10 Dec C.J. Lawrence Weekly – Overweight Communications Services Sector for Both Offense and Defense

The stock market’s recent swings have been dramatic. On several occasions the S&P 500 has completed a round-trip move of more than 3% in a single session. Last week the Index reached a high of 2,800 but finished the week at 2,623, down 6.3% from the intra-week high and down 4.6% for the week. The market’s price action highlights its fragility and investor and trader lack of conviction in directional moves. Tweets, headlines, and rumors are giving the markets fits at a time when longer-term investors are grappling with the prospects for slowing global growth. But while the broader market has been unpredictable, patterns within the market have been quite consistent. On big equity decline days, treasury bond prices have rallied and equity investors have rotated to “defensive” sectors like utilities, real estate, and consumer staples, and out of stocks that have outsized year-to-date gains or meaningful overseas sales exposure. Technology shares have suffered the largest declines as they meet both criteria.

The two areas of macro focus for most stock investors continue to be the status of trade with China and the outlook for profit margins in the face of growing wage pressures at home. Thus, the attractiveness of utilities and real estate investment trusts has grown beyond their defensive characteristics as a result of their predominantly domestic revenue exposure. Consumer staples stocks still check the defensive box due to the resiliency of their revenue streams, but their risks are rising as sector constituents have relatively high exposure to overseas markets. A challenge for investors looking to utilize these sectors in defensive strategies is that they’ve also become expensive. Utilities stocks and real estate investment trusts are trading close to peak historic valuations on a price-to-earnings (P/E) and a price-to-funds from operations (P/FFO) basis. Staples stocks have come off their peak valuations recently but slowing global growth presents major revenue headwinds for most of the sector’s constituents.

S&P 500 Sector Sales Exposure to China (LTM) | Source: FactSet Data

S&P 500 Sector Sales Exposure to China (LTM) | Source: FactSet Data

Meanwhile, one sector that has been beaten down over the last year despite a good mix of both defensive and offensive characteristics is the recently created Communications Services Sector. It was formed this fall by S&P Global as part of their GICS (global industry classification system) sector reclassification. The sector carries close to a 10% weight within the broader S&P 500 but still lags that weight in most index funds and ETFs. For instance, the assets under management (AUM) in the Technology Select Sector SPDR ETF is near $19.3 billion, while the AUM in the Communication Services Select SPDR ETF is $3.2 billion. That is close to a 6 to 1 ratio in assets, while the weights within the S&P 500 Index have a 2 to 1 ratio. The imbalance would suggest that sector funds will need to build positions in the Communications Services sector stocks in the coming year to restore relative balances and avoid tracking error. With faster sales growth than the S&P 500, high profit margins, and low international revenue exposure, particularly to China, the sector also looks attractive on both a fundamental and a relative macro basis. To be sure, the sector’s heavy weights, Alphabet and Facebook, continue to face regulatory scrutiny, but both companies’ stocks have been commensurately punished over the past year and are trading at historically low valuations. The sector’s other large industry weights are in the media and entertainment industry groups, which tend to be resilient to economic downturns and are less exposed to wage pressures due to their low compensation cost ratios. Meanwhile Communications Services is the second worst performing sector year-to-date, down ~9.5%. It may have already taken its medicine and is poised for relative outperformance.

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

03 Dec C.J. Lawrence Weekly – Earnings on Watch

The trade détente between the United States and China may provide temporary relief from the negative sentiment around global trade. Whether the dialogue can transition into an actual agreement will play out over the next several weeks. But to date, despite growing consensus expectations of both slowing international trade and global growth, company analysts have not dramatically ratcheted back their 2019 sales and earnings growth forecasts and are therefore unlikely to raise them if a deal is consummated. On third quarter earnings calls, dozens of companies cited uncertainty around global trade as a potential headwind for future quarterly results, but very few took a shot at trying to quantify the impact. The analysts, meanwhile, have been attempting to recalibrate forecasts against what is turning out to be a record high in S&P 500 quarterly sales and earnings. As the last few 3Q18 company results trickle in, it appears that quarterly earnings growth will come in around 26% higher than last year, and sales will be up 9.5% during the same period.

Third quarter results have eclipsed even the most optimistic expectations. 78% of reporting companies delivered earnings results in excess and mean expectations while 68% of reporting companies exceeded sales forecasts. However, strong corporate financial performance has not been enough to off-set the growing fears of “peak earnings” and trade-related disruption. In fact, companies that generated positive earnings surprises for 3Q18 experienced stock price increases of only 0.1% in the four-day period surrounding their earnings release (two days before and two days after). Companies that delivered results that fell below analyst expectations experienced average stock price declines of 3.1%, worse than the 2.5% average decline set over the past five years.

 

S&P 500 2019 Bottoms-Up Earnings per Share Estimate | Source: FactSet

S&P 500 2019 Bottoms-Up Earnings per Share Estimate | Source: FactSet

Corporate sales and profit forecasts for 2019 are little changed over the past few months. Rates of growth have been trimmed but primarily due to better-than-expected 2018 performance without a corresponding lift to absolute 2019 expectations. According to FactSet, bottoms-up forecasts for the S&P 500 call for earnings of ~$176 per share in 2019 and ~$195 per share in 2020. Both assume profit margin expansion beyond the current record level of around 12%. We think that analyst profit margin expansion expectations may be too optimistic given rising labor, materials, and transportations costs. Should Chinese and U.S. trade negotiators fail to avert even a minor trade war, further pressure could be exerted on margins. Using flat margins on 2019 sales expectations would give us an earnings result around $170 per share. Applying a P/E multiple range of 15x to 17x against that estimate would suggest an S&P 500 price range of 2,550 to 2,900 over the next twelve months. With the index currently trading around 2,760 that would suggest downside risk of about 7%, and upside potential of around 5%, putting the broader markets’ risks and rewards close to balance. In this type of environment, the challenge for managers and investors is to find and own stocks of companies that grow market share and control their own destinies and avoid stocks of companies that require a lift from the market to perform. We increasingly find these names in the technology and health care sectors, and in select consumer discretionary industry groups.

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

26 Nov C.J. Lawrence Weekly – Checking the Pulse of the Freight Economy

The shift in economic and market sentiment during the past few weeks has been palpable. The once synchronized global growth chorus has subsided and has been replaced with a negative refrain of global growth deceleration. Recent lackluster economic data releases from China and Europe have contributed to growing pessimism. In conjunction with downward foreign GDP estimate revisions, economists have ratcheted down expectations for 2019 U.S. GDP growth in conjunction with slowing international trade. Some economists have gone as far as to forecast a U.S. recession in the next 12-18 months. Analysts who contribute to the FactSet consensus estimate for the S&P 500 Index are not aligned with that positioning. 2018 earnings expectations are down only 0.8% from their peak, and 2019 estimates are down only 0.4% from their peak. The market has reacted to the economy-versus-market tug-of-war by reducing the P/E multiple investors are willing to pay for 2019 S&P 500 earnings per share from 16.6x at the beginning of the year, to its current level of 15x, despite a 3.5% increase in estimates. Freight flows are often good indicators of the direction of economic activity and are currently giving some mixed signals.

