While many technology stocks have experienced a soft spot since July as investors begin to push back on high share valuations, technology stocks continue to be the main driving force of the Index and the larger market as the lure of substantive government spending on infrastructure and tax windfalls for domestic financial and non-financial companies succumbed to the imbroglio that defines the current state of Washington politics. The Wilshire US Large-Cap Growth Index ($DWLG) has maintained a strong and consistent presence above its 50-day moving average for much of the year through Friday's market close (25 Aug), dipping but briefly beneath the marker in April, July and now in August as 2nd quarter earnings reports come to a conclusion. Technology stocks have outpaced the S&P 500 benchmark by just over 10% on the year thanks in part to the comparative advantage gained in world markets gained from the weakness of the US dollar where many technology companies derive the lion's share of their sales and profit. Those revenue streams have long been bolstered by the strategic routing of a growing proportion of these earnings through low-tax rate regimes about the world, making technology companies, for better or worse, highly desirable engines of economic growth (see Figure 1, below).
Figure 1: Wilshire Large Cap Growth and Large Cap Value Indices
By contrast, the US Large-Cap Value Index ($DWLV) paints a more nuanced portrait of market volatility for the period whose fortunes, arguably, appear more readily traceable to the ebb and flow of legislative progress on the Republican agenda in Washington. Value stocks hail from the cyclical sectors of the economy, many of which are domestically based with little foreign profit-- but outsized US income tax exposure. Accordingly, with supply chains and revenue streams largely contained within US borders, proposals to reduce corporate taxes to 15% to 20% would create outsized benefits for such companies across the US economic landscape. The Index experienced an anticipatory 5% market surge during the months of February and March as House Republicans worked diligently on a bill that would both dismantle and replace the Affordable Care Act (ACA). The repeal of ACA, of course, was the first step of the master plan that was to release an estimated $1 trillion tax windfall over a ten-year period, comprising a critical funding component for the Republicans' revenue neutral tax reform package. After being unceremoniously pulled from a floor vote in early March in its original form, the American Health Care Act (AHCA) finally squeaked through the House in the opening days of May with four votes to spare, laden with sugary amendments to attract the necessary votes for passage. The fact that AHCA proposed to disenfranchise an estimated 22 million people from access to basic health care insurance over a ten-year period proved to be a mountain-sized obstacle to overcome. Accordingly, the final vote saw 20 Republican lawmakers cast votes in opposition. The underwhelming majority vote in the House coupled with the public outcry over such large and disparate number of people being forced from insurance roles across the country assured a Senate rewrite, largely erasing the gains made on the Wilshire 1000 Value Index to date (see Figure 1, above).
On the Senate side of the repeal equation invoked similar market enthusiasm as investors again poured into domestic-based value stocks in anticipation of setting in place the first leg of Republican tax plan windfall. The Index soared above its 50-day moving average to an anticipatory year-to-date high as deliberations on the Senate repeal bill were conducted behind closed doors. Finally brought to light, the Better Care Reconciliation Act (BCRA) largely mirrored its House cousin in both form and content and garnered similar opposition from more moderate Republican senators, especially those facing reelection in competitive states. The market response was predictable as the votes for passage--even on a strict party-line vote--failed to materialize. Market selling sent the Index close to its 50-day moving average for the remainder of June and into July before a host of amendments to the original bill aroused market enthusiasm once again through much of the month of July and up to the final vote as the month came to a close. The final, last ditch effort to pass a stripped down version of the original bill to force a conference committee with the House failed as July came to an end, placing the Senate's attempt at repealing ACA on permanent hold. The Wilshire 1000 Value Index plunged beneath its 50-day moving average where it remains through Friday's market close (see Figure 1, above).
A less rigorous version of the argument pits consumer staple spending (XLP) against consumer discretionary spending (XLY). The average volume of trades for the period came to almost 10 million with spikes of just over 25 million in June and surges over 20 million in the March and June periods when market expectations for a breakthrough on the ACA repeal legislation appeared to be more than the smallest measure of probability. In both periods, the market overbought XLP and took profits soon thereafter as more information on the economic impact of each of the measures became available. The sell-off after the Senate deadlocked in June produced the lowest post since mid-February, erasing almost 19% from its peak in first days of June to its July trough. True-believers sent XLP surging through its 50-day moving average before collapsing for a second time, as the final Senate vote exhausted all the BCRA variants for the last time in the closing days of the month (see Figure 2, below).
