Terry Gardner, Jr., Author at C.J. Lawrence
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16 Jul C.J. Lawrence Weekly Market Comment – Healthy Corporate Fundamentals and Stalled Bond Yields Keep the CJL Market Monitor in BUY Territory

The C.J. Lawrence Market Monitor was created in the early 1980s to measure the attractiveness of the stock market. It calibrates the relative appeal of stocks versus fixed income, and tests the internal technical health of the stock and bond markets.  Over the Market Monitor’s 38-year history, it has been a useful asset allocation tool.  While not developed as a timing model, the SELL signals generated prior to the stock market crash of 1987, and again in the period leading up to the bursting of the internet bubble in 2000, are two of the Market Monitor’s more notable measurements. It went to a HOLD reading pre-financial crisis in 2007 but became more positive when the Federal Reserve instituted their 0% interest rate policy in 2008-2009 during the credit crisis.  The Market Monitor’s current reading is “BUY”, with a numerical score of +1, the lowest reading in BUY territory, on a scale of -6 to +6.   As the Fed has lifted the Fed Funds target rate, the year-over-year interest rate rate-of-change models have weighed on the Monitor score.  But despite rising rates, the cash flow and earnings yields on stocks continue to outshine the relative appeal of bond yields.

The Market Monitor consists of six components.  Each is constructed to generate individual BUY, HOLD, and SELL signals.  Two of the components are driven by equity fundamentals, two by the direction and rate-of-change in short and long interest rates, and two by technical and market breadth indicators.  The interest rate signals were less useful post financial crisis, as rates fell to historically low levels and even small basis point changes had a meaningful rate of change impact.  But the interest rate models are beginning to come back into balance as rates are normalized.  At this point in the business cycle one might expect that interest rate models would be solidly negative for stocks.  But interestingly the Long Bond Model is in neutral territory.  The current yield on the benchmark U.S. 30-Year Treasury bond is 2.93%.  In May of this year, the yield reached 3.21%.  Historically, during rate tightening cycles, this component has generated a negative signal.

The Market Monitor’s positive stance on stocks is understandable given the strength in equity earnings and cash flow generation.  As 2Q18 earnings results are recorded, the related Monitor components are likely to strengthen further.  Thus, the ongoing battle being waged in the markets, as reflected in our Market Monitor reading, is between the strength of equity fundamentals relative to changes in the risk-free rate of U.S. Treasury bonds.  Asset allocators, increasingly worried about the veracity and length of the current bull market in stocks, may find comfort in the CJL Market Monitor’s positive stance.  A breakdown in equity market technical metrics and breadth would certainly weaken its conviction, but the improving fundamental backdrop will likely keep the Market Monitor favoring stocks for the balance of 2018.  We continue to overweight equities in balanced portfolios.

C.J. Lawrence Market Monitor

C.J. Lawrence Market Monitor

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.


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02 Jul C.J. Lawrence Weekly Market Comment – New S&P Sector Construct Could Create Volatility this Summer (Repost from March 12, 2018)

As we mentioned last week, we will not be publishing a new WMC this week. However, since discussion of the S&P 500 sector reconstitution is heating up, we thought we’d resend the piece we wrote about the topic back in March.

Why should you care? The new sector structure has meaningful implications for investors who invest at the sector level. But the reconstitution could also create some near-term volatility at the market level. Over the next several weeks, investors, traders, and advisors will reposition portfolios to conform to the new sector definitions and constituents. As we pointed out in our March piece, in some cases, the sectors will be meaningfully different. For example, heavily weighted Facebook and Google will no longer be “Technology” stocks. They will be included in the new “Communications Services” sector. Investors who used to buy the Telecommunication Sector index for the dividend yield, may have to look elsewhere as the yield drops from around 5.6% to around 1.2% due to the new construct. Our view is that the adjustment period could be bumpy.

Followers of the CJL Weekly Market Comment are familiar with our practice of looking below the broader market indices to compare the fundamentals, price performance, and valuations of the 11 different S&P Sectors, 24 Industry Groups and, 157 Sub-Industries. This style of analysis dates back to the original C.J. Lawrence. For decades, the firm published tables showing the relative sector winners and losers of market share within the S&P 500 Index. This long-term lens has provided an important perspective to investors utilizing a top-down approach in their securities analysis. Indeed, we continue to consider the changing landscape highlighted in our Sector Shifts table in our investment process.

Standard and Poor’s Corporation, (now S&P Global, Inc) was the developer of the original indices, and is still today the owner, vendor, and licensor of the index data. The indices follow the Global Industry Classification Standards (GICS), a standard developed in 1999 by S&P and MSCI, which allows for the consistent categorization of individual securities. This categorization is relevant because it determines which securities are included in funds and products that track the indices and sub-indices. Periodic index reconstitutions have become important market events as companies are added to, and removed from, the various indices, while derivative product manufacturers react to the changes. One of the larger definitional changes undertaken by S&P in recent years was the separation of the REIT stocks from the Financials sector in August of 2016. Since the split, the Financials Sector Index has delivered a 59.5% total return, while the new REIT Sector Index has produced an -5.7% return during the same period. The post-split impact has been meaningful for index trackers. In November of 2017 S&P announced another major change, to take place this year.

In September, S&P will broaden the Telecommunication Services sector index and rename it Communication Services. Importantly, S&P will remove social and interactive media companies from the Technology sector and add them to new Communications Services sector. The same shift will take place for interactive home entertainment companies. Stocks impacted by the move include the third and fifth largest market capitalization companies in the S&P 500, Alphabet (GOOGL) and Facebook (FB), as well as widely held gaming companies Activision Blizzard (ATVI) and Electronic Arts (EA), among others. Additionally, Broadcasting, Cable and Satellite, Movies and Entertainment, and Publishing stocks will be transferred out of the Consumer Discretionary Sector and will also be added to the Communications Services sector. Traditional hardware and software companies will now dominate the Technology Sector index. To help ease the transition, S&P Global is considering publishing tracking indices that mimic the new construct. But the index changes could ultimately lead to increased volatility this coming summer and fall as index trackers adjust their holdings, and index algorithm creators and traders re-write sequences and code to account for new trading patterns and conditional relationships. There is a frequently run TV and radio commercial that poses the question, “Why own single stocks when you can own the entire sector?” This realignment may be one of the reasons why.

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

 

25 Jun C.J. Lawrence Weekly – Down but Not Out…Industrial Stocks Warrant a Closer Look

Investors in industrial stocks are likely disappointed with the sector’s year-to-date price performance.  The S&P Industrials Sector Index price is down 4.3% year-to-date despite being up 5.1% over the last year.  The sector became a market darling in late 2017, but lost its luster in early 2018 as fears of international trade battles percolated.  According to FactSet data, over 36% of sector revenues come from outside the U.S.  Adding to industrial stock owners’ anxiety is a comment made by Caterpillar’s (CAT) management during their 1Q18 earnings call, which they have since retracted, suggesting that the current economic environment could be as good as it gets.  That comment, as off-the-cuff as it sounded, stoked investor fears that sector earnings were approaching a cyclical peak, and catalyzed a re-rating of industrial shares.  The sector is now down over 9% from its January high.  But a closer look at sector fundamentals, and the progression of sales and earnings forecasts, suggests that industrial stocks may have been prematurely discounted.

In early 2018, analysts recalibrated earnings forecasts to incorporate the impact of corporate tax reform.  Prior to the adjustment, the 2018 earnings per share forecast for the S&P Industrials Sector Index was $32.73.  By the end of March, the tax reform-adjusted estimate was $36.00.  On average, analysts expected that tax reform would increase annual earnings per share by ~10%.  That was a healthy boost to earnings that were already expected to grow by 9.4% from 2017 levels.  Sector earnings per share are now projected to grow 18.6%, 12.7%, and 11.7% for 2018, 2019, and 2020 respectively.  Bears have seized upon the downward slope of the growth curve, suggesting that earnings growth has peaked and that the group therefore deserves a lower price-earnings (P/E) multiple.  But stripping out the tax reform adjustments paints a different picture.  By our estimates, the pre-tax reform, organic growth progression looks more like 7.5%, 11.9%, and 11.7% in 2018, 2019, and 2020, respectively.  That is an attractive earnings growth profile for a sector now trading at a forward earnings multiple below its’ 15-year average.  Sector revenue growth is expected to jump 8.2% this year, off-setting low levels of domestic capital spending and sales growth between 2014 and 2016.  Top-line growth is expected to resume a steady pace in 2019 and 2020 with estimates forecasting 5.5% and 5.7% advances.

S&P Industrials Sector - EBIT Margins vs Net Debt/EBITDA

S&P Industrials Sector – EBIT Margins vs Net Debt/EBITDA

To our eye, the out-year sales and earnings forecasts look conservative.  The current economic backdrop remains constructive, oil and natural gas prices have rebounded to the point of spurring capital investment, and general capital expenditure growth is accelerating.  Additionally, should a badly needed national infrastructure plan come together in the next 12-24 months, industrial companies would be the direct beneficiaries.  Furthermore, the Index’s constituents look to have learned hard lessons from the past financial crisis and subsequent recession.  Leverage ratios are near cyclical lows while EBIT margins are at historic highs.  The increased business model leverage positions industrial companies to weather trade related disruption should it materialize, and to ramp faster earnings growth in a stable and/or improving economic environment.  Trade related risks to the broader market look to be increasing, and industrial stocks are not immune to trade war related disruption.  But industrial stock prices may already reflect much of that risk and may not be discounting the possibility that we are in the midst of a capital spending cycle that is supportive of multi-year earnings growth.  It may be a bumpy path forward, but industrial stocks warrant another look.

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

18 Jun C.J. Lawrence Weekly – Moderate Inflation Supports Healthy S&P 500 Revenue Growth

The May Consumer Price Index (CPI) reading, released last week, came in close to 2.8% with the core reading at 2.2%.  The Producer Price Index (PPI) reading echoed the improvement with a 3.1% annualized advance.  The healthier pricing environment was confirmed in the Empire Manufacturing Index reading which came in hotter than expected, with all pricing metrics remaining high.  These are encouraging reports for inflation watchers who have been hoping that the past decade’s monetary stimulus initiatives would usher pricing power back into the U.S. economy.  The Federal Reserve Board likely took comfort in these advances when they raised the target Fed Funds rate by 25 basis points last week.  Somewhat surprisingly, the equity markets have taken the reports, and the expected rate hike, in stride, with the S&P 500 index price performance flat for the week and up 2.5% in the last month.  Perhaps stock investors are taking their cues from the bond market and from gold, which seem to be forecasting a firm pricing environment but no runaway inflation.  The U.S Benchmark 10-year U.S. Treasury bond yield fell 2 basis points last week and is down 15 basis points in the past month.   Gold prices, which tend to rise in tandem with inflation, are down 2.1% year to date.