The Baltic Dry Index measures the price of shipping raw materials such as metals, ores, and grains by sea. The largest category of ship tracked by the BDI is the Capesize class. It was given its name because the ship’s size precludes it from transiting the Panama Canal, necessitating shipping routes that circumnavigate the Capes of Good Hope and Horn. Demand for Capesize capacity is closely tied to the health of Chinese commodity demand. Rates for these ships are down 70% since August. The broader BDI is down 38% from its August peak and is down 31% from this week last year. Meanwhile, global air cargo traffic is still growing but current growth is below trend. The International Air Transport Association (IATA), reported global air cargo traffic up 2.0% in September and up 2.3% in August, which are both below the five-year average growth rate of 5.1%. Estimates for October, due out next week, suggest a consistent pattern. October data from the Hong Kong International Airport, a major global cargo transshipment facility, showed a 2.8% increase in international freight tonnage in October, versus that same period last year.

US Total Rail Car Loadings (4-Week Rolling) | Source: Association of American Railroads

US Total Rail Car Loadings (4-Week Rolling) | Source: Association of American Railroads

The domestic freight landscape looks markedly better. Rail traffic, on a rolling four-week basis, is surging on the back of strong petroleum and grain shipments. Intermodal traffic (rail shipments of containerized cargo) is up 2.3% on a four- week rolling basis, versus the same period last year. Truck traffic remains strong with the American Trucking Association reporting a 9.5% increase in total tonnage in October versus the same period last year. The Cass Freight Index, which measures a different sample of U.S. shippers than the ATA, showed shipments up 6.2% in October. These reports highlight the relative strength of the U.S. domestic economy versus other industrial economies and provide a good barometer for economic activity at home and abroad. While the U.S. freight economy appears buoyant, a continued slowdown in global activity will likely weigh on domestic indicators in the months ahead. The bright spot in the freight traffic mix continues to be U.S. to U.S. trade where healthy domestic consumers and companies are transacting with each other at high levels. Investors looking for attractively priced equity market opportunities amid current volatility would be well served to follow the freight flows.

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

19 Nov C.J. Lawrence Weekly – Does “Jay” Do the Thanksgiving Shopping?

This week, millions of consumers will finish their shopping for the time-honored American tradition, the Thanksgiving Dinner. If Jerome “Jay” Powell, the Chairman of the Federal Open Market Committee, handles those duties for his family, he’ll find some interesting data to consider, adding to the tame core CPI report released last week. On Thursday, the American Farm Bureau Federation released its survey results for the cost of the traditional Thanksgiving feast. The 33rd annual survey, which measures a consistent basket of items for a Thanksgiving dinner for 10 came in at $48.90, down $0.22 from last year’s survey. After adjusting for inflation, the cost of this year’s Thanksgiving dinner is $19.37, the lowest level in more than a decade.

The shopping list for the Farm Bureau’s survey includes turkey, stuffing, sweet potatoes, rolls with butter, peas, cranberries, a veggie tray, pumpkin pie with whipped cream, and coffee and milk. The quantities measured are enough to serve a family of 10 with plenty of leftovers. The marquee item, the turkey, cost slightly less than last year, coming in at $21.71 for a 16-pound bird. That’s close to $1.36 per pound, down 3% percent from last year. Turkey prices are now at the lowest level since 2014. Other items showing price decreases this year include; a gallon of milk, a 3-pound bag of sweet potatoes, a 1-pound bag of green peas, and a dozen rolls. Items that saw modest increases in prices this year include; cranberries, pumpkin pie mix and stuffing. The survey is consistent with consumer price reports showing that food inflation remains tame.

It’s unlikely that the measured pace of food inflation, and in some cases deflation, will alter the Fed’s current course of near-term rate hikes. But if Jay Powell also stops for gas on his way home from Stop and Shop, he may reconsider the Fed’s plans for next year. Since the beginning of October, the national average unleaded gasoline price is down $0.25 per gallon to $2.57. Given the recent decline in oil prices, gas prices are likely headed lower. The U.S. 10-year treasury bond yield looks to also be questioning the outlook for growth and inflation. Despite strong employment reports and record treasury issuance, the 10-year yield has drifted back below 3.1%. Odds are high that the Fed will raise the Fed Funds target rate at its December meeting. But the bigger question for the equity markets is whether, after giving thanks for lower consumer prices at Thanksgiving, the Fed will be in a gift-giving mood for Christmas. On behalf of our team here at C.J. Lawrence, we wish you and yours a very Happy Thanksgiving!

Thanksgiving Cost Index | Source: American Farm Federation Bureau

Thanksgiving Cost Index | Source: American Farm Federation Bureau

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

12 Nov C.J. Lawrence Weekly – The Battle Between Rising Interest Rates and Corporate Earnings Growth is On…CJL Market Monitor at Neutral

The C.J. Lawrence Market Monitor was created in the early 1980s to measure the relative attractiveness of the stock market versus bonds, and to test the internal technical health of the stock market. Over the 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 readings. Post financial crisis the Monitor assumed a very bullish stance on equities as record low yields on treasury bonds posed little competition to even modest earnings yields on stocks. But over the past several months the Monitor’s bullishness has moderated as interest rates climbed towards more “normal” levels. The Market Monitor’s current reading is NEUTRAL, with a reading of 0, on a scale of -6 to +6.

CJL Market Monitor | Source: C.J. Lawrence

CJL Market Monitor | Source: C.J. Lawrence

Each of the Monitor’s components is constructed to generate individual BUY, HOLD, and SELL signals. Two of its components are driven by the comparison of equity fundamentals to bond yields, two by the direction and rate of change in short- and long-term interest rates, and two by technical and market breadth indicators. Currently the two components incorporating equity fundamentals are positive and neutral, the two year-over-year bond yield comparison models are negative, and the technical models are positive and neutral. The challenge for Monitor disciples, like ourselves, is to account for its sensitivity to the rate of change in interest rates regardless of absolute levels. For instance, an increase in 3-month treasury bill yields from an absolute level of 50 basis points to a level of 100 basis points can generate the same negativity for stocks as a scenario where yields move from 3.0% to 3.5%. This is symptomatic of much of the market commentary we hear today in the financial press when experts discuss the “rising rate environment”. Yes, rates are rising, but they also remain at historically low levels. The larger question, in our view, is if, and when, interest rates will climb to levels that are more competitive with the yields on stocks.

S&P 500 Earnings Yield (NTM) to U.S. 10-Year Treasury Bond Yield Spread | Source: FactSet Data

S&P 500 Earnings Yield (NTM) to U.S. 10-Year Treasury Bond Yield Spread | Source: FactSet Data

For additional perspective, it can be instructive to look at the spread between the earnings yield on the S&P 500 (the inverse of the Price/Earnings ratio) and the 10-Year Treasury Bond yield over time. Since 1969 the differential has averaged 0.78. It now stands near 3.0%, making stocks the heavy favorite. A common rule of thumb is that stocks need to deliver an earnings yield more than 100 basis points higher than the yield on short term (3-month treasury) paper to compensate investors for the risks associated with holding equities. Today, the earnings yield on the S&P 500 is well in excess of that level, and the above comparison illustrates favorable spreads to maturities further out on the yield curve. But the path of Fed monetary policy threatens to change that calculus, and the long end of the yield curve has been cooperative of late. Strong corporate earnings reports have helped keep spreads wide, but a future slowdown in corporate profit growth that coincides with increases in interest rates could shift the balance between equity and bond yields and tilt the Market Monitor towards negative territory. The current pace of earnings growth has been encouraging and suggests the status quo should hold. But asset allocators would be wise to keep an eye on corporate earnings forecast revisions for signs that the spreads between stock and bond yields are tightening.