Figure 2: Consumer Staples Select SPDR and Consumer Discretionary SPDR
Rather than the sum of a 1,000 positions, both XLP and XLY are dominated by the three top positions in either ETF: Proctor & Gamble (PG) at 11.57%, Phillip Morris (PM) at 8.91% and Coca Cola (KO) at 8.64% on the consumer staple side; Amazon (AMZN) at 14.31%, Home Depot (HD) at 7.43% and Comcast (CMCSA) at 7.31% on the consumer discretionary side through the end of April. The three positions in XLP and XLY are evenly matched at just over 29% (see Figure 3, below).
For XLP, the position is testing market lows sketched out in early July as KO and PM continue to lose ground as investors continue to digest a generally upbeat 2nd quarter earnings season while juxtaposing growing political uncertainty both here in the US and abroad. Proctor & Gamble has surged almost 7% since the second week in July, single-handedly providing the driving force behind XLP for the period. For the year, PG is up just over 10%. The surge has placed PG about 13% above the S&P 500, averaging a tight 1% market directional movement for the period. Phillip Morris is up just over 27% while KO is up 9.44% on the year. XLP is up just under 6% for the period or about 3 percentage points to the rear of the S&P 500 benchmark.
Figure 3: Consumer Staples Select (XLP)
Amazon and HD at 21.74% of XLY have had a singular impact on the fortunes of the ETF YTD. Until the 26th of July, AMZN was up just under 40% on the year. Home Depot hit a year high of $158.81 in June, up 18% on the year to that point. In the closing days of July, XLY was up 12.47% on the year. Since the end of July, HD has slid just under 4% while AMZN is now in correction territory with a 10.14% market slide below its July peak. Still, Amazon is up just under 26% on the year, with an average market directional movement of just over 2% for the period. Home Depot while HD is up just under 12% for the same period. XLY is left with a gain of just over 8% for the year, about 1 percentage point below the S&P (see Figure 4, below).
More downside potential for consumer staple stocks comes from Amazon itself as the company begins to incorporate the 460-store Whole Foods into its overall business plan. While just under 2% of the total full-service grocery sector, Amazon's historical bent toward slashing prices and to trade short-term losses for long-term market share is apt to break out in a price war in the sector as the company works to broaden Whole Food's price appeal. Meanwhile, weak earnings reports from JM Smucker (SJM) and Hormel Foods (HRL) sent the two stocks down 11.43% and 7.61% respectively through Friday's market close (25 Aug). The Amazon price war threats put downward price pressure on three stalwart grocery shelf stocks as Kellogg (K), Campbell Soup (CPB) and General Mills (GIS) fell 2.46%, 5.10% and 4.61% respectively by week's end.
Figure 4: Consumer Discretionary Select
Since 2009 technology in general and Amazon in particular have had spectacular market runs since the S&P 500 nadir in March of 2009 which, coincidentally, marks the beginning of the Federal Reserve's asset purchase programs. Amazon has market gains just short of 1,123%, one of the best runs on the market. Technology logged just over 166% in market gains for the period. Proctor & Gamble is up just short of 93% over the same period (see Figure 5, below). These cumulative gains are not lost on investors.