Moderate inflation can be a constructive force for higher Gross Domestic Product (GDP) and corporate sales growth.  A combination of volume growth and higher prices are currently at work helping S&P 500 companies grow revenues at their fastest pace since 2011, when the economy was climbing out of recession.  Double digit top-line growth in the Energy, Industrials, and Technology sectors are driving this year’s forecasted 7.9% revenue improvement.  Next year, without the benefit of expanding Energy sector revenues, which are expected to slow to 0.5%, and considering sub-3.0% revenue growth contributions from the Telecom and Materials sectors, S&P 500 Index revenue growth is expected to slow to a healthy 4.5%, before reaccelerating in 2020 at a 5.5% rate.

S&P 500 Sales per Share Growth

S&P 500 Sales per Share Growth

Consecutive multi-year revenue growth, above 4.0% annually, has historically been a strong underpinning for stock prices.  Over the past 25 years, there have been three periods when the S&P 500 produced 4.0%+ revenue growth for three or more consecutive years.  During those periods the average annual total returns on the Index were 31%, 13%, and 11% respectively.  The current cycle started in 2017 with 6.5% top line growth and an S&P 500 Index total return of 21.8%.  If the forecasts prove correct, the market has at least another three years of robust revenue growth to go.  Within the Index, the highest rates of forecasted multi-year top line growth can be found in the Technology, Industrials, and Consumer Discretionary sectors.   Shares of companies in these sectors that are taking market share, developing new markets, and driving top-line expansion warrant meaningful overweight positions 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

11 Jun C.J. Lawrence Weekly – Support for Consumer Discretionary Stocks…U.S. Household Net Worth Exceeds $100 Trillion for First Time

It’s not surprising that U.S. Consumer Confidence is high.  U.S. household net worth eclipsed $100 trillion for the first time in 1Q18, according to the Federal Reserve Board’s quarterly Flow of Funds report.   The two categories that have the greatest impact on household balance sheets are property values and the value of households’ direct and indirect equity holdings.  In 1Q18 the value of real estate held by households increased by $0.5 trillion, while the value of directly and indirectly held corporate equities declined $0.4 trillion.  Data from the recent S&P/Case-Shiller Home Price Indices suggests no let-up is in sight for rising home prices and values.  Meanwhile, negative returns on corporate equities, which off-set some of the improvement in real estate values in the first quarter, will likely be a tailwind in the second quarter report, with the S&P 500 Index already up 5.2% quarter-to-date.

Household Net Worth vs Percent Change in Household Debt

Household Net Worth vs Percent Change in Household Debt

According to the report, U.S. household debt rose at a 3.3% annual rate in 1Q18.  That compares to household net worth growth of 7.0% from the year-ago period, resulting in improving household debt-equity ratios.  Consumer credit grew at an annual rate of 4.2%, while mortgage debt (excluding charge-offs) grew at an annual rate of 2.9%.  Interestingly, U.S. households were sellers of corporate equities and buyers of U.S. Treasury securities in the quarter, which may reflect reactions to lower stock prices and continued rebalancing of household portfolios that had breached equity asset allocation targets due to rising stock prices.

U.S. Consumer Confidence

U.S. Consumer Confidence

The Fed’s recent snapshot paints a picture of a healthy U.S. household sector.  That is good news for U.S. Gross Domestic Product (GDP), two-thirds of which is driven by consumer spending.  But while some market watchers suggest that the U.S. economy is late in the business cycle, U.S. households have not levered up to the extent they have at the end of past cycles, raising the prospect that this cycle could last longer than consensus forecasts.  In fact, by the Fed’s measures, U.S. household balance sheets continue to improve.  Of course, the Fed’s report does not categorize different segments of the population, some of which may not be experiencing the same improvement.  But the aggregate data is supportive of a growing consumer economy and consumer segment health.  Meanwhile, the S&P Consumer Discretionary Sector Index is up 12% year-to-date, outpacing the S&P 500 by over 700 basis points.  The backdrop remains constructive for continued outperformance.

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 Jun C.J. Lawrence Weekly – Beware of the Bond Trap

Rising bond yields are often cited as an important risk to equity prices. Not only do higher interest rates render yields on fixed income instruments more competitive with stock earnings and dividend yields, but higher interest rates raise the equity risk premium that investors absorb when owning stocks. While still low by historic standards, U.S. Treasury Bond yields continue to trend higher. The U.S. 10-Year Treasury Bond yield finished last week at 2.89%, up from its one-year low of 2.05% in September of 2017. That is an 82-basis point increase, or a 40% rise in yield, from the September trough. The U.S. 10-Year Benchmark Treasury Bond yield began the year at 2.42%. But higher yields don’t always mean higher returns for investors with existing bond portfolios.

Yields on new-issue corporate bonds, priced off U.S. Treasuries, are also moving higher. But for holders of long term bonds issued prior to the 2008 financial crisis, replacing income from maturing bonds, with income from newly issued lower yielding bonds, continues to leave an income gap. In June of 2007 the yield on 10-Year Treasuries was ~5.0%, with investment grade spreads (versus Treasuries) between 50-75 basis points. Even with 100+ basis point spreads on current U.S 10-Year Treasury Bond yields of around 3.0%, most new issues lack the yield punch delivered prior to the financial crisis. The likelihood that pre-crisis yields may return is rising, but individual long-term investment grade bond holders are experiencing meaningful bond price erosion while they wait.

Vanguard Long-Term Corporate Bond ETF (VCLT)

Vanguard Long-Term Corporate Bond ETF (VCLT)

The Vanguard Long-Term Corporate Bond ETF (VCLT) holds investment grade bonds with maturities greater than ten years. The fund has a yield-to-maturity of 4.2% and tracks the Bloomberg Barclays U.S. 10+ Year Corporate Bond Index. Investors find the 4+% yield attractive given the high quality of the underlying holdings and the fund’s excess yield above treasuries. But the rising interest rate environment has not been kind to the prices of the fund’s underlying bonds. As interest rates climbed, the bonds’ declining prices have more than off-set their yields, leaving the fund with a -5.7% total return year-to-date. Declining prices and a limited ability to replace higher yielding securities with equivalent yields is symptomatic of the challenges facing asset allocators in rising rate environments. Investors looking to rebalance and reallocate balanced portfolios towards bonds may instead want to consider cash or short term fixed income instruments as a rest stop while the market recalibrates prices on longer dated maturities. Yes, risks to stock prices rise with interest rates, but bonds with relatively low yields and declining prices don’t look like good total return alternatives.

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

 

31 May From Pre-School to Pre-Med, the CJL College Planning Center Helps You Navigate the Path from College Savings to College Selection

American Family Spending on Youth Activities Soars While Education Savings Lags

Today’s American families are spending record amounts of time and resources on their kids’ activities, and parents are pulling out all the stops to enable and encourage their children’s success.  Research conducted by Utah State University in 2015 suggested that families included in their study spent up to 10.5% of their gross income on youth sports alone!  This significant commitment comes at a time of diminishing odds that American kids will play professional or college sports, perform with the NY Philharmonic, act in a Broadway show, or qualify for the U.S. Olympic team.

Of course, participation in most forms of youth activities including sports, the arts, clubs, and other enrichment programs, have social and developmental benefits for children, and teach them important life lessons.  But in today’s society, there appears to be a mismatch in resource allocation when measured against outcomes.  While less than 1% of high school athletes will participate in NCAA Division I athletics, almost 70% of high school seniors will attend some form of college after graduation.  Yet, as youth athletic program spending soars, only 22% of American families, that are actively saving for college, have opened 529 college savings plans.  Of course, 529 plans are not the only available programs for college savings, but most financial professionals view them as the most effective and tax efficient.  Indeed, assets in 529 plans grow tax free, and are distributed for qualified education expenses on a tax-exempt basis.  And those who establish them early in a child’s life reap the multi-year benefits of compounding investment returns.  Some states even allow 529 plan contributions to be deducted from the contributor’s taxable state income.

The Cost of School Sports Infographic

The Cost of School Sports vs Investing in 529 College Savings Plan

Among the reasons cited for not saving for college, most families place (1) lack of funds, and (2) competing priorities, near the top.  But detailed analysis of family spending patterns often encourages a reallocation of resources and uncovers opportunities for college savings carve-outs and matched spending.  A hypothetical example illustrates the benefits.  In the example scenario, the parents of a 16-year-old spent $2,000 per year on their child’s athletic programs, beginning in the child’s ninth year.  During the same period, they contributed half of that annual amount ($1,000 per year, or $83 per month) to the child’s 529 college savings plan, invested in an S&P 500 Index fund.  Fast forward to the present and the amount spent on athletic activities totaled $16,000, while hypothetically, the family built a $13,444 college savings nest egg.  This hypothetical example does not incorporate fees and expenses, and future returns may not match historical returns.  But it does illustrate the advantages of starting 529 plans early, and allocating a percentage of activity spending to education, while also highlighting the tax and compounding returns benefits inherent in 529 college savings plans.

During March and April every year, more that 20 million American students open mailed and online letters from college admissions officers.  The “decision letters” which are often the culmination of months, and sometimes years, of preparation and hope, can be a cause for celebration.  For others, they can be a source of disappointment and despair.  But for students who achieve their dream of acceptance to the college of their choice, only to be confronted with the cold hard reality of the out-of-reach cost of matriculation, excitement can quickly turn to anxiety and frustration.  Preparing a plan now can help families avoid that difficult quandary in the future.

Whether your student is “in the zone” of the college admissions process, or you are just getting started down the path of considering college savings, the CJ Lawrence College Planning Center has important information and insights you need.  Log on to explore thousands of colleges and universities, majors, demographics, statistics, and costs.  Input current, or prospective, scores and grades to see how your student stacks up versus previous applicant pools.  For families with young children, build a road map for college savings and compare different state run 529 College Savings Plans.  The resources you need at each stage of the process are available at the C.J. Lawrence College Planning Center website. Of course, before making any investment decision, please consider consulting a financial or tax professional regarding your unique situation.