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

05 Nov C.J. Lawrence Weekly – S&P 500 On Track for “Quiet” Year Despite Spike in VIX

The Chicago Board of Trade (CBOE) developed and launched the Market Volatility Index (VIX) in 1993, based on the Sigma Index and methodology created by Menachem Brenner and Dan Galai in 1986.  Today it is a commonly referred to as the “fear gauge” because of the perception that higher volatility index readings represent negative stock market action.  In fact, the VIX does tend to spike during meaningful stock market declines and remains low during periods of stock market appreciation.  But the VIX is often misperceived as a measure of equity price action.  Instead, the VIX Index represents the anticipated level of volatility of the S&P 500 Index over the next 30 days, calculated by aggregating the implied volatility of hundreds of SPX option spreads.  Thus, while the VIX may not be a good indicator of future stock market returns, it is a good measure of near term institutional investor sentiment and provides insight into the level of protection they are seeking in choppy markets.

CBOE Market Volatility Index (VIX) | Source: FactSet Data

CBOE Market Volatility Index (VIX) | Source: FactSet Data

The five-year average for the VIX now stands at 14.7.  It spiked to 25.2 on October 24 and closed last week at 20.2.  The current reading suggests that options market participants believe there is an elevated level of equity risk in the market over the next 30 days and are seeking protection from that risk.  As the daily VIX Index chart shows, the reading can change quickly and tends to be more reactive than proactive.  Nonetheless, it is an important trader tool that can also help longer term investors identify over-sold markets and attractive entry points.

S&P 500 Index Price 30-Day Rate of Change | Source: FactSet Data

S&P 500 Index Price 30-Day Rate of Change | Source: FactSet Data

Media headlines, suggesting that the recent spike in the VIX is associated with record high volatility in stocks, miss the mark.  An analysis of historical patterns of annual high and low prices suggests that stock price differentials have been muted in 2018.  The S&P 500 Index hit a year-to-date closing high on October 3rd at 2,925.51 and a year-to-date closing low of 2,581.00 on Feb 8.  That represents a 13.3% differential between high and low.  If it holds that level, 2018 will deliver the 5th lowest level of high-low price differential over the past 50 years.  The compressed high-low price gap and paltry 1.8% year-to-date price return suggest that S&P 500 Index volatility isn’t living up to the hype.  Instead, what keeps managers and investors awake at night is the pace at which the market gyrates within the high-low boundaries.  The good news is that following bottoms in the S&P 500 30-day rate of change, stock prices tend to deliver attractive returns over the next ninety days.  After the troughs in August of 2015 and February of 2016, the S&P 500 Index appreciated 11.8% and 12.8% respectively over the subsequent 90-day periods.  Periods that follow coincidental spikes in the VIX and troughs in the S&P 500 Index 30-day rate of change have historically represented good entry points for stocks.  Long-term investors would be wise to keep their favorite idea shopping lists handy.

Terry Gardner Jr. is Portfolio Strategist and Investment Advisor at C.J. Lawrence. Contact him at tgardner@cjlawrence.com or by telephone at 212-888-6403.

 


Terms and Conditions

29 Oct C.J. Lawrence Weekly – Innovation on Sale

The recent market sell-off has investors questioning their allocation strategies and the underpinnings of the bull market in stocks.  Year-to-date, the S&P 500 is now down 0.56%, after being up 11.2% at its September peak.  The Technology, Health Care, and Consumer Discretionary sectors were joined by Utilities last week as being the only sectors with positive year-to-date price performance.  The Materials and Financials sectors are the worst performing sectors, year-to-date, with sector index prices down 14.8% and 8.3% respectively.  Thursday’s earnings announcements from Amazon and Alphabet that showed lower-than-expected quarterly top-line results thwarted a rebound in broader index shares that began mid-week.  The top-line misses shook the stocks of the two companies in Friday trading and kicked at the foundation of a market that was already on shaky footing.

Approaching the release of calendar 3Q18 corporate financial results, the high estimate bar raised the risk that companies failing to clear the hurdle would be punished by the market.  But not only have the stocks of those companies been punished, but the stocks of companies that hit most of their marks were sold.   Since the beginning of earnings season, the S&P 500 Index price is down 8.5%, despite 78% of reporting companies delivering positive earnings surprises.  Market sentiment is shifting to a position where the consensus now views 2018 as a peak year in S&P 500 sales and earnings growth.  As that view takes hold, pressure may continue to build on stock valuations, which tend to compress during periods of earnings growth deceleration.  Initially, most stocks feel the weight of multiple compression and trade in unison with the broader market.  But eventually the wheat is separated from the chaff and individual leaders emerge and outperform.

Amazon.com Research and Development Spending

Amazon.com Research and Development Spending

The recent market downdraft may be creating opportunities for active managers and investors to buy industry leaders and innovators at attractive prices.  In April of this year, we authored a note titled Innovation at a Reasonable Price, which highlighted increasing rates of research and development spending (R&D) by the market’s leading change-agents, innovators, and disruptors.  The point remains that companies that lead in this area are creating future value and optionality and should be owned not only for today’s cash flow generation but also for tomorrow’s innovation.  In many cases, R&D spending, and its prospective return on investment, is not reflected in the innovator’s stock price, creating opportunities for investors with longer horizons.  Recent financial results suggest that some leaders are accelerating their research and development efforts.  Amazon.com, for example, leads the R&D list having increased its quarterly spend by 21% from last year’s level.  On a four-quarter trailing basis Amazon’s annual R&D spend has eclipsed $27 billion, up from $22 billion at the beginning of this year.  Alphabet takes the second spot on the list of R&D spenders, having bumped up its investment by 24%, versus last year, and is closing in on $20 billion of annual R&D spending.  Microsoft and Apple are following close behind with annual R&D outlays of $15 billion and $13 billion respectively.  All four companies are massive cash flow generators allowing them to funnel resources into continuous product research and development, helping to widen their competitive moats.  Except for Amazon, they trade at less than 1.5x the market P/E multiple.  In recent weeks these, and other R&D leaders, have not been spared by the market sell-off.  Broad market downdrafts can be opportune times for investors inclined to buy “innovation at a reasonable price” especially when “innovation is on sale.”

 


Terms and Conditions

22 Oct C.J. Lawrence Weekly – Is U.S. Economic Growth Reaching a Peak?  The Bond Vigilantes May Tell Us.

In the early 1980’s our former Deutsche Bank colleague, Dr. Ed Yardeni, coined the phrase “Bond Vigilantes” to describe bond market reactions to loose fiscal policy.  When the federal government threatened to ramp debt-fueled spending, the Bond Vigilantes would ride in, sell treasuries, and push yields higher, administering the market’s own justice on issuers.  During the “Great Bond Massacre” in late 1993 – early 1994 the yield on the U.S. 10-Year Treasury Bond rose from 5.1% to 8.0% in response to fears of massive federal government spending increases.  The U.S. Treasury is currently engaged in another massive funding cycle, issuing increasing amounts of debt to fund the country’s mounting budget deficit.  But so far, the Bond Vigilantes have kept their guns holstered and foreign buyers of treasuries don’t look poised to join their posse if they ride again.  Strong demand for treasuries, and the specter that U.S. economic growth could slow because of trade wars, could keep the Vigilantes at bay.