Figure 5: Amazon, Proctor & Gamble and SPDR Technology Select (XLK) since 2008
While stocks have generally hit a soft spot over the course of the last month, the uncertainty of domestic and international politics continues to claim center stage. That uncertainty will garner a new edge with the advent of the Federal Reserve's expected announcement at its September FOMC meeting setting into motion its portfolio reduction plan that will see $6 billion of maturing Treasury notes and $4 billion of maturing mortgage backed securities not reinvested in their respective markets. While billed as eventful as watching paint dry, the impact of the Federal Reserve's slow but nonetheless methodical move out of the mortgage credit market without a deep-pocketed designated replacement could add further pressure on would-be home buyers' forced into the credit markets to finance their purchases. A third hike in the federal funds rate for the year is also outstanding. On another pressing topic, in back-to-back speeches at Jackson Hole, European Central Bank (ECB) President Mario Draghi and Federal Reserve Chair Janet Yellen both stressed the importance of facing down populist calls for loosening the regulatory fabric stitched into place since the financial meltdown in 2007-08 and protectionist urges-particularly at a time when central banks across much of the developed world continue to supply markets with extraordinary access to liquidity. The combined impact of the world's leading central bank heads was a powerful and at the same time telling push-back to the current regulatory and protectionist paths of the Trump administration. The administration, whose sine quo non is largely defined to date by the deregulation of not only the financial sector but the economy at large-including the US pullback from multinational trade agreements-is not expected to heed the call. Zero-sum rhetoric makes for good political theater: It is easy to explain, carries high emotional appeal, translates readily into pithy if often mindless 'Tweets' for immediate consumption and effectively targets and channels political wrath-but makes for frighteningly short-sighted and often dangerous public policy.
Arguably, it is well within the purview of central banks to worry about financial stability. That said, concerns about risk-taking should not pull rank over the legitimate demands of economic growth. Large, systemically significant US financial institutions are now fairly well-capitalized by most measures. There is likely room for regulators to loosen their grip on smaller such institutions which could, in turn, loosen lending standards at the local and regional levels. Yet given the current bent of the administration toward wholesale deregulation of much of the economy, Yellen's plea for vigilance will not only receive a mixed-at best-reception from the White House. It will likely seal her fate as a one-term Federal Reserve chair, paving the way for the additional spillage of transitional uncertainty at the Federal Reserve into markets both here in the US and beyond.
While politics continue to dominate most news sources here in the US, investors largely remain focused on corporate earnings that continue to strengthen, albeit with the generous help from a weakened dollar in world currency markets. Historically cheap borrowing costs will continue to provide corporate and household borrowers with extraordinary access to liquidity for the foreseeable future. US Treasuries inched higher in the wake of Yellen's Jackson Hole address which largely avoided the topic of monetary policy. The yield on the 10-year Treasury note edged lower to 2.169%. The interest sensitive yield on the 2-year Treasury note remained largely unchanged at 1.334%, keeping the spread between the two US benchmarks at 84 basis points-hardly a range that would traditionally justify an upward tick in the federal funds rate in the immediate future. While new orders fell 6.8% in July as civilian aircraft sales fell 70% during the month, new orders in the greater economy rose 0.5% MOM and 5.3% YOY, a rate more than twice the growth rate of the economy through the end of the 2nd quarter. Across the Pond, the euro hit $1.1940 to the dollar, its highest post since the end of December of 2014. The common currency is now up 14.59% on the year against the dollar through Friday's market close (25 Aug). The relentless din from European companies, particularly German exporting companies, on the ever-strengthening euro continues to grow louder.
Consumer staple stocks as well as small- and medium-cap stocks have become all the more reliant on the first major rework of the US tax code since 1986. While the Trump administration has promised renewed focus on the issue, the inability to capture tax and subsidy streams from a repealed ACA coupled with the ongoing revenue loss from a politically dead border adjustment tax, likely means a corporate tax rate in the 15% to 20% range is now well beyond the pale of a revenue neutral tax package. Deprived of such outsized funding windfalls, a major component of tax reform is likely to take the form of incenting dubious past corporate behavior rather than underwriting future economic growth. Rewarding multinational companies for tax avoidance and one-off shareholder payouts rather than providing incentives to invest in jobs, production capacity and productivity sends a rather poignant message indeed-as the American Jobs Creation Act of 2004 aptly demonstrated. Of course, we still know very little about the scope and breadth of tax reform.
From a market perspective, without the tax windfall consumer staples and companies with predominantly domestic supply chains and revenue streams will offer little in forward earnings growth sufficient to justify current valuations. While valuations of growth stocks and in particular technology stocks are hardly cheap by historical standards, buying the S&P 500 remains the most viable option through the end of the year-and likely beyond. An oversold bounce in S&P stocks appears likely as the new limits of tax reform takes hold and the low-trading volumes of summer morph into the more historical patterns of fall (see Figure 6, above).
This article was written by
Disclosure: I am/we are long AMZN, HD, XLK, XLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.