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

29 May C.J. Lawrence Weekly – Growth Stocks Reaccelerate

On a relative basis, it has been a challenging decade for value investing practitioners.  Since January of 2009, the S&P 500 Growth Index has delivered a 326% total return, while the S&P 500 Value Index returned 212% during the same period.  Definitions of what constitutes value stocks and growth stocks differ, but most agree that to qualify as a value stock a company’s shares should trade at relatively lower price-to-fundamentals (earnings, sales, book value, etc.) than the market.  Conversely, to qualify as growth stocks, shares should exhibit faster fundamental growth than the market, and typically trade at premium valuations.  Traditional value sectors include Energy, Consumer Staples, Telecom, Utilities and Financials.  Growth names can typically be found in the Technology, Consumer Discretionary, and Health Care sectors.  Industrial stocks can be found in both but tend to tilt towards value.

S&P 500 Growth Index versus S&P 500 Value Index

The cyclical nature of value stock investing makes timing important.  But head-fakes can be common.  In 2016 it appeared as if growth’s relative outperformance was waning as the mean-reversion trade took hold and value closed the price gap.  That looked to be the right trade as economic and corporate profit growth forecasts increased steadily through 2017, bolstering the case for economically sensitive shares.  But value’s rally stalled and growth stock prices reaccelerated in 2017 as relative valuation multiple gaps closed.  Stronger than expected fundamentals allowed earnings to grow into growth stock multiples, rendering their relative value more attractive.  Meanwhile valuations on value stocks had reached historical highs making the “value” case less compelling.

iShares S&P 500 Value Index (IVE) Price-Earnings-Ratio (Next Twelve Months)

Using P/E multiples to measure the attractiveness of value stocks can be challenging because investors will often award high multiples to cyclical shares at trough earnings, and pay lower multiples for peak earnings.  But the relative value analysis can be instructive if peak earnings are not yet in sight, which we believe is the current scenario.  Weak financial share price performance, on the back of solid earnings reports and upward estimate revisions, and higher oil prices that have boosted the outlook for energy company earnings growth, have both contributed to the value style’s relative valuation improvement of late.  But the value style still has its challenges.  Oil and energy company share prices rolled over at the end of last week as talk of increased OPEC production spread through the market.  Industrial stocks rallied early in 2018 but fell out of favor as fears of a pending cyclical top percolated.  The heavy-weight financial stocks posted strong price performance in 2017 but have lagged the broader market in 2018, despite an improving economy and interest rate environment for lenders.  Utilities, Telecom, and Consumer Staples shares lost their allure as bond surrogates in the face of higher interest rates, leaving them to trade on fundamentals alone.  While we believe that growth stocks will continue their relative outperformance, some “growth-cyclical” stocks, particularly in the industrial and financial sectors, look attractive, and warrant inclusion in both balanced and 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

 

21 May C. J. Lawrence Weekly – Healthy U.S. Consumer is Bullish for Consumer Discretionary Sector Leaders  

After a difficult second half of 2017, the S&P Consumer Discretionary sector index has staged an impressive comeback.  In the past six months the sector price index is up 12.1%, 6.9% ahead of the broader S&P 500 Index.  Over the past several years, the bull-bear battles within the sector have limited the advance of many of its constituents, despite headline sector outperformance.  Most of those battles have been centered around the brick and mortar retail groups and investor fears that stock price advances among leaders will be limited by the persistent overhang of the “Amazon-effect”.  Even headlines suggesting that Amazon might consider entering a new category have caused sell-offs.  The battles have touched almost all the sector’s sub-indices including; Auto Parts, Leisure Products, Media, and Household Durables.   Interestingly, while Amazon’s shadow has cast a pall over its fellow sector constituents’ stock prices, its own heavily weighted shares have, at times, carried the entire sector price index on its back.  Amazon’s parent industry group, Internet and Direct Marketing Retail, is up 36% year-to-date.  But better-than-expected results last week from Macy’s and Walmart, may have assuaged some investor fears that retail is a zero-sum game, and raised the specter that “peaceful” coexistence is a possibility.  While the picture of the future retail landscape remains cloudy, and ambiguity around international trade adds to the uncertainty, it is likely that, in the near term, retail and the broader Consumer Discretionary sector will be supported by a healthy U.S. consumer.

Last week’s positive retail company financial results came on the back of Tuesday’s U.S. Retail Sales report from the Commerce Department, which showed a headline gain of 0.3% in April, consistent with most economists’ estimates, and raised the previously released March result to 0.8%, well ahead of expectations.  The retail-control group sales, which are used to calculate gross domestic product (GDP) and exclude food services, auto dealers, building materials stores and gasoline stations, improved 0.4% after an upwardly revised 0.5% March gain.  Retailers are optimistic, and the winning streak looks like it will continue.  A recent Global Port Tracker report from the National Retail Federation, which measures shipping container traffic coming into U.S. ports, pointed to robust container shipping activity.  According to the report, in April, US ports handled an estimated 1.73 million Twenty-Foot Equivalent Units (TEUs) of incoming cargo, an increase of 6.4% over the prior year period.  A TEU is one twenty-foot long container, or its equivalent.  May shipments are forecasted to reach 1.82 million TEU, up 4.3% from last year, and June is expected to come in at 1.82 million TEU, a year-over-year increase of 6.1%.  Annual shipment growth for July and August traffic is expected to come in at 5.5% and 4.6% respectively.

U.S. Household Debt Service and Financial Obligations Ratio

The healthy pace of retail sales, and historically high readings for Consumer Confidence and Consumer Comfort, bode well for U.S. GDP growth, 65%-70% of which is driven by U.S. consumer spending.  Some observers have suggested that the consumer is extended and that the current level of consumer spending is debt-fueled and is unsustainable.  But a relevant analysis conducted by the U.S. Federal Reserve Board suggests that is not the case.  At the end of each quarter, the Fed publishes a measure called the Household Debt Service and Financial Obligations Ratio.  The ratio measures household debt as a percentage of household disposable income.  While U.S. households have taken on increasing amounts of debt in recent years, disposable personal income growth has outstripped it.  In fact, the ratio is at multi-year lows.  This is a supportive backdrop for companies in consumer businesses, and is bullish for select leaders in the Consumer Discretionary sector.

 

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

 

14 May C. J. Lawrence Weekly – Profit Margin Expansion Suggests Current Business Cycle Has Legs

In the late stages of a business cycle it is typical to see profit margins contract in the face of rising input costs and strained revenue growth.  But over the past decade, U.S. business efficiency improvements have helped companies avoid the deep margin troughs of past cycles, and sustain historically high profit ratios.  In late 2014, aggregate margins on most of the major equity indices looked to be peaking, but got a second wind in 2015 and retraced their expansion in 2016 and 2017.  Profit margins on the S&P 500 Industrials Index, which excludes Financials, REITs, and Utilities, are now close to 8.0%, which is approaching the 8.3% calendar year peak achieved in 2013.  For the past 50 years the annual profit margin on the S&P Industrials, and its successor index, the S&P 500 Industrials, has averaged 5.5%.  Meanwhile, index profit margins broke the 8.0% barrier for the first time in 2011 and have eclipsed that mark, on an annual basis, four times since.

Not only are S&P 500 Industrials Index margins expected to sustain a rate above 8.0% this year, but if estimates prove correct, they will eclipse 9.0%, on a 4-quarter trailing basis, for the first time.  The broader S&P 500 Index shows the same progression, with profit margins expected to reach 12.0% this year, up from 10.6% in 2017.  The sector contributing most to aggregate margin expansion is the heavily weighted technology sector, which produced a 21.7% profit margin in 2017, versus its 20-year average of 15.3%.  Interestingly, the Technology Sector, the constituents of which help others become more productive, is the sector producing the highest organic productivity and profit improvement.  Conversely, Consumer Staples margins are below their 2002 peak of 9.4%, and finished 2017 below their 20-year average of 6.6%.

S&P Industrials After-Tax Profit Margin (4-QTR Trailing)

Market consensus suggests that current year margin improvements are being driven primarily by the benefits of corporate tax reform.  Indeed, lower rates are an important contributor, but S&P 500 companies are also showing operating improvements above the tax line.  EBIT (Earnings Before Interest and Taxes) margins on the S&P 500 are expected to reach 16.6% in 2018, versus 15.8% in 2017, and are expected to expand to 17.1% in 2019 and 17.3% in 2020, according to bottoms-up estimates collected by FactSet.  At the same time, top line growth is expected to accelerate in 2018 by 7.2%, and maintain a good growth clip of 4.7% in 2019.  This is a constructive backdrop for stocks and suggests that the current business cycle and outlook remain healthy.  Meaningful revenue growth combined with expanding margins is a good recipe for profits, and owning stocks with that winning combination is a proven strategy for capital appreciation.  The most attractive candidates can be found in the Technology and Industrials sectors which are delivering on both.

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 May C. J. Lawrence Weekly – Falling Down on the Multiple Staircase

S&P 500 earnings per share estimates (EPS) for 2018 have increased 8.8% since the beginning of the year, and look to be heading higher.  2019 estimates have climbed by about the same amount.  The Index price, however, is not following suit, and is down slightly (-.38%) year-to-date.  The road block to higher stock prices is the contracting market multiple, or the price that investors are willing to pay for future earnings.  At the beginning of the year, the S&P 500 price-to-earnings multiple (P/E) stood at 18.5x.  Since then, it has declined by 9.6%, more than off-setting the positive EPS estimate revisions.  This is a classical late-cycle set up.  In previous cycles, the market multiple declined as investors discounted what they believed to be “peak earnings”.  At this point in past cycles, the expectation would emerge that the Federal Reserve would tighten monetary policy to slow an over-heating economy and curb rampant inflation.  Often, that strategy also put in a top for corporate revenue and profit growth.  The challenge to applying that narrative to today’s market is that we have neither an over-heated economy nor run-away inflation!  Most economists agree that the Fed’s current tightening agenda is aimed more at normalizing rates than on reigning in excesses.  In fact, it wasn’t six months ago when interest rate conversations revolved around the hope that the Fed’s easy money policies would eventually stoke some much-needed inflation.