The Treasury International Capital (TIC) data on August activity showed that foreign buyers purchased more U.S. bonds than in previous months.  U.S. 10-year paper, with a ~3.2% coupon, still looks relatively attractive versus paltry European sovereign yields hovering around 0.46% and Japanese 10-year paper at 0.14%.  But wide spreads on global sovereign debt is not the only demand driver for U.S. treasuries.  U.S. households continue to be large buyers of treasury securities as they express skepticism of the bull market in stocks.  Even in the face of growing issuance, the U.S. Treasury is finding buyers for its debt.  During the week of October 8, the U.S. Treasury held bond auctions for $36 billion in 3-Year notes and $23 billion in reopened 10-year notes.  The bid-to-cover ratios for both auctions were slightly lower than previous auctions, but they were fully subscribed, and yields are now back below auction levels.

But the day-to-day movements in yields may be less important than the changing narrative around the prospects for global growth and the potential impact that slowing international trade could have on the U.S. economy.  A growing chorus of investors and market watchers are recalibrating 2019 and 2020 growth expectations on the back of rising fears that a slowdown in trade will ultimately catch up with U.S. companies and crimp the expansion.  This path would likely lead to slower top-line growth for U.S. companies and pressure future earnings power. Meanwhile, consensus forecasts remain for the Federal Reserve to continue its telegraphed path of Federal Funds target rate hikes, and for the long end of the yield curve to follow suit.  With a backdrop of heavy issuance, the prospect for the Bond Vigilantes to re-emerge and force an even sharper steepening of the yield curve would be a likely outcome under that scenario.  But these two paths cannot run parallel for long.  Eventually one will dictate market direction and psychology.  Expectations still favor Bond Vigilante intervention and higher rates.  However, their inaction, in the face of growing Treasury bond issuance, would be an important signal on the trajectory of growth and inflation.

S&P Industrials Index Sales Growthy (Yr/Yr%) vs U.S. 10-Year Treasury Yield | Source: FactSet Data

S&P Industrials Index Sales Growthy (Yr/Yr%) vs U.S. 10-Year Treasury Yield | Source: FactSet Data

 


Terms and Conditions

15 Oct C.J. Lawrence Weekly – February Redux?  Maybe Not.

The S&P 500 Index hit a new record high on January 20th of this year.  Then, within nine trading days of the new high, it lost over 10% of its value. Sparking the sell-off was the release of some “hot” economic data, which was expected to usher in higher inflation and higher interest rates, and growing concerns about the demise of the North American Free Trade Agreement (NAFTA).  During the nine-session decline, the U.S. 10-year Treasury bond yield climbed 23-basis points putting it up 42 basis points in just one month.  During the next month the 10-year yield settled down, increasing only 4 basis points.  Over that period, the S&P 500 Index recovered most of its lost ground, rising 8% from the February 8th low.  Stocks tested lows again in April before setting course to new highs in October.

A similar pattern has emerged during the past several weeks.  The S&P 500 Index hit a new all-time high on October 5, and on the same day the 10-year Treasury bond yield reached 3.23%, its highest level since 2011. The new highs in stock prices and rapid ascent in treasury yields were accompanied by domestic economic data that some inflation watchers viewed as incendiary.  At the same time, China-U.S. trade relations appeared to deteriorate to new lows.  The news flow, perceived as negative for stocks, was like a hot spark in a drought-stricken forest.  As in January, once the selling started, the algorithmic, systematic, and technical traders took charge and the intra-day moves were indiscriminate and dramatic.  The S&P 500 finished the week down 4.1%, after being down 5.5% through Thursday.

In the January downdraft defensive sectors like Consumer Staples, Utilities, and Telecom were relative outperformers.  Then, once the market found its footing, investors returned to growth sectors, with Technology leading the way until the most recent new high.  A similar pattern was observed last week with a rotation to defensive sectors during the downdraft, with a modest recovery on Thursday and Friday in growth sectors like Technology and Consumer Discretionary.  But what’s changed in the backdrop is the calculus on global growth.  The U.S.– China tariff and trade battle has cast a pall over the global synchronized economic growth scenario, encouraging the IMF to lower its forecast for global economic growth for this year and next, to 3.7% from 3.9%, and to express concerns about capital flight from emerging markets.  Adding to the pressure on the global growth leg of the stool was the German government’s negative 2018 GDP forecast revision from 2.3% to 1.8%.  The shifts in sentiment and economic forecasts are likely to spur continued stock price volatility and periodic flights to safety.  But previous cycles have shown us that flights to safety eventually shift to flights to quality, and that market leadership narrows.  Finding stocks and groups that can grow sales and earnings in excess of market rates becomes paramount for managers and investors seeking to outperform.  Its time again to water the flowers and cut the dandelions.

S&P 500 Index vs U.S. 10-Year Bond Yield | Source: FactSet Data

S&P 500 Index vs U.S. 10-Year Bond Yield | Source: FactSet Data

 


Terms and Conditions

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09 Oct C.J. Lawrence Weekly – Don’t Fear the Rate Cycle

Last week’s dramatic stock market headlines sounded much worse than the result. The S&P 500 Index finished down 0.9% for the week, and, as of Friday, was up 7.9% on the year. The technology heavy NASDAQ Composite did not fare as well trading off 3.2% for the week but was outperforming most other major equity indices for the year, up 12.8% at the close of the session. The action was similar yesterday with the S&P 500 flat and the NASDAQ Composite down .67%. The attention-grabbing headlines have highlighted the rapid ascent of treasury bond yields which are rising on the back of particularly strong domestic economic reports. The ISM Manufacturing Index reached its highest level since the Index was created, the unemployment rate fell to a 50-year low, and the Consumer Confidence Index reached an 18-year high. The strong reports have pushed treasury bond yields meaningfully higher. The U.S. 10-Year Treasury bond yield closed the week at 3.23%, its highest level since early 2011.

The 10-Year yield looks to have finally found solid footing above 3.0%, giving the Federal Reserve some clear air to maintain its projected schedule of target federal funds rate hikes, without worrying about inverting the yield curve. This evolving outlook may be causing a shift in equity market psychology whereby good news for the economy is now being viewed as bad news for equities. Higher rates are perceived as negative for stock prices. To be sure, higher bond yields create competition for earnings yields on stocks and put downward pressure on valuation multiples.

