optimistic that the Fed can pull it off.


Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy or sell securities, refer to terms and conditions page for a full disclaimer.


Terms and Conditions

27 Sep C.J. Lawrence Weekly – “The Prospect for Corporate Tax Reform May Be Keeping Bears in Their Dens”

The Prospect for Corporate Tax Reform May Be Keeping Bears in Their Dens

Senator John McCain’s indication that he would not support the Graham-Cassidy Health Care Bill threw more sand into
Washington D.C.’s gears last week. Week-end jockeying may make the bill more palatable to hold-outs, but the machinations
highlight the fact any new legislation faces considerable challenges in making its way through the current congress. Tax
reform looks to be next on the docket, with many Beltway watchers suggesting that corporate tax reform has a better chance of
success than individual income tax reform.

With top marginal corporate tax rates nearing 40%, KPMG lists the United States as having the highest corporate tax rates
globally, among developed countries. Of course, there are nuances in the comparisons, but there appears to be consensus,
even in Washington, that U.S. corporate rates need to be reduced. The timing of legislation is unclear, with most policy
analysts suggesting that 1Q18 or 2Q18 is most likely. We may see a framework for the legislation released this week.

The President has suggested the new corporate rate should be near 15%. While it is unlikely that new legislation will go that
far, even a reduction to 25% would have a meaningful impact on corporate profits. Roughly 70% of S&P 500 constituent
revenue comes from domestic sources. That ratio is higher in U.S. focused sectors like Telecom (96.2%) and Utilities (95.3%),
and lower in global sectors like Materials (53.1%) and Energy (57.6%). For the broader index, if U.S. pre-tax income was taxed
at a 25% rate, instead of the current 33% effective rate, the index could see a ~7.5% boost to net income. That would put S&P
500 EPS estimates (assuming a static share count) for 2018 slightly above $155. Under this scenario, earnings would be up 19%
in 2018 and the current price-earnings multiple on the index would be 16x 2018 estimates. That is a constructive backdrop for
stocks. The prospect of corporate tax reform may encourage hibernating bears to stay in their dens.

25 Sep C.J. Lawrence Weekly – “Inflation & the Rule of 20” – September 18, 2017

Higher gas prices and housing costs helped push last month’s Consumer Price Index (CPI) reading to 0.4%, versus the 0.3% most economists were expecting.  Interestingly, it was the medical cost category that restrained the index, growing at the slowest pace since 1965, according to the U.S. Bureau of Labor Statistics.  The higher-than-expected result helped raise the annual CPI rate to 1.9%.  That was welcome news for inflation seekers, but domestic inflation remains at historically low levels and below the Federal Reserve’s 2.0% target.  The U.S. 10-Year Treasury Bond responded to the report by tacking on 15 basis points of yield, finishing the week at 2.20%.

The rate of inflation is watched closely by equity investors.  In the early 1980’s, C.J. Lawrence Investment Strategist, and our current Chairman, Jim Moltz, pioneered the CJL Rule of 20 as a measuring stick for the relationship between the market multiple and inflation.  The simple calculation behind the Rule suggested that the sum of the S&P 500 price-earnings multiple and the annual rate of inflation should equal about 20.  The premise suggested that so long as inflation remains tame, the market multiple can climb and remain elevated.  Using Factset consensus S&P 500 earnings per share forecasts of $131 for 2017, and $145 for 2018, and a 2.0% CPI estimate, puts the current reading between 21.2 and 19.3, with a midpoint of 20.3.  That sounds about right.

The current result suggests that the market is certainly not undervalued, but that the valuation is also not stretched beyond historical norms.  In 25 out of the last 50 years, the ratio has held between 19 and 22.  Out of those 25 periods, only three experienced negative equity returns.  Two of those periods were the 1973-1974 period when the S&P 500 returned -14% and -37% consecutively in the bear market of the early 1970’s.  The other negative return period was 2008, at the onset of the credit crisis and subsequent recession.  The average return for the full 25 periods was 9.5%.  There are plenty of risks to equity prices, but the current market multiple, given the historical relationship with inflation, does not look to be close to the top of the list.

Terry Gardner is a Senior Managing Director and Portfolio Strategist at New York based C.J. Lawrence.

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