Directionally, the market multiple tends to move opposite of interest rates and inflation.  As the risk free-rate on U.S. treasury bonds rises, asset allocators require increasingly higher earnings yields on stocks to compensate for their risk.  But P/E multiples also move directionally in long cycles.  In the 1980s, C.J. Lawrence Chairman, Jim Moltz, observed the long-term cyclical trends in P/E multiples and coined the progression, the “Multiple Staircase” (see chart below).  The Multiple Staircase showed that the S&P 500 P/E multiple trended in stair-step fashion, in one direction for about 12 years, before reversing course and trending in the other direction for 18 to 20 years.  The market multiple found the bottom of the Staircase in 2011 and has worked higher since.  If the progression holds true, there would be another 12 years of elevated multiples in the current cycle.  While it’s difficult to make a case for meaningfully higher valuations from current levels, the current range has precedence.

S&P 500 Price/Earnings Multiple

S&P 500 Price/Earnings Multiple

Two previous periods with similar economic conditions to the current environment, were the 1960-1967 and the 2002-2007 periods.   During these years of steadily increasing interest rates and inflation, the average P/E multiple on the S&P 500 ranged between 16.0x and 18.5x.  Applying that range to today’s earnings forecasts would yield an Index price range, on the S&P 500, of 2,560 (-4.0%) to 2,960 (+11.2%).  Perhaps the uncertainty around global trade trims the top off the range, but a steady improvement in economic activity, without a corresponding spike in inflation, may support the P/E multiple on the bottom edge.  The market multiple may have stumbled on the Multiple Staircase but any signs that “peak earnings” are not yet in sight may help it regain its balance.

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 Apr C. J. Lawrence Weekly – Rising Rates Provide Headwind, not Barrier, for Stocks

Last week’s market action was noteworthy for its flowing cross-currents.  Economic and corporate earnings reports were particularly strong, but for bulls, the equity market’s reaction was disappointing.  The S&P 500 Index finished the week close to flat, versus the prior week’s close. Market watchers were confounded by Tuesday’s 1.3% decline, which coincided with strong corporate earnings releases.  In fact, of the 54% of Index constituents that have reported 1Q18 results to date, 80% have delivered earnings per share that exceeded analysts’ expectations. That is remarkable progress! The Index is now on track to deliver 23% year-over-year earnings growth for the quarter.  We estimate that the new corporate tax rates may account for ~7% of the improvement, suggesting ~16% growth, pre-tax benefit. Either way, the reported, and forecasted, results represent a meaningful improvement from last year’s level, and a significant uptick in growth forecasts from the beginning of the year.  In January, analysts were expecting 10.7% 1Q earnings-per-share growth.

The economic data released last week painted a similarly rosy picture.  Existing and new home sales, consumer sentiment, and 1Q18 GDP all came in ahead of expectations.  Bond yields rose on the back of the reports, causing the U.S. 10-Year Treasury Bond Yield to pierce the psychologically important 3.0% mark.  The rise in long rates may be encouraging a shift in target asset allocations in favor of bonds versus equities. The recent fund flow figures from Investment Company Institute confirm that the growing enthusiasm for equity funds, experienced at the beginning of the year, has flamed out. In fact, for the week ending 4/18, taxable bond funds saw net inflows of $9.3 billion, while domestic equity funds realized $2.4 billion of redemptions.  This trend is likely to continue in the coming weeks as the Federal Reserve stays on track with its rate normalization plan, and heavy issuance from the U.S. Treasury keeps upward pressure on yields.

As the economy improves and inflation perks up, it’s likely that rising rates will exert downward pressure on the stock market’s price-to-earnings (P/E) multiple.  In past cycles, that backdrop has resulted in narrowing market breadth. But analysis of previous periods with similar market conditions also suggests that these conditions do not preclude stocks from delivering attractive returns.  One recent example is the 2012-2013 period, when interest rates followed a similar pattern to the one being witnessed now. Between July of 2012 and September of 2013, the U.S. 10-Year Bond yield climbed from 1.4%, at its trough, to 2.97%, at its peak.  During that time, the S&P 500 rose 26%. In the twelve months following that peak, the Index climbed another 18.5%. Technology Hardware, Semiconductors, and Internet Software and Services were the best performing groups during that period. The Commodity Chemicals, Hotels, and Metal and Glass Containers groups also performed well.  The thesis of rising rates being negative for stocks is widely accepted. However, history suggests that even in the face of multiple compression and profit margin pressures, stocks can continue to rise on the back of meaningful sales and earnings growth. But with breadth narrowing, portfolio outperformance will increasingly be driven by owning select leaders rather than the entire pack. 

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 Apr C. J. Lawrence Weekly – Innovation at a Reasonable Price…IRP Investing

For decades, U.S. corporate research and development (R&D) spending was dominated by automotive and pharmaceutical companies.  In the 1960s and 1970s, as the big-3 auto companies became embroiled in market share wars amongst themselves, and later versus foreign auto manufacturers, research and development became a critical weapon in the battle for competitive edge.  For pharmaceutical companies, the persistent threat from generics, and continued advancements in medicine and treatments by upstarts, accentuated the need for rapid and continuous innovation and development.  Interestingly, in most periods, levels of R&D spending among industry competitors remained relatively even.  In rapidly changing industries, company managements realized that falling behind in R&D posed potential existential threats in later years.  Thus, even financially challenged corporations ramped R&D spending, sometimes as a defensive measure.  In recent years, the number of companies raising the R&D bar has been climbing.  In 2014 there were 52 S&P 500 companies spending over $1 billion on R&D.  In 2017 there were 60 S&P companies spending more than that amount.

During the past few decades, technology industry participants figured prominently among the top R&D spenders.  While rarely in the top spot, technology companies consistently comprised close to a third of the top twenty.  In 1997 the top five U.S. corporate R&D spenders included two auto companies (GM and Ford), and three technology companies, (IBM, Hewlett Packard, and Intel).  Ten years later, in 2007, the top five included two auto companies (GM and Ford), two pharmaceutical companies (Johnson and Johnson and Pfizer), and one technology company (Microsoft).  But in 2017, something changed.  Last year, all five of the top U.S. R&D spenders were technology companies (Amazon, Alphabet, Intel, Microsoft, and Apple).  Facebook was not far behind, in the number 8 spot.  We took some liberty at lumping Amazon in with technology companies given S&P categorizes it as a Consumer Discretionary company.  But its massive spending initiatives have largely been in the technology arena, warranting inclusion in that bucket, in our view.  Interestingly, not only have the upper echelon technology companies risen to the top of the R&D roster, they are extending their spending leads.  Amazon, the top R&D spender in 2017, invested almost $23 billion in research and development in that year alone.  That is more than 3x the amount of the tenth largest corporate R&D spender, Pfizer!

Amazon.com Research and Development Spending

Amazon.com Research and Development Spending

A challenge for investors is figuring out how to incorporate R&D spending into stock valuations, as not all projects and initiatives bear fruit.  But what’s clear is that most of the companies at the top of the list have high conversion rates in turning R&D spending into profitable businesses, and in widening competitive moats.  In past cycles, it was not uncommon for investors to pay 40x, 50x, or 60x future earnings for the stocks of cutting edge, innovative companies.  In today’s market, investors don’t need to climb as far out on the valuation curve to purchase innovation.  Companies like Alphabet, Microsoft, Facebook, Apple, and Intel all trade near or below the market multiple, while delivering a mix of core earnings growth and industry leading innovation.  Amazon is a bit tougher to assign a specific valuation given its penchant for capital reinvestment at the expense of earnings per share growth. But the company’s rapid revenue growth is testament to its true earning power, in our view.  While the current news cycle focuses on issues like whether Alphabet will meet quarterly earnings expectations, or if Facebook will be singled out by governing bodies for privacy regulation, or if a feared slowdown in communications chip sales will slow Intel’s earnings reacceleration, long-term growth investors should not lose sight of the prize.  Alphabet and Microsoft are close to breakthroughs in Quantum computing, according to a recent article in the Financial Times.  Intel is extending its lead in autonomous vehicle technology through its acquisition of Mobileye.  Facebook is leading the charge in artificial intelligence technology, and Amazon is charting a new course in robotics.  These are the types of investments and innovation that differentiate leaders.  In this cycle, innovation can be purchased at a reasonable price (IRP).

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 Apr C. J. Lawrence Weekly – Cash Flow on the Rise

A once highly anticipated technology sales pipeline report was released on Wednesday with little fanfare.  Worldwide shipments of traditional personal computers (desktops, notebooks, and workstations) in 1Q18 were equal to last year’s level, according to the International Data Corporation (IDC) Worldwide Quarterly Personal Computing Device Tracker.   The result was viewed positively by industry watchers who consider flat to be the new up in a market that has undergone dramatic change over the past decade. The evolution of mobile and networked devices, as well as cloud-based software and solutions, have supplanted the traditional PC hardware and software business models resulting in a steady decline in traditional PC sales.  But during the reign of the PC, the IDC report was a market-moving event for the entire technology ecosystem. Followers of Hewlett Packard, IBM, Microsoft, Intel, and others closely monitored the report for clues on business activity and trends across the technology landscape.  The report now plays a minor role for market participants who are more focused on the evolution of cloud computing, artificial intelligence, machine learning, and the internet of things (IoT).

But the IDC report also serves as a reminder that solid core franchises, even ones that no longer grow, can generate meaningful cash flow to support growth businesses, and creates optionality for corporate management teams.  Microsoft is a good example. Revenue generated from sales of the company’s Windows operating system have remained remarkably steady, while its percentage of total corporate revenues has dropped to a historic low. The Windows business, which after a recent restructuring sits in the company’s Experiences and Devices business line, is not growing, but generates considerable cash flow that supports Microsoft’s growth and shareholder return initiatives.  In the company’s fiscal year 2017, which ended in June, Microsoft generated over $31 billion in free cash flow. That allowed Microsoft to pay out $11.9 billion in dividends, repurchase $11.8 billion worth of common stock, and pay down $12.9 billion of the company’s higher interest rate debt. That all came after spending $12.1b billion on research and development.