But an examination of past rate cycles suggests periods of steadily rising rates do not end bull markets. In fact, periods of economic growth and tightening interest rate conditions are often accompanied by strong equity performance. Excluding the high-inflation period of the late 1970’s-early 1980’s, most rising rate cycles have experienced double-digit stock returns. The market may have to endure a digestion period where multiples compress, and earnings rise, but those conditions rarely catalyze a meaningful equity market sell off. Instead, the end of tightening cycles typically ushers in lower stock prices as Fed activity cools an over-heated economy and/or runaway inflation. Excluding the hyper-inflation period of the late 1970s and early 1980s, the average peak 3-month T-Bill yield for tightening cycles is 5.25%. The current 3-month T-Bill yield is around 2.2%. If history serves as a guide, we are much closer to the beginning of the rate cycle than to the end. The rate of change in rates bears watching. But during most previous periods of measured advances in rates, stock investors were rewarded with attractive returns.

Treasury Bill Cycles

Treasury Bill Cycles

 


Terms and Conditions

01 Oct C.J. Lawrence Weekly – Will China’s Pain be India’s Gain?

By many accounts, the pace of growth of the Chinese economy has been slowing over the past two quarters and the Chinese government is considering new sources of stimulus to help the country sustain its 6.5% target rate of GDP growth. The imposition of import tariffs on many Chinese goods destined for the United States has cast doubt on whether that country’s export-led economy can keep pace. Whether the next round of tariffs goes into effect or not, the threat alone has global supply chain managers re-examining their manufacturing and logistics networks and considering alternatives. With a burgeoning middle-class consumer population, it’s likely that China can continue to grow at a good clip fueled by its domestic activity alone. But if trade between the U.S. and China, the world’s #1 and #2 economies, slows, who fills in the gaps? Does China’s pain ultimately become India’s gain?

The IMF expects India 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 a potential powerful engine of global economic growth. Already intent on becoming a global leader in the digital economy, both private and public Indian enterprises have embarked on aggressive spending programs to build out the country’s 5G data network. With only 34% internet penetration across the country, India is able to leap-frog the development of traditional internet infrastructure and move directly to a mobile computing architecture, expediting e-commerce growth and encouraging the development of the country’s consumer class. The potential size of the Indian market has the world’s largest companies positioning themselves to participate in that growth.

But for India, the path to prosperity has been, and promises to be, bumpy. The banking sector is wrestling with rising rates of loan delinquencies and non-performing assets, the steel and aluminum sectors are negatively impacted by recent U.S. tariff programs, most transportation infrastructure is below developed country standards, headwinds from high oil prices are emerging, and deep government bureaucracies make foreign direct investment and market access difficult. But since 2014, despite some periodic set-backs, the Modi administration has made good progress in its efforts to cut red tape, modernize the Indian economy, and raise living standards for the country’s massive population. Recent reports suggest that trade representatives from India and the U.S. are engaged in negotiations for a comprehensive trade deal between the two countries that could pave the way for closer economic ties. With China-U.S. trade rhetoric at a heightened pitch, the India-U.S. negotiations could be coming at a fortuitous time for both. Should the Modi administration continue its success in pushing reforms, and the U.S. and India strike a comprehensive bi-lateral trade deal, the catalysts could be in place for Indian market outperformance. The MSCI India Index is down 9% year-to-date, which is better than most of its emerging market brethren. For long term investors looking for increased emerging market exposure, India is becoming an increasingly attractive option.
 

iShares MSCI India ETF (INDA)

iShares MSCI India ETF (INDA)


 


Terms and Conditions

24 Sep C.J. Lawrence Weekly – Peak Margins? Not Yet.

The U.S. Benchmark 10-Year Treasury Bond Yield closed at 3.07% on Friday, up 8 basis points for the week, continuing its recent uptrend. In fact, the 10-year yield is up 22 basis points in the last month. Despite strong demand for treasuries, which tends to suppress yields, the 10-year treasury yield is approaching its one-year intra-day high of 3.11%, set back in May. Prior to the May peak, it last nicked 3.0% in January of 2014. The Federal Reserve Board is expected to raise the Fed Funds Target Rate by 25 basis points at its Wednesday meeting, so the increase at the long end of the yield curve is welcome news to those fearing yield curve inversion and indicates that market confidence in U.S. economic growth remains intact.

Those looking at the stock market glass as being half empty will point to rising rates as a headwind for corporate profits and stock prices. Higher interest rates increase the attractiveness of bonds versus equities and increase corporate borrowing costs. In a classic business cycle, the higher borrowing costs and accompanying employment and goods inflation pressure profit margins. Thus, late in the business cycle, corporate sales can continue to grow while margins compress, putting a lid on corporate profit growth. Some analysts are submitting that we are there now. But an examination of recent margin trends suggests that profit margins have not peaked, and bottoms-up forecasts suggest they will climb to new highs in 2019 and 2020.

The combination of improved corporate operating efficiencies, new process technology, automation, and lower corporate tax rates look to be contributing to a new era in profit margin expansion. The S&P 500 Index trailing 12-month net income margin reached 11.3% in 2Q18 and is expected to rise to 11.9% by year-end 2018, according to data provided by FactSet. If forecasts prove correct, S&P 500 net income margins could reach 12.5% in 2020, buoying profit estimates. While rising inflation and interest rates do in fact provide margin headwinds, it is important to remember that annualized core CPI in August was 2.2%, well below historical averages, and that even a U.S. 10-year treasury yield of 3.5% would be lower than the closing yield in all but 8 of the last 60 years. Instead, should interest rates and inflation continue to rise at a consistent and measured pace, the impact on corporate profit margins may feel less like a headwind and more like an onshore breeze.

S&P 500 Net Income Margin

S&P 500 Net Income Margin | Source: FactSet Data

 

 


Terms and Conditions

17 Sep C.J. Lawrence Weekly – The New S&P Sector Construction is Coming, and It Matters

Back in March we highlighted an announcement by S&P Global, Inc. that stated it was realigning three of its eleven S&P sectors, on Sept 28, to more accurately reflect the constituents’ lines of business.  The realignment will result in changes to the make-up of the Technology and Consumer Discretionary sectors and a reduction in their weightings within the S&P 500 Index.  S&P will also change the composition of the Telecom Services sector and change its name to Communications Services.  Some index-based funds have begun the process of adjusting their weightings and fund compositions to ease the transition.  But many have not.  Funds that seek to minimize tracking error (the difference between the fund composition and the composition of the index it tracks) will wait until the cut-over date to initiate their re-balances.  This could create some near-term volatility in stocks impacted by the changes.  It is also likely that there will be a lasting impact on sector strategies that investors and traders employ in investment portfolios, trades, and hedges as historical correlations are broken.

The realignment is based on adjustments to S&P’s classification system, known as GICS (Global Industry Classification Standards).  GICS was developed in 1999 by S&P and MSCI, to foster the consistent categorization of individual securities.  Hundreds of sector and thematic funds base their portfolio construction on these definitions.   In its 2017 annual survey of assets, S&P Global estimated that over $200 billion in assets were invested or benchmarked in S&P sector index products based on S&P GICS sector definitions.  As large as that figure is, it accounts for less than half of total sector index-based products, many of which do not track to S&P Index construction but do utilize GICS definitions in their own index construction.