S&P 500 Free Cash Flow Per Share

At a broader level, free cash flow (after capital expenditures) generation from S&P 500 companies is expected to reach record levels in 2018, and grow at a double-digit rate in 2019 and 2020.  That is an important underpinning for the index. Stocks tend to perform well during periods of increasing cash flow. Corporate managements will be challenged to put capital to work to generate shareholder returns through growth initiatives, M&A, share repurchases, dividend increases or some combination of each.  By most measures, they will have the cash to deploy. Companies, with cash generating core businesses, legacy or otherwise, create additional optionality for their management teams, separating those who can create value and those that can not. We screened the S&P 500 for companies with debt-to-total capital ratios below 30%, that grew free cash flow per share in excess of 10% each year for the past three years.  Our constructed equally-weighted index of qualifiers has generated 570 basis points of excess return year to date, versus the S&P 500. In volatile markets, stocks of companies with strong cash flow characteristics are good bets.

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 Apr C. J. Lawrence Weekly – Dividend Growers Provide Stability in Choppy Markets

It’s difficult to identify a singular catalyst for the market’s recent volatility.  Whether it’s politics, trade, or corporate stumbles, the equity markets’ reaction to events and news has been swift and pronounced.  The large intraday swings in stock prices suggest that traders are shooting first and asking questions later.  Among the primary reasons cited for last week’s swings are; increased fear of rapid rate hikes by the Federal Reserve, the escalation of trade rhetoric between the U.S. and China, and the abdication of technology sector leadership.  It’s difficult to calculate how any of these singular issues, in isolation, could cause significant market turmoil.  But in combination, and along with other macro concerns, these uncertainties are causing the market serious indigestion.

On the interest rate front, considerable analysis went into recent comments by the new Federal Reserve Chair, Jerome Powell, which were viewed by some as being incrementally more hawkish than previous comments.  Our sense, however, is that the markets have previously calibrated the expectation for three more rate hikes in 2018, and that Chair Powell’s recent comments did little to change that expectation.  Meanwhile, the US-China trade spat is an important new development for the market to digest, but there appears to be adequate time for debate and détente before proposed tariffs would be enacted, and it is unclear what the ultimate impact would be on trade, inflation, and GDP.  While the U.S is a major importer of Chinese goods, only 3.7% of S&P 500 constituent sales are made in China.  That share figure is down 13.1% from 2016, with the biggest one-year share gainer being Canada, with a 13.5% improvement.  A new NAFTA deal, if one materializes, could potentially help off-set reduced S&P 500 company sales in China.  Finally, the technology sector did, in fact, lose ground over the past two weeks and has ceded the sector leadership position it has held for much of the past two years.  But its anticipated demise may be premature.  Technology remains one of only two S&P sectors with positive year-to-date performance, with the Software and Communications sub-groups holding positions in the top 10 performing groups for the year.

Regardless of catalysts, the recent market volatility has made investment strategy selection increasingly challenging for investors and managers.  Growth versus value comparisons have broken from historical patterns as market downdrafts have been equally punishing.  But the dividend growth strategy, which looks to have fallen out of favor in early 2018 on a relative basis, may warrant another look.  Most conventional dividend growth indices are market capitalization weighted so may paint a different picture from what is happening across a broader swath of dividend growers.  We screened U.S. listed stocks with market values exceeding $5 billion, for companies that have raised their dividend more than 15% every year, for the past five years.  Our equal weighted index of qualifiers has outperformed the S&P 500 Index by 3.1% year-to-date, and by 5.0% since February 1.  Improving fundamentals and corresponding increases in corporate cash flow should help dividend payors maintain and increase payouts to shareholders in 2018.  Shares of companies with track records of consistent and meaningful dividend increases, look poised to outperform in 2018 and deserve a meaningful weight in both growth and value 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

 

02 Apr C.J. Lawrence Weekly – The Bears are Back. Contrarians Take Note.

Despite a strong close to last week, the S&P 500 Index finished in negative territory for the first quarter of 2018. The Index is down 1.2% year-to-date. Interestingly, the headline-challenged Technology sector index continues to lead the performance pack among the major sectors, followed by Consumer Discretionary. They are the only sectors with positive year-to-date price performance, gaining 3.2% and 2.8% respectively. At the broader index level, 2018 had started on a strong note, with most major equity indices posting positive returns in January. Then, in February, the market’s psychology turned. In just the past two months, the S&P 500 experienced two 6+% corrections, and the CBOE Volatility Index (VIX) surged. In 2017, the VIX, which has an average reading of 17 since 2010, hovered close to a record low reading of 10 for most of the year. In fact, during 2017, the VIX closed above 15 only eight times. But since February 1, volatility has returned in spades, and it looks like it is here to stay. In the past two months the VIX has surged, and has closed below 15 only twice.

The recent increase in volatility, and concurrent swift and dramatic market corrections, have altered market psychology and have increased investor sensitivity to headlines and changes in momentum. The erosion in market sentiment is playing out in mutual fund and exchange traded fund flows, where equity flows have turned negative, according to data from the Investment Company Institute. Coming into the year, expectations were high that investors would reverse a multi-year trend of flows out of equity funds and into bond funds. That looked to be the case early in 2018, but increased volatility may have contributed to a “return to safety” and sent buyers back into the arms of bond fund managers. Since February 1, domestic stock mutual funds and exchange traded funds have experienced $52 billion of outflows while bond mutual funds and exchange traded funds have experienced $20 billion of net inflows.

The equity fund outflows correspond with a meaningful shift in market sentiment, as reflected by the American Association of Individual Investors (AAII) weekly survey. The most recent results show bearish sentiment at its highest level in seven months. In fact, the pessimism measure has climbed by a cumulative 14 percentage points over the last two weeks. Bullish sentiment, meanwhile, declined to 31.9% in the most recent survey, staying well below its historical average of 38.5%. The institutional community is reflecting similar negative posturing as reflected in put-call spreads. Indeed, demand for put-options has surged over the past two weeks. The 10-day put/call ratio has moved from a multi-year low in January to its highest level since the 2016 elections. The message in these signals is that the bears are back, and that individual and institutional investors are re-positioning portfolios for a bumpier ride. Contrarians will take note of this development, and will find the shortage of bulls constructive.

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

 

26 Mar C.J. Lawrence Weekly – The Stumble-Prone Equity Market Remains on Solid Footing

2017’s prize-fighter equity market now looks like it may have a glass jaw.  In 2017, the S&P 500 posted a positive return in each month of the year, and shrugged off negative news at nearly every turn.  But already in 2018, the market has experienced two 6+% corrections.  Events that would have slid off the market’s teflon coating last year are now sticking and causing stumbles.  A myriad of issues cropped up last week sending the S&P 500 index down almost 6%.  As of Friday, the Index is in negative territory for the year, down 2.8%.  The abdication of leadership from the Technology sector worries market participants who have relied on the sector as an important prop for the broader market.  Episodes like index heavyweight Facebook’s fall from grace are disruptive.  But in previous markets, that disruption might have been off-set by strong performance by new leaders.  In last week’s action the leadership void was left empty.

A much hoped-for rally in financial shares did not materialize, as the 2-to-10-year treasury bond yield spread tightened to its lowest level since January.  As a result, bank profitability was questioned and investors sold shares of financial stocks.  As a result, the Financials Sector Index was the second worst performing sector in the S&P 500 last week, down 7.2%.  But interestingly, the market’s correction, and crisis of confidence, comes at a time when corporate earnings forecasts are climbing, and the underlying economic data is trending positive. At the beginning of 2018, bottoms-up forecasts for current year S&P 500 Index earnings per share were $146.  That figure now stands at $157, an 8% increase.  At the same time, the multiple on those earnings has fallen from 18.3x to 16.5x 2018 estimates, all while forecasted returns on equity (ROE) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margins reach 20-year highs.

Underneath the market, global and domestic economic growth remains supportive, and domestic manufacturing is improving.  Global trade activity warrants increased attention as trade barbs are exchanged between the world’s largest economies.  But to date, most trade metrics look steady.  The Baltic Freight Index, which acts as a good measure of demand for bulk commodities, is down for the year but is off its February lows.  Domestically, freight shipments have been a mixed bag, but skew positive in the areas of chemicals, petroleum, and petroleum products.  According to the American Association of Railroads, shipments of chemicals are up 2.7% year-to-date, versus last year, and petroleum and petroleum products shipments are up 4.8%.  Conversely, shipments of autos and grain are lower on a year-to-date basis.  Total intermodal loads (container shipments that are often used in import/export) are up a meaningful 6.2% from year ago levels.  Data from the American Trucking Association (ATA) confirms positive domestic freight shipping trends.  The ATA’s truck tonnage index dipped in February, versus January, but is up 7.1% year-to-date over last year’s level.  Thus, our outlook for the stock market remains constructive, based on improving economic and equity market fundamentals, but recognizes that the market is prone to stumbles.  For long-term investors willing to wade into the market’s volatile waters, the risk-reward ratio remains favorable.

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

 

19 Mar C.J. Lawrence Weekly – Tight Capacity Utilization Bodes Well for Select Machinery, Building Products, and Construction Equipment Stocks

Among the economic data released last week, both Industrial Production and Capacity Utilization came in well ahead of economists’ expectations. The Industrial Production reading, a measure of total U.S. factories, mines, and utilities output, rose 1.1% from the prior month, and 4.4% from last year’s figure. Capacity utilization reached 78.1%, the highest level since January 2015. The two metrics tend to go hand-in-glove. As manufacturing activity accelerates, idle and underutilized manufacturing capacity is re-engaged and the utilization rate climbs. Most economists believe that 80% is an important utilization hurdle. When the utilization rate climbs above that level, and available manufacturing capacity is tight, firms increase capital expenditures on new productive capacity. It appears we are closing in on that trigger level.

US Industrial Capacity Utilization versus S&P 500 Capital Expenditure Growth

US Industrial Capacity Utilization versus S&P 500 Capital Expenditure Growth Source: FactSet, S&P Global

Conversely, utilization, and corporate spending on plant, property, and equipment, falls off dramatically towards the end of, and in the aftermath of, recessions, as orders cancelled during recessions hit the books. Then, in subsequent years, utilization ramps and capital spending re-accelerates, off a lower base, and compensates for the prior spending lag and pent-up demand. Indeed, S&P 500 company capital expenditures fell 24% in 2002 and 9% in 2003 in the aftermath of the 2001 recession. It took almost three years for expenditures to return to pre-recession levels. Likewise, S&P 500 capital spending fell 19% in 2009 and took until 2011 to return to pre-crisis levels. What’s unique about the current economic cycle is that since 2012, capital spending growth, among S&P 500 constituents, has been punk. In fact, there has been no net growth in S&P 500 capital expenditures over the past four years. In 2015 and 2016 capital expenditures declined by 5.5% and 3.8%, respectively, and look to have recovered only modestly in 2017.

Thus, the strong Industrial Production and Capacity Utilization reports are welcome news for investors betting that the current economic cycle has long legs, and that the domestic economy is on the cusp of a new capital spending cycle. Healthy corporate profit growth, fiscal stimulus, and relatively low interest rates are combining with rising utilization, pent up capital spending demand, and healthy corporate balance sheets to form a potent manufacturing brew. Industrial stocks are the likely beneficiary of this convergence, and came out of the gate strong in the beginning of 2018, but have ceded ground on a relative basis over the past two months. While the stocks have largely anticipated the reacceleration in economic activity, some groups look to be discounting peak earnings and have experienced multiple compression. Those groups, including Building Products and Construction and Engineering, in addition to select Machinery and Construction Equipment names, may warrant another look, as the next capital spending cycle gets into gear.

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

 

12 Mar C.J. Lawrence Weekly – New S&P Sector Construct Could Create Volatility this Summer

Followers of the CJL Weekly Market Comment are familiar with our practice of looking below the broader market indices to compare the fundamentals, price performance, and valuations of the 11 different S&P Sectors, 24 Industry Groups and, 157 Sub-Industries. This style of analysis dates back to the original C.J. Lawrence. For decades, the firm published tables showing the relative sector winners and losers of market share within the S&P 500 Index. This long-term lens has provided an important perspective to investors utilizing a top-down approach in their securities analysis. Indeed, we continue to consider the changing landscape highlighted in our Sector Shifts table in our investment process.

Sector Shifts

Standard and Poor’s Corporation, (now S&P Global, Inc) was the developer of the original indices, and is still today the owner, vendor, and licensor of the index data. The indices follow the Global Industry Classification Standards (GICS), a standard developed in 1999 by S&P and MSCI, which allows for the consistent categorization of individual securities. This categorization is relevant because it determines which securities are included in funds and products that track the indices and sub-indices. Periodic index reconstitutions have become important market events as companies are added to, and removed from, the various indices, while derivative product manufacturers react to the changes. One of the larger definitional changes undertaken by S&P in recent years was the separation of the REIT stocks from the Financials sector in August of 2016. Since the split, the Financials Sector Index has delivered a 59.5% total return, while the new REIT Sector Index has produced an -5.7% return during the same period. The post-split impact has been meaningful for index trackers. In November of 2017 S&P announced another major change, to take place this year.

In September, S&P will broaden the Telecommunication Services sector index and rename it Communication Services. Importantly, S&P will remove social and interactive media companies from the Technology sector and add them to new Communications Services sector. The same shift will take place for interactive home entertainment companies. Stocks impacted by the move include the third and fifth largest market capitalization companies in the S&P 500, Alphabet (GOOGL) and Facebook (FB), as well as widely held gaming companies Activision Blizzard (ATVI) and Electronic Arts (EA), among others. Additionally, Broadcasting, Cable and Satellite, Movies and Entertainment, and Publishing stocks will be transferred out of the Consumer Discretionary Sector and will also be added to the Communications Services sector. Traditional hardware and software companies will now dominate the Technology Sector index. To help ease the transition, S&P Global is considering publishing tracking indices that mimic the new construct. But the index changes could ultimately lead to increased volatility this coming summer and fall as index trackers adjust their holdings, and index algorithm creators and traders re-write sequences and code to account for new trading patterns and conditional relationships. There is a frequently run TV and radio commercial that poses the question, “Why own single stocks when you can own the entire sector?” This realignment may be one of the reasons why.

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

 

05 Mar C.J. Lawrence Weekly – Bond Yield Forecasts Still Not Competitive with Earnings Yield on Stocks

Our CJL Market Monitor reading weakened in February, understandably, as interest rates rose and previously positive market technical measures reversed course. The Monitor remains narrowly in BUY territory with a +1 reading, on a scale of -6 to +6. The two components that lost ground in February include our Year/Year Long Bond Model, and our NYSE Composite Moving Average Spread Model. The Long Bond model incorporates moves in the U.S. 30-Year Treasury Benchmark Bond yield. That model had generated a BUY signal in previous months as movement at the long end of the yield curve stalled. But the 30-Year Treasury yield made a meaningful move higher in February, and nudged that component’s reading into NEUTRAL territory. The NYSE Composite Moving Average Spread model also dropped a level as equity market volatility returned and positive market momentum was broken.

The interest rate components of the Monitor highlight the importance of the rate of change in bond yields versus the direction and levels of equity earnings. But the rate sensitive components have been less useful over the past decade as record low rates tilted those component models overwhelmingly towards stocks. Those measures are now working themselves back into normal balance. As they do, the conundrum will be how to calibrate the rate of change in interest rates versus their still historically low absolute levels. The current yield on the U.S. 3-Month T-bill is ~1.65%. Many Fed watchers are forecasting that three to four 25-basis point interest rate hikes are in the cards over the next twelve months. If these forecasts prove accurate the U.S. 3-Month T-bill yield should reach ~2.65% by this time next year. The last time the T-bill yield was at this level, and rising, was in January of 2005. The T-bill rose almost 200 basis points that year. Despite rising rates being a headwind for stocks, the S&P delivered a 4.8% total return in 2005 and a 15.8% return in 2006, as rates continued to climb. Headline CPI was 3.4% and 3.2% in 2005 and 2006, respectively.

S&P 500 Industrials Earnings Yield to U.S. 3-Month T-Bill Yield

S&P 500 Industrials Earnings Yield to U.S. 3-Month T-Bill Yield

To find another period when U.S. T-bill rates were ~2.65% and rising, one must go back to 1962. In that year T-bill yields began an ascent that took them to 5.2% in November of 1966. The S&P 500 struggled in the first year of that rate cycle, posting a -8.8% return in 1962, but delivered total returns of 22.6%, 16.4%, and 12.4% in 1963, 1964, and 1965 respectively. The S&P 500 earnings profiles in both periods (1962-1966 and 2004-2006) looks similar to today’s outlook, with EPS growing, and expected to grow, at a double-digit rate for three consecutive years. Another of our Market Monitor’s components takes earnings into account by measuring the Earnings Yield (inverse of the P/E) on stocks versus the 3-Month T-bill yield. At current levels of forecasted S&P earnings, the T-bill yield would have to ise to 5.1% for that component to flip in favor of bonds. It’s likely that rising rates, from any level, will provide a sentiment headwind for stocks, and will continue to pressure the market multiple. But history suggests that in periods of rising bond yields off multi-year lows, concurrent with double digit S&P 500 earnings growth, stocks can deliver attractive absolute returns and have historically outperformed bonds on a relative basis.

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.


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26 Feb C.J. Lawrence Weekly – Technology Continues to Deliver

The 4Q17 earnings season for the S&P 500 is 91% complete and the results, to date, are impressive. Earnings per share for the S&P 500 are coming in 14.7% ahead of last year’s level. 72% of reporting companies have delivered earnings results that were ahead of analyst expectations, a 5-year high for positive earnings surprises. Tax reform and other GAAP related earnings adjustments have created some cloudiness and debate around the headline numbers, making pure “operating results” less clear. But revenue results, on the other hand, can provide an unadjusted view of business progress. FactSet reports that, to date, 77% of reporting companies have delivered better-than-expected revenue results for the quarter, the highest positive revenue surprise reading since FactSet began compiling the data in 2008.

To date, S&P 500 revenues are coming in 8.2% ahead of last year’s level. If that figure holds, as the remaining constituents report, it will mark the highest sales growth rate since 3Q11. Currently all eleven sectors are posting positive revenue comparisons, with leadership being provided by Energy, Materials and Technology. They are up 20.3%, 20.1%, and 13.4% respectively, versus 4Q16. A rebound in oil prices helped boost energy company top lines, while rising product prices supported major and specialty chemicals sales. Materials sector sales have also been aided by the addition of E.I. DuPont de Nemours’ revenue results to Dow Chemical’s revenue line, post-merger. Without the combination, the Materials sector top line would be up 12% from the prior year.

Once again, the Technology Sector is delivering strong top line results. It has been the most consistent producer of revenue growth among all sectors, over the past fifteen years. In fact, Technology has had only one down year for revenues (-4.0% in 2009) during the period. 2017 sector revenues will likely come in 10.2% higher than 2016. Leading the way, within the sector, are the Internet Software and Services group and the Semiconductor and Semiconductor Equipment group, which are on track to deliver 25% and 18% year/year top line growth for 4Q17. Analysts surveyed by FactSet are looking for continued outperformance from the sector with revenues forecasted to grow another 10% in 2018 and 7% in 2019. Over time, sectors, groups, and individual companies that have been successful at generating consistent and meaningful revenue growth have outperformed the broader market. The technology sector continues to exhibit these characteristics, thus warranting a meaningful overweight position in growth portfolios, in our view.

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.


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20 Feb C.J. Lawrence Weekly – Financials Sector is the Baby that Should be Put Back in the Bath

We made the point in a recent Weekly Market Comment that the shrinking US publicly traded company share count could be a contributing factor to the equity market’s long bull run. The same phenomenon can also contribute to stock price volatility on a short-term basis, as witnessed during the last two weeks of trading. As volatility returned to the market and sentiment shifted in both directions, the stock market’s gyrations became more pronounced. Human and electronic traders are using new tools to gain the immediate exposure they seek. When the market turns, all babies go out with the bathwater.

There are now around 4,000 publicly traded companies on major U.S. exchanges, and almost 2,000 equity ETF’s and ETN’s that own them. ETFs and ETNs now account for over 30% of daily dollar trading volume. Many of these funds own the same securities. When market sentiment shifts, as it did on February 2, with the release of better that expected average hourly earnings data (inflationary), those exchange traded products tend to be the first levers pulled. In the case of negative sentiment and selling activity, the fund sales can quickly overwhelm the markets of the individual underlying securities with sell orders, scare away natural buyers, and send the underlying share prices gapping down. As selling begets selling, corrections take shape. Several of the largest equity ETF’s experienced 2.5x-3.0x their average daily trading volumes between February 5 and February 9. Yet some of their largest holdings experienced only 1.2x-1.7x increases in average volume during the same period, suggesting that fund selling was likely dragging many underlying security stock prices along for the ride, without the corresponding increase in individual security trading volume.