Sector Shifts - New Sector Weightings

Sector Shifts – Sector Weightings Within S&P 500 Index | Source: S&P Global, C.J. Lawrence Inc. Research

To many the reshuffle sounds like an academic exercise.  But the impact could be felt in the coming days and weeks as sector funds buy and sell stocks to match the new definitions.  For instance, the S&P Technology Sector Index will no longer include Alphabet and Facebook, and will instead include larger weights in Apple, Microsoft, and Visa.  That means that funds tracking the S&P Technology Sector Index will be selling large amounts of Alphabet and Facebook stock and buying large amounts of Apple, Microsoft and Visa stock in the coming three weeks.  Alphabet and Facebook will be the heavy-weights in the new S&P Communications Services Sector Index, but funds tracking that index are much smaller in AUM (assets under management) and have not been attracting sufficient assets to soak up the new supply.  As an example, State Street Global Advisors is the sponsor of the Technology Select Sector SPDR Exchange Traded Fund (XLK).  It is the largest technology sector ETF with over $23 billion in assets under management.  As of Friday, the fund has an 11.3% weighting in Alphabet, and a 6.3% weighting in Facebook.  On Oct 1, those weightings will both be 0%.  Conversely, the new Communications Services Sector Index will have a ~23% weighting in Alphabet and a ~20% weighting in Facebook, so by Oct 1 the new Communication Services Select SPDR ETF will add positions in those securities to match their new sector index weights.  But the imbalance will be sparked by the large funds selling stocks and the small funds buying stocks.  To use the SPDRs as an example, the $23.0b XLK is selling Alphabet and Facebook, and the $0.6b XLC is buying Alphabet and Facebook.  It could take weeks or months before Communications Services Sector related funds gather enough assets to absorb the other sectors’ abandoned shares.  In the meantime, investors interested in purchasing the new Communications Services constituents like Alphabet, Facebook, Activision Blizzard, Comcast and Disney should not have a tough time finding stock.

 

 


Terms and Conditions

10 Sep C.J. Lawrence Weekly – Stock Valuations and Earnings Growth Play Tug-of-War in Earnings-Driven Markets

Better-than-expected economic data released last week did little to buoy stock prices.  The 49-year low in unemployment claims, impressive increase in the ISM non-manufacturing Index, jump in non-defense capital goods orders, and 2.9% year/year growth in wages all failed to propel the market higher.  Instead, fears of escalating tariff wars and the potential for a corresponding deceleration in global economic growth dominated the financial news headlines and investors’ psyche.  The S&P 500 Index was down 1% last week and is down 1.5% from the new high set on August 29.  The stall, in the face of robust domestic economic data, has some market watchers asking if the stock market has lost a gear, or if it might be stuck in neutral.  But it is not unusual for stocks to experience pauses, or even corrections, during transitions from price-driven to earnings-driven markets.  Like the barking dog that finally catches up to the car, investors find themselves in the midst of the current earnings recovery asking the question, “what now?”

From the beginning of 2013 to the end of 2017 the S&P 500 Index price rose 87%.  During that period S&P 500 earnings per share rose 25% while the Index’s price-to-earnings (P/E) multiple expanded by 62%.  That mix is now reversing.  The P/E multiple on the S&P 500, using next-twelve-months earnings, looks to have peaked around 18x in late 2017.  The P/E now stands at 16.5x next-twelve-months earnings forecasts and at 16.2x 2019 calendar EPS estimates.  Meanwhile, since December 2017, 2018 earnings per share forecasts for the index have increased 10.2%, and 2019 forecasts have climbed 10.0%.  The P/E multiple on the S&P 500 has declined 9.4% during the same period.  The tug-of-war between the market P/E multiple and the pace of earnings growth is pitched.

Earnings driven markets are characterized by compressing multiples and declining market breadth.  The narrowing leadership makes outperformance increasingly challenging.  In previous earnings-driven markets, premium valuations were often awarded to companies with consistent and visible streams of sales and earnings, and to companies that possessed the ability to grow sales and earnings faster than the rest of the market.  Today, stocks with those characteristics are increasing found in growth sectors like Technology and Consumer Discretionary, and currently in select Industrials groups.  Earnings-driven markets can move to new highs, but it is typically a small group of leaders that act as the propellant.  To outperform, investors and managers need to be increasingly selective, identify new leadership early, and avoid the rest of the pack.

 

S&P 500 Forward Price / Earnings Multiple vs S&P 500 Earnings Growth

S&P 500 Forward Price / Earnings Multiple vs S&P 500 Earnings Growth Source: S&P Global, FactSet Data, C.J. Lawrence, LLC

 


Terms and Conditions

 

04 Sep C.J. Lawrence Weekly Market Comment – Freight Economy Remains Strong Despite Tariff Uncertainty

International trade watchers marked Sept 6 on their calendars as the conclusion of the public comment period for the U.S. administration’s proposed $200 billion in new tariffs on Chinese imports. The new tariffs could be imposed any time thereafter and come on the heels of $50 billion in new tariffs that were phased-in this summer.  China responded in kind to the first round with $60 billion in new import tariffs of their own and are threatening to retaliate if the U.S. moves forward with the next round.  There appear to be only token efforts by both countries to negotiate through the current stalemate and thwart the next round of restrictive trade measures.  Meanwhile, on other trade fronts, the U.S. and the European Union, which reached trade agreements in principle this spring regarding non-automotive goods, are now considering talks to remove all auto-related tariffs.  A U.S.-Mexico trade deal also looks like it is in the offing, with Canada likely to join tri-partite discussions in the next week or two.

The shifting trade landscape is causing some consternation among U.S. manufacturer and shipper groups who fear disruption in purchasing patterns, and among some consumer groups who are forecasting higher prices on imported goods because of China tariffs.  But in general, the stock market’s reaction has been one of optimism.   Despite the uncertainty and trade posturing, the S&P Road and Rail sub-index, which contains four railroads and a long-haul trucker, is up almost 22% in the last six months.  Financial performance for the group has been steady with earnings per share growth for the index forecasted to climb 40% this year on the back of increased freight flows, improved pricing, and corporate tax reform.  Analysts expect that earnings per share will continue to experience healthy growth in 2019 and 2020 with earnings estimates up 12.3% and 12.7% respectively.  Supporting those views are robust bulk and intermodal freight flows through U.S. ports and across the country’s freight transportation network.

The American Trucking Association reported recently that year-to-date truck tonnage, on a seasonally adjusted basis, is up 8% from last year’s level with strength across the manufacturing, retail, and construction segments.  That sentiment was echoed by the American Association of Railroads, which last week reported 3% year-to-date carloadings growth, with strength in Metallic Ores and Metals (+4.1%) and Petroleum and Petroleum Products (+14%).  Year-to-date intermodal traffic is up 5.1% from last year.  At the macro level, U.S. imports, exports, industrial production, and capacity utilization have all advanced during the past six months. The Baltic Dry Index, which tracks rates for ships carrying dry bulk commodities, and which is often used as a proxy for global trade and global economic health, is up 43% during the past six months.  Trade uncertainty is often cited as a primary risk to U.S. and global economic growth and to the U.S. stock market.  Yet the trade landscape during the past six months has been anything but certain and predictable, and many of these important metrics continued to advance.  Freight flows have a way of flowing like water, finding the paths of least resistance.  Should the former NAFTA participants work through new deals, the U.S.-EU trade discussions solidify, and the U.S-China trade relationship stabilize, the positive momentum in goods and freight transportation could advance to a new higher level.

Baltic Freight Index

Baltic Freight Index

 


Terms and Conditions

 

27 Aug C.J. Lawrence Weekly Market Comment – Irrational Exuberance? No. Healthy Skepticism.

According to most conventional measures, the current bull market in stocks has now earned the moniker as the “longest bull market in history”. Most peg the beginning of the current bull run to March of 2009. Since then, the S&P 500 Index has risen over 320%. That falls short of the previous appreciation record holder, the bull market of the 1990s, during which the S&P 500 climbed over 415%. The current bull’s impressive longevity has some market watchers anxious and calling for its imminent demise. But it is important to remember that bull markets do not expire on a timeline. Previous bull runs have varied in length and amplitude, while their endings were more often catalyzed by the unwinding of “excesses”. The end of the bull run in 1987 was accompanied by the proliferation of misunderstood portfolio insurance. Meanwhile, the bull markets of the 1990s and the 2002-2007 periods ended with the bursting of the internet and real estate bubbles. A common theme to most bull market endings is that sentiment becomes decidedly bullish and investors can be found piling into stocks just prior to the market peaks. Famed stock investor, John Templeton, is credited with the quote, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” If equity and bond fund flows are good proxies for investor sentiment, this bull market is a long way from euphoria.

Monthly Net Domestic Equity and Bond Fund Flows Source: Investment Company Institute

Monthly Net Domestic Equity and Bond Fund Flows Source: Investment Company Institute

On Wednesday, the Investment Company Institute published its weekly estimate of net equity and bond fund flows. The results were consistent with the pattern witnessed over the past three years. Domestic equity mutual funds and exchange traded funds (ETFs) continue to experience net outflows, while bond mutual funds and bond exchange traded funds continue to experience inflows. Net flows out of domestic equity funds totaled $66 billion in 2016, $50 billion in 2017, and have already experienced $87 billion of outflows year-to-date 2018. That compares to massive inflows into bond funds of $190 billion in 2016, $381 billion in 2017, and $169 billion of inflows year-to-date. The trend suggests that most retail investors, the largest buyers of funds, still lack conviction in the stock market rally and prefer the perceived relative safety of bonds. This is hardly “euphoric” behavior. Some might even suggest that the retail investor is still back in the skepticism phase.

The lack of bullish sentiment is also confirmed in the American Association of Individual Investors’ weekly Bull-Bear survey. Bullish sentiment stands at 38.5% which is at the survey’s long-term historical average. On the institutional front, put-call ratios on the S&P 500 Index are neutral, suggesting a lack of conviction among institutional traders looking out over the next six months. Volatility, as measured by the CBOE VIX Index, which tends to elevate near market tops, closed the week below 12, versus a year-to-date average of 15.5. To be sure, there are plenty of risks to this bull’s health including a potential slowdown in global economic growth, trade and tariff disputes, U.S. political upheaval, and emerging market weakness, among others. But the classic set-up of a euphoric top is not materializing and that could mean that this bull’s matador may not yet be in the arena.

 


Terms and Conditions

 

20 Aug C.J. Lawrence Weekly Market Comment – Back to School with 529 College Savings Plans

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

13 Aug C.J. Lawrence Weekly Market Comment – S&P 500 Companies Beat High 2Q18 Expectations

Second quarter financial reporting season is approaching its close, with over 90% of S&P 500 constituents having announced quarterly results. If the remaining companies deliver results in line with expectations, earnings per share for the index will be up around 25% from last year’s level.  The expected 2Q18 earnings growth rate was 18.5% on March 31 of this year, marking a steady ratchet up in expected and delivered performance.  Second quarter earnings growth is now on track for the highest level achieved since the third quarter of 2010.  According to data from FactSet, over 79% of reporting companies delivered positive earnings surprises in 2Q18, which is the highest positive surprise result since they began tracking the data in 2008.

On the top line, 72% of reporting companies delivered sales results that were higher than expectations.  This figure is consistent with the past year’s quarterly average (72%) and is above the five-year average (58%).  At the sector level, the Health Care (83%) and Information Technology (82%) sectors have the highest percentages of companies reporting revenues above estimates, while the Consumer Staples (58%) and Energy (60%) sectors have the lowest percentages of companies reporting revenues above estimates. The Financials (+3.0%) sector is reporting the largest upside aggregate difference between actual sales and estimated sales, while the Consumer Discretionary (-1.0%) sector is reporting the largest aggregate downside difference between actual sales and estimated sales.

S&P 500 Earnings Per Share Growth

S&P 500 Earnings Per Share Growth

After incorporating better-than-expected 2Q18 results, full year 2018 S&P 500 earnings per share are now expected to grow 22% from 2017’s level, and revenues are expected to grow 8.6% over the same period.  But some corporate managements are striking a cautious tone regarding the third quarter and beyond as they await further clarity on the implementation and impact of tariffs and trade restrictions.  Of the 74 companies in the S&P 500 that have issued earnings per share guidance for 3Q18, 55 have issued negative guidance and 19 have issued positive guidance. The percentage of companies issuing negative guidance is 74% (55 out of 74), which is above FactSet’s 5-year average of 72%.  But despite the caution, analysts are still projecting robust earnings growth of 20.3% and revenue growth of 7.7% for the next quarter.  Should trade and tariff tensions settle down, the set-up could be building for more upside surprises in corporate earnings.  The stock market may be wrestling with important risks, but the outlook for U.S. corporate profit growth does not look to be among them.

 


Terms and Conditions

 

06 Aug C.J. Lawrence Weekly Market Comment – Growth Remains Attractive…Comparisons to the “Nifty Fifty” and Internet Bubble Periods Miss the Mark

The sell-off in technology shares at the end of July spurred in a chorus of money managers to suggest that the growth dam had finally broken and to forecast that the performance gap between growth stocks and value stocks would close. Several market pundits cited “excessive” valuations on growth stocks, particularly in technology, as a catalyst for their reversal. But as we’ve noted in previous Weekly Market Comments, growth stock valuations don’t look particularly expensive versus fundamentals and previous cycles, and stocks assigned to the “value” category may not be as cheap as one would expect. On 2019 forecasted earnings, the value-oriented Consumer Staples, Utilities, and Real Estate Sector Indices are trading at higher price-earnings multiples than the S&P 500, while the Industrials, Health Care, and Energy Sector Indices are trading at multiples roughly in line with the market. To be sure, there are plenty of gems to be owned within the value style, and financials and select industrial groups look attractive to us. But while the relative price gap between growth and value has widened over the past few years, the valuation gap has not.

Some growth doubters have likened today’s environment to that of the “Nifty Fifty” period in the 1970s, or to the new economy stock mania in the late 1990s prior to the bursting of the internet bubble. But deeper analysis suggests that those comparisons don’t stand up. The original “Nifty Fifty” was a group of fifty stocks identified in the early 1970s as having high and consistent growth characteristics worthy of long term ownership. The group traded at historically high price-earnings multiples based on the belief that their earnings would continue to grow, and that they could be owned at any price. During periods in 1972, McDonalds’ (MCD) stock traded at 86x earnings per share, and Disney’s (DIS) stock traded at 82x earnings per share! When the Nifty Fifty finally rolled over, critics of the strategy claimed that even strong companies could not generate meaningful earnings growth consistently over long periods of time. But in fact, many of the original Nifty Fifty stocks went on to grow earnings at a rapid pace for decades, and have been good investments for as long. Instead of an earnings-related sell-off, the end to the Nifty Fifty success was more likely driven by the crushing weight of sky-high inflation experienced in the mid and late 1970s that compressed Nifty Fifty valuations and sent stock prices plummeting. Meanwhile in the late 1990s the internet bubble stocks sold off after investors came to grips with the fact that many had unsustainable business models and that others were victims of unreasonable expectations.