For investors looking through a longer-term lens, these periods can expose attractive opportunities for long term accumulation. In the recent market downdraft, the S&P Financials Sector Index declined 11.3% from peak to trough (2/8/18). Meanwhile, 2018 earnings per share estimates for the sector have climbed 10% in just the last two months. The Index has regained 6% of its price decline but still trades at an attractive valuation. At 13.7x 2018 forecasted earnings per share, and 12.3x 2019 estimates, the S&P Financial Sector Index is priced at historically low multiples of earnings for periods of economic expansion. The low valuations come at a time when index constituents are experiencing double digit returns on equity, and improving net income margins. Inflation and interest rate related volatility is likely here to stay, and will continue to pressure P/E multiples on stocks. But at the same time, higher rates, a steepening yield curve, and an improving economy are constructive for financial shares. We continue to be overweight the sector and would be opportunistic in periods when market volatility throws out financial babies with the proverbial market bathwater.

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.


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12 Feb C.J. Lawrence Weekly – Volatility Returns (Chairman, James Moltz)

This week we are pleased to offer thoughts on the market from our Chairman, James Moltz.  Jim launched the Weekly Market Comment at the original CJ. Lawrence back in the early 1970s and authored the piece for several decades.  We are fortunate to have his perspectives and are grateful for his leadership in our investment process.  Please do not hesitate to reach out if you have any questions. 

The abrupt rise in stock market volatility is being driven by a growing concern that recently enacted fiscal stimulus will overheat the economy bringing with it inflation, higher interest rates and federal funding issues. The 10% correction in the major U.S. indices is testimony to the market’s penchant to discount the future. Right now, business is good. Reports from Davos confirm that global corporate leaders are very optimistic about the outlook. But recent editorials in The Wall Street Journal, The New York Times and The Economist offered varying degrees of caution. The Economist’s February 10th cover carries a speeding car describing the American economy as “running red hot”. Inside the issue it pleads for the Fed not to lose its head. While official inflation numbers are relatively benign, several companies have recently announced the need for higher prices to offset rising transportation and materials costs. Numerous businesses have offered bonuses or wage increases to be funded by lower corporate taxes. LinkedIn, which focuses on corporate hires, sees a heightened demand for workers. All this has caught the market’s eye.

In the bond market, investors cite the movement in the 10-year treasury yield as telling. Since December it has advanced from 2.4% to 2.9%. The Fed is promising three fed fund increases in 2018 and some believe it will be four. Quarterly targets have been set to retire its fixed income inventory. However, the combination of the tax cut ($1.5 trillion) and increased spending ($ 400 billion) will double the 2019 budget shortfall to $1.19 trillion. That must be financed. A spike in short rates can be costly. At the end of 2017, 50% of U.S. debt matured in three years and the average coupon was only 1.77%. The U.S. is going to be in the awkward position of the Fed selling paper or letting it mature while The Treasury is issuing record new amounts hoping foreigners and U.S. investors will be buyers. A weak dollar would not help the cause.

Using S&P 500 earnings of $153.00, the Index’s p/e has declined from a high of 18.8x to the current 17.1x. The average low p/e for the past three years is 16.1x. A 16.0 multiple produces a 2448 Index Price of 6-7% below the February 9 close of 2619. Essentially that would allow 4% inflation and results in a 6.3% earnings yield. Current estimates for 2019 income are around $155.00 – $170.00. Future price action will depend heavily on upcoming inflation and interest rate news.

 
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.


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05 Feb C.J. Lawrence Weekly – The Tug‐of‐War Between Lower Valuations and Faster Earnings Growth Still Skews Towards Growth

There are multiple reasons cited for last week’s equity market blow off. It’s difficult to know which event set the downdraft in motion but the rapid rise in interest rates, after several years of historically low rates, is a good place to start. The U.S. Benchmark 10-Year Treasury Yield finished the week at 2.85%, up 39 basis points in just one month. It’s probably fair to say that the market has been expecting higher interest rates, but has been hoping for a more gradual climb. Recently released economic data, has confirmed that both the U.S., and global, economic recoveries are accelerating and inflation is beginning to push through. The U.S. bond market is recalibrating to higher economic growth expectations.

The classical cycle of an economic recovery leading to higher inflation and interest rates looks intact. But a signal may be developing at the long end of the yield curve questioning the rate of change in inflation, versus the rate of change in growth. Yield curve disciples cite the short end of the curve as being most responsive to Fed policy, the middle-to-long portion of the curve most sensitive to economic activity, and the longest end of the curve most susceptible to changes in inflation expectations. Over the past twenty years the spread between the yields on the U.S 10-Year Treasury Bond and the U.S 30-Year Treasury Bond has averaged 63 basis points. That spread now stands at 24 basis points. The ratio bears watching as the 30-year bond is the maturity least impacted by Fed policy, and may provide the best barometer of inflation expectations. Inflation that stays lower for longer could slow an equity market valuation re-rating, precipitated by higher short rates.

Growth and inflation expectations impact the relative value of stocks versus bonds, as reflected through the market multiple. Our CJL Rule of 20 tells us that an economic environment with 2.0% inflation can accommodate an 18x price-earnings (P/E) multiple on current year earnings. Thus, should inflation climb towards 3.0%, the appropriate multiple would likely trend towards 17x current year earnings. At 17x the consensus 2018 EPS forecast of $155, the fair market value for the index would be around 2,635, or 4.5% below the current level. But that is a static calculation that does not incorporate faster earnings growth, which should be assumed if inflation trends towards 3%. For stocks to offset a potential negative re-rating, earnings will need to grow faster than the rate of decline in the market multiple. This is happening. In just the past two months, bottoms-up earnings forecasts for the S&P 500 have climbed 7% for 2018 and 8% for 2019. Estimates are likely to climb higher as the remaining 50% of S&P 500 constituents report 4Q17 earnings results and issue guidance for 2018. The race between earnings growth rates and the rate of decline in the market’s P/E multiple is on. Along the way, the 10-30 year treasury bond spread may provide insights into the appropriate market multiple to apply. The challenge for equity investors will be to find stocks with earnings growth rates that exceed the rate of decline in P/E multiples. Based on current forecasts, they can be found in the technology and financial sectors. We remain overweight in both.

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.


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29 Jan C.J. Lawrence Weekly – Want to Buy Stocks? Get In Line.

Positive 4Q17 earnings results, an improving economic backdrop and outlook, rising corporate profit forecasts, and increasingly bullish sentiment have added fuel to an already roaring stock market fire. The S&P 500 Index tacked on another 2.2% last week, putting the index price up 7.5% year-to-date. Hungry bears saw a meal in last week’s report that net flows into stock funds spiked in the past two weeks, and suggested that a euphoria based sell signal is building. But we would caution against reading too much into the recent fund flows results, noting that ~80% of the net new equity flows went into “global” equity funds and not into domestic funds, according to Investment Company Institute data. The return to positive equity fund inflows can also be viewed as welcome news after more than two years of net outflows. Nonetheless, the net equity inflows, and the marked increase in bullish sentiment in several widely followed investor surveys, suggest to us that the once considered “most hated bull market in history” is finally getting some love.

 

But for the growing number of investors looking to build new, or add to existing, stock positions, finding attractively priced, highly liquid stocks to purchase is getting more challenging and competitive. The number of public companies listed on major U.S exchanges peaked in 1998 at around 7,500. At the end of 2017 there were less than 4,000. Robust merger and acquisition activity, low cost debt-aided leveraged buy-outs, and a dearth of Initial Public Offerings (IPOs) have all contributed to the net reduction. According to private equity data provider, Prequin Ltd., in the US alone, there are now close to 7,500 private equity-owned companies, almost twice the number of public companies. Costs and risks associated with being a public company, and broader access to capital for private companies, are encouraging corporate managements to stay private longer, if not indefinitely. Corporate tax reform has also made many of them healthier, allowing for larger dividends to be paid to private equity owners, and reducing the urgency for exits. Only 47 private equity sponsored companies went public in 2017, up 42% from the decade low 33 IPOs set in 2016. On the other end, a record 770 first-time private equity funds are currently seeking capital, according to Palico, an online marketplace for funds. That is 48% more than the previous all-time high of 520 in 2008. Once raised, that money will have to be put to work, gobbling up private and public companies alike.

 

Exacerbating the shortage of public company shares are corporate re-purchase programs which are reducing share counts of the remaining public companies. For the average S&P 500 company, the annual buy-back pace slowed in 2017, but is likely to reaccelerate in 2018, as tax reform-freed capital is deployed for capital expenditures, but is also returned to shareholders in the form of dividends and increased share buy-backs. Meanwhile on the supply side, there were 236 U.S. IPOs priced in 2017, raising $52.2 billion, surpassing the $26.5 billion raised in 2016 (143 IPOs) and $41.0 billion raised in 2015 (217 IPOs). But the new supply of shares brought to market during the past three years, in aggregate, pales in comparison to the value removed from the market through repurchase programs in just the first three quarters of 2017. During that period, S&P 500 Index constituents executed $518 billion in share repurchases. By the time 4Q17 final results are tallied, that figure could climb well above $650 billion. Equity exchange traded funds are also contributing to the contraction in tradable shares through their creation process, which removes shares from circulation in exchange for floating the basket (ETF). Equity ETF’s now account for between 5% and 7% of most S&P 500 companies’ publicly traded float. As the ETF industry grows, those figures will continue to climb. The supply-demand equation for stocks remains tilted toward the demand side, and looks unlikely to change any time soon. So long as fundamentals stay intact, that could keep a bid under stocks for a long time.

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.


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22 Jan C.J. Lawrence Weekly – Inflation Counter‐Forces in the New Economy

In the previous millennium, strategists and economists would sometimes gauge inflationary pressures by measuring and comparing the prices of New York City taxi medallions versus the price of a seat on the New York Stock Exchange. The price for a NYSE seats, which allowed the limited number of holders to trade stocks on the floor of the exchange, peaked in 1999, at $2.65 million, then dropped to $975,000 in 2005. Seat prices rallied later in 2005 on the announcement that the NYSE and Archipelago would merge, become a public company, and exchange seat licenses for IPO shares and cash. But the point had been made that the value being created in stock trading was in networks and no longer in exchange floor real estate. Meanwhile, NYC taxi medallion prices peaked in 2014 near $1.3 million. Several were auctioned off last week for less than $200,000 each. The commonality between the declines of these two once prized assets is the deflationary pressures of competition and disruption. The rapid evolution of electronic trading networks doomed the on-site, in-person trading floor, while disruptors like Uber and Lyft threaten the once protected franchises of NYC taxi medallion holders.