The valuation picture for today’s growth stocks versus these two periods is much different. While today’s growth stocks trade at premium multiples to the market, their absolute levels are much lower than those experienced in the 1970s or late 1990s. As a comparison to the original Nifty Fifty, we constructed an index of fifty S&P 500 companies that achieved 10%+ earnings growth in both 2016 and 2017 that are also expected to grow earnings 10%+ in both 2018 and 2019. The average annual earnings growth for this index’s constituents over the four-year period (two reported and two un-reported) is 38%. The average P/E multiple on 2018 earnings forecasts for the same group is 24.1x. This compares to an annual average P/E of 45.2x for the original Nifty Fifty in 1972. Likewise, in 1998 and 1999 multiples on technology stocks soared on the back of euphoria surrounding the evolution of the internet and internet related business models. During that period, companies without earnings, and sometimes without sales, were instead valued based on “eyeballs” and “clicks”. The valuations on real fundamentals were astronomical. Even established technology companies were bestowed internet halos and traded at rich premiums. In 1998 Cisco (CSCO) traded at 117x and Oracle traded at 104x forward earnings estimates! Today, investments in select value names may be warranted, but major shifts in style allocation look suspect based on relative fundamentals. History repeats, but comparisons between today’s backdrop and the Nifty Fifty and internet bubble periods miss the mark.

First Graph: Original Nifty Fifty Price-Earnings Multiples (1972) and Second Graph: CJL Consistent Grower Index Price-Earnings Multiples (2018)

First Graph: Original Nifty Fifty Price-Earnings Multiples (1972) and Second Graph: CJL Consistent Grower Index Price-Earnings Multiples (2018)

 


Terms and Conditions

 

30 Jul C.J. Lawrence Weekly Market Comment – Supply-Demand Imbalance Bodes Well for Rebound in Housing Related Stocks

Estimates of U.S. Households[/caption]Wednesday’s dramatic decline in Facebook’s share price overshadowed another significant sell-off in a housing related stock.  Shares of Mohawk Industries (MHK) declined 17.5% in Thursday’s trading session after the company reported 2Q18 results that fell short of analysts’ expectations, and management indicated that margin pressure and slowing sales growth would likely persist for the balance of the year.  The manufacturer of industrial and residential flooring products also noted that North American sales growth was not keeping pace with raw material cost inflation. Similar circumstances were cited in the 2Q18 results for Fortune Brands Home and Security (FBHS), which manufactures doors, plumbing supplies, and cabinetry.  Despite the strengthening economy, the homebuilding, building products, and household furnishings groups are among the worst performing S&P groups in 2018.

The lackluster price performance of these groups is at odds with an improving domestic economy and low unemployment.  That backdrop has historically been good for housing construction and viewed as a catalyst for increased supply.  But housing construction fell in June as single-family and multi-family starts declined by 12.3%.  Housing permits, an indicator of future activity, also fell in the period, pulled down by a plunge in multi-family permits. Overall, housing construction and permits have been slowing at a time when demand for housing is growing.  The lack of new supply helped push the median sales price of existing homes up 5.2% in June.

There are, however, some recent signs that the new housing pipeline will build in the back half of this year.  Last week’s housing report from the U.S. Census Bureau, showed a 2.2% increase in home completions in June versus last year’s level, and indicated that the number of housing units currently under construction increased by 4.9% on an annual basis. Additionally, construction labor, which saw an increase of nearly 4,000 residential construction jobs between May 2018 and June 2018, supports further improvement in the pace of home-building, and signals that housing construction is likely going to increase in the months ahead.  The growth in the pace of housing completions, now at a 1.26 million seasonally adjusted annualized rate (SAAR), suggests that the U.S. housing market remains under-supplied and is only inching its way back to balance.  At the same time, millennials are entering the housing market at a rapid pace, household formation is accelerating, and baby boomers are living longer and more independently than previous generations.  With that backdrop, builders and suppliers will remain under pressure to keep up with the growing demand.  That bodes well for these out-of-favor groups.

Estimates of U.S. Households

 


Terms and Conditions

 

23 Jul C.J. Lawrence Weekly Market Comment – Favorable Risk-Reward Emerging in Leading Chinese Consumer Stocks

Trade and tariff concerns caused U.S. equity markets to stumble in early June and have dominated the business news flow since. But as investors turned their attention to 2Q18 earnings results, some fear subsided, and U.S. stock prices recovered. The S&P 500 Index price is up 3.1% since July 1. But the same cannot be said for the Chinese stock market. Since U.S. tariffs on $50 billion of Chinese imports were announced on June 14th, the Shanghai Composite Index is down 6% in local currency. It is now down 14% for the year. Since the tariff announcement, the Chinese yuan is down ~6% versus the U.S dollar making currency adjusted performance even worse.

The prospect of a protracted trade war with China appears to present more risk to China than to the U.S., but most experts agree that trade and tariff wars, regardless of protagonist, lead to casualties on all sides. A sell-off in Chinese shares is understandable given that country’s position as an export-lead economy, the recent release of some lackluster economic data, and a rising debt-to-GDP ratio. Chinese shares have also been caught in a downdraft of emerging market equity fund redemptions. Despite having the second largest economy in the world, China remains the most heavily weighted country in emerging market equity indices and funds. After a strong start to the year, the MSCI China Index is down 4.4% in the last three months, while the MSCI Emerging Markets Index is down 5.1% during the same period.

The sell-off in Chinese shares, including those listed on U.S. stock exchanges, may provide an attractive buying opportunity for investors with a longer-term view. Despite its challenges, China remains the worlds’ fastest growing economy, according to data provided by the World Bank, and its domestic consumer economy is being fueled by a growing middle class, which is expected to reach 780 million people, from a current level of 430 million, by the mid-2020s. Should trade and tariff wars persist, that growing consumer base will focus increasingly inward for goods and services. According to a report from Mizuho Securities, Chinese retail sales will reach $5.8 trillion in 2018, a level on par with the United States. Forrester Research suggests that Chinese consumer online spending will exceed $1 trillion in 2019, up from just $300 million five years ago. This massive growth in consumer buying power and demand is being met by leaders in e-commerce, digitization, logistics, cloud computing, and entertainment like Alibaba Inc. (BABA), Tencent Holdings (TCEHY), JD.com Inc. (JD), and Baidu Inc. (BIDU). On average, these companies are expected to grow revenues at a 30% pace in both 2018 and 2019. The risk-reward for large cap, U.S. listed, Chinese consumer and e-commerce related companies looks increasingly 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.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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Terms and Conditions

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

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

 

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

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

 

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

 


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Terms and Conditions

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

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

 

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

 

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

 


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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.

 


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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