 

Today’s disruptors are doing the same thing in mature industries throughout the economy. The new “gig” economy has introduced deflationary forces that some feel could challenge the traditional cycle of inflation. Economic history tells us that the correlation between labor markets and inflation is tight. For inflation watchers, that means the current set-up suggests higher prices are ahead. Labor conditions are tight, the economy is growing, monetary policy remains relatively accommodative, and the U.S. economy recently received a healthy dose of fiscal stimulus. That is a potent inflationary mix. Trade restrictions, if imposed, would further contribute to upward inflationary pressure. A confirmatory signal has been flashed by the benchmark U.S. 10-year treasury bond yield, which closed the week at 2.65%, up 25 basis points in the last month.

 

But the rate at which prices rise, the amplitude of the increases, and the duration of the pricing cycle, particularly in certain segments of the economy, are less clear in the modern economic era. E-commerce and the “Amazon effect” have helped to drive prices and margins of most consumer goods to historic lows. Hydraulic fracturing has revolutionized the oil and gas industry, by dramatically reducing the response time to imbalances, and constraining the industry’s ability to raise prices. Cloud computing has democratized software consumption and modularized previously one-sizefits-all product offerings. A recent announcement by a group of hospital executives suggests they will collaborate on the development of their own generic drugs to compete with established pharmaceutical companies and distributors. New technologies in agribusiness and ranching are increasing crop and herd yields and are improving the resiliency of supply lines. These are just a few examples of the deflationary forces at work in today’s economy. Many of these trends are not new, but the pace of change appears to be accelerating. Equity investors should be wary of mature companies in industries where price erosion is prevalent. Inflation certainly looks to be on the rise, and the reflation trade may still have some legs, but history suggests that long-term equity investors are well served by owning companies that innovate, possess pricing power, and grow market share in any economic environment.

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.


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16 Jan C.J. Lawrence Weekly – Want Blockchain Exposure? Buy a Basket “OF MAGIC”

Until last week, Kodak was an imaging company struggling to manage the transition from film and hardware to digital and software. The 130-year-old company, which emerged from bankruptcy in 2012, had lost 80+% of its market value since re-emerging as a public company. But on Tuesday, Kodak announced that it was launching a cryptocurrency called Kodak Coin and would be launching an image rights management platform, that leverages blockchain technology, called Kodak One. The stock soared on the announcement, finishing up almost 200% in a week. A similar halo was bestowed on drinks company Long Island Iced Tea Company, which changed its name to Long Blockchain Corp. only to see its stock quadruple on the announcement. Likewise, the price performance of new digital coin and token issues has been measured in multiples, rather than percentage point moves. For those who invested through the dot com boom and bust period in the late 1990’s, these stories sound eerily similar to the concept (pre-revenue) IPOs that launched in the late 1990’s in response to the market’s insatiable appetite for anything resembling an “internet company.”

Cryptocurrency and blockchain debates have dominated the business news cycle over the past few weeks. Recent moves by South Korea and China to limit cryptocurrency trading fueled volatility on exchanges already besieged by wide price swings. In an on-air interview with New York University’s expert on corporate valuations, Prof. Aswath Damodoran, highlighted the point that cryptocurrencies are currently being priced, not valued, and that the full faith and credit behind cryptocurrencies is the software code that defines them, and not any one entity, agency, or balance sheet. He also introduced the concept of crypto-commodities, versus cryptocurrencies, which some advocates consider more akin to gold than the Swiss Franc or Russian Ruble. No doubt, these instruments have their supporters. But mainstream adoption of cryptocurrencies and crypto- commodities may be evolutionary, not revolutionary. Central bankers, government officials, consumers, and consumer protection agencies world-wide, all with their own agendas, will need to agree on global protocols and processes, before cryptocurrencies become mainstream. Unlike dot com companies, which opened access to new services consumers previously did not have, cryptocurrencies seek to replace existing processes and means of exchange, that unquestionably have flaws, but which few would claim inhibit consumers’ ability to transact. Thus, for all the benefits of cryptocurrencies, the lack of a pressing unmet need may slow their adoption. Meanwhile, blockchain technology, the infrastructure behind cryptocurrencies, looks to have broad application, and may warrant more immediate investor attention.

Blockchain is a shared public ledger which tracks transactions and ensures the record of those transactions remains transparent. There are broad applications for the technology, and various initiatives are currently underway exploring the benefits of blockchain ledgers in the financial services, e-commerce, food safety, digital media, pharmaceuticals, cybersecurity, and transportation industries, among others. Leading the charge in these areas are several of the world’s most successful technology companies. Microsoft, IBM, Oracle, Alphabet (Google), and Accenture all have major initiatives underway aimed at integrating blockchain technology into current business processes. Facebook CEO, Mark Zuckerberg, has stated that blockchain and crypto currency will be one of his top personal priorities in 2018. In our view, these companies, and a few other technology leaders, possess the size, scale, engineering prowess, and balance sheets to bring blockchain technology from white board to implementation. There will no doubt be “moon shot” start-ups and disruptors that make their founders and owners rich. But for investors seeking a lower risk approach to participation in the new paradigm of blockchain technology, we suggest establishing a basket “OF MAGIC” (Oracle, Facebook, Microsoft, Accenture, Google (Alphabet), IBM Corp., and Cisco) which delivers broad exposure to this revolutionary technology.


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.


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08 Jan C.J. Lawrence Weekly – CJL Market Monitor Continues to Favor Stocks

As investment managers, we sleep with one eye open and the other on our Market Monitor. The C.J. Lawrence Market Monitor was created in the early 1980s to measure the attractiveness of the stock market. It calibrates the relative appeal of stocks versus fixed income and tests the internal technical health of the stock and bond markets. Over the Monitor’s 37-year history, it has been a useful asset allocation tool. While not developed as a timing model, the SELL signals generated prior to the stock market crash of 1987, and again in the period leading up to the bursting of the internet bubble in 2000, are two of the Market Monitor’s most notable measurements. The Market Monitor’s current reading is solidly in BUY territory at +3, on a scale of -6 to +6.

The Monitor consists of six components. Each is constructed to generate individual BUY, HOLD, and SELL signals. Two of the components are driven by equity fundamentals, two by the direction and rate of change in short and long interest rates, and two by technical and market breadth indicators. The interest rate signals were less useful post financial crisis, as rates fell to historically low levels and even small basis point changes had a meaningful rate of change impact. But the interest rate models are beginning to come back into balance as rates are normalized. Interestingly, in the December period, the Long Bond model generated a BUY signal, after several months in Neutral territory, as monthly average U.S. 30-Year Benchmark Treasury yields fell more than 10% below last year’s level. Normally, at the beginning of a rate tightening cycle, this component would be generating a negative signal.

C.J. Lawrence Market Monitor Chart - January 8, 2018

C.J. Lawrence Market Monitor Chart – January 8, 2018

The Market Monitor’s bullish positioning is understandable given the recent improvement in equity fundamentals and cash flow yields on stocks, versus the still relatively paltry yields on fixed income instruments. As U.S. interest rates rise, as they are expected to do in the coming year, the risk-free rate on treasuries should become more attractive. But the pace at which the economy, and corporate profits, improves may continue to tilt the relative equation towards stocks. Asset allocators, increasingly worried about the veracity and length of the current bull market, may find comfort in the CJL Market Monitor’s stance. A breakdown in equity market technical metrics and breadth would certainly weaken its conviction, but the improving fundamental backdrop will likely keep the Market Monitor favoring stocks in 2018. We continue to overweight equities in balanced 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.


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02 Jan C.J. Lawrence Weekly – 2017 Scoreboard Highlights Consistent Technology Leadership

When we wrote the year-end market summary last year, we noted the high level of sector rotation that took place on a quarterly basis throughout 2016. In 2017, leadership was instead remarkably consistent. Of the major S&P 500 sectors, Technology led all others in three out of four quarters and finished the year at the top of the leader board, having generated a 39% total return. It was followed by the Materials and Consumer Discretionary sectors, which lagged the leader by wide margins, but produced attractive returns of 24% and 23% respectively.

What is also noteworthy is that the relatively high dividend, “bond proxy” sectors finished the year consistently at, or near, the bottom of the performance charts, despite historically low bond interest rates. Telecom stocks finished in the bottom position having delivered a negative return of 1.3% for the year. The Energy Sector Index also delivered a negative annual return (-1.0%) having experienced meaningful negative returns in the first half of the year, off-set by positive returns in the second half.

The broader S&P 500 Index returned 21.8% for 2017, making it the 32nd time the S&P 500 total return has eclipsed 20% in the last 90 years. The strong index performance and a proliferation of index related products may have helped to lift the prices of almost all index constituents. Only four S&P sub-index groups finished in negative territory for the year. The top performing groups for the year were Personal Products (+49.6%), anchored by the strong price performance of Estee Lauder, and Internet Retailing and Direct Marketing (+47.3%), which is driven primarily by the price performance of Amazon.com and Netflix. The worst performing groups were Energy Equipment and Services (-15.1%) and Leisure Products (-12.2%) which is comprised of Hasbro and Mattel.

Earnings per share, for the broader index, are expected to grow 11.4% in 2018 and 10.1% for 2019, according to bottoms-up forecasts provided by Factset. Interestingly, the current estimates are below the levels recorded at the beginning of 2017. Analysts appear to be waiting for company guidance before incorporating tax reform benefits into their models. Consensus forecasts suggest that the new corporate tax rate of 21% could add another 9%-10% of growth to next year’s S&P 500 Index EPS estimate. The fastest earnings growth in 2018 is expected to be generated by the Energy sector, driven by low comparisons and firming oil prices. Materials and Technology are expected to round out the top of the earnings growers list, while Telecom and Utilities are expected to lag. If earnings growth drives sector performance in 2018, the year’s leaders and laggards list could look very similar to 2017.


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.


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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.


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.


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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.

 


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 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!

 


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

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.

C.J. Lawrence

Investment Management