The Good News In Tuesday's Selloff

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Includes: AAPL, BK, BRK.B, CAKE, CMI, DE, DIA, GE, GLD, ITB, MS, MSFT, PCAR, PPLT, QQQ, SLV, SPY, STT, UTX, XLU
by: DoctoRx

Summary

In one sense, Tuesday's market action was a risk parity investor's bad dream: both stocks and bonds saw price declines.

Yet there were some positives.

Broadly speaking, the trends in Tuesday's and recent market action may point to a renewed "Goldilocks" scenario of a not-too-hot/not-too-cold economic and market scenario.

If so, there could be some new stock market leaders in the months ahead.

First, the bad news

The stock market as most investors define it is the S&P 500 (SPY); it dropped 0.7% Tuesday. Bond prices dropped sharply as well, with interest rates on Treasuries and corporate bonds rising. That's the bad news.

But I found the day more encouraging than not, for some major reasons that, I propose herein, are worth tracking. They just might presage the beginning of a change of leadership.

Possibly most important:

Gold (GLD) cracked

GLD dropped 1.6% to $122.5; both it and bullion have been going nowhere for years. The drop in gold was accompanied by further deterioration in the other precious or semi-precious metals, most prominently silver (SLV) and platinum (PPLT). SLV and PPLT have each broken down on the charts, and GLD and spot bullion are showing serious signs of deterioration as well. In other words, the "inflation is running wild" meme that has been so prevalent - and against which I have been stoutly arguing - started to not look so good Tuesday.

I'll get to the USD in context of the next point:

Bonds are not acting "too" badly - really

What matters is not just where the 10 year Treasury is, it's also where the 30-year is. The 10-year closed Tuesday at 3.07%, a new high yield since 2011> Scary? Breakout? Maybe, but look at the chart of the 30-year:

Chart ^TYX data by YCharts

It's not even above its 2015 high, and it's not close to its 2013-4 peak of 4%. Here are the 5-year charts of the 30- and 10-year bonds:

Chart ^TYX data by YCharts

The 10-year is coming up in waves closer and closer to the yield on the 30-year, which as of now is in the middle of its 5-year trading range. So, what's wrong if the yield curve flattens somewhere between 3% and 3.5%? In 2007, the last time it was flat, the level was 5.25%. The current projections look like a "rosy scenario" to me so long as the Fed does not overdo it.

With precious metals dropping and crude oil finally back around its long term average of one ounce of gold equaling about 17 barrels of oil, the markets may be signaling that - once again - Fed tightening is having an effect. Trend-followers projecting straight-up rising inflation and rising GLD and oil prices may be fooled.

In that context, the rise in the USD index and the broader trade-weighted dollar index provide additional market support for theview that the Fed is already succeeding in quelling inflationary fires. Not to be forgotten is that a deregulating and "drill, baby, drill" administration provides a certain disinflationary supply-side factor. As in the Reagan years, investors who think only of deficits and not on other administration policies may get the inflation story partly wrong.

In other words, the "Goldilocks" scenario may be evolving.

What could keep Goldilocks from sleeping soundly?

There has only been one consistent event that has led to significant inflation and significant pain to bondholders in modern US financial history, which I define as the Federal Reserve era, 1914 to the present. That event is war, and its immediate aftermath especially when wartime price controls were in place.

Absent entry into a major war at least on the level of the George W. Bush era Iraq/Afghanistan wars, empirically Federal deficits don't matter much to inflation: if the Fed is not monetizing the debt, then Fed tightening results in... tightened financial conditions. War is, by far, the major reason (or, pretext) for rampant debt monetization.

Absent a fresh war, the the fall in GLD, normalization of the gold:oil ratio, rise in the USD, churning in the SPY, and narrowing of the 10-30 spread in Treasuries all point toward Goldilocks going back to sleep, dreaming of which stocks are going to provide alpha.

With that context, next I provide the following names and types of stocks for your consideration.

Change in leadership underway?

By sector or concept:

Tech

Both Apple (AAPL) and Microsoft (MSFT) have led the latest tech bull market. This sort of leadership from the two mature giants makes sense for a strong dollar period where the Fed is restraining growth. With its immense customer loyalty, AAPL has substantial resilience if the pace of growth slows. As the world's leading B2B tech company, MSFT is largely unaffected by slower growth. (I have a draft article cooking on MSFT, my candidate "most improved" company.)

Beneficiaries of lower inflation

Who benefits if oil prices stop rising, and perhaps fall as I have projected; return to food commodity stability or deflation; and continued restrained wage pressures despite a good economy?

I pointed to one with the current set-up in mind in a March article, The Cheesecake Factory: The Shorts Are All Over It, But I Like It. Since then, the stock has gone up 8%, from $48 to $52 (rounding). That's with no special good news. Technically, the stock has reversed a prolonged downtrend and is showing very nice relative strength and is above its 50,150 and 200 day exponential moving averages, which are almost in perfect alignment (the 150 remains a bit below the 200 day ema). The Cheesecake Factory (CAKE) shows the following 5-year chart:

Chart CAKE data by YCharts

It's a 'meh' chart at best. But fresh leadership often arises from this sort of blah pattern.

I like CAKE as a beneficiary of disinflationary growth with a strong/rising US dollar (minimal ex-US revenue sources). And, if I have the macro wrong, the company can prosper and the stock will take care of itself over time.

Moving to industrials, many companies are harmed by high and rising crude oil prices, including transports. Two such names that rose against the downtrend Tuesday from depressed prices are Paccar (PCAR), and Cummins (CMI). Disinflationary growth, restrained interest rates and very reasonable valuations (almost getting truly cheap on a prospective P/E basis) may allow these stocks to provide alpha now. On Tuesday, I added to my PCAR and reinitiated a position in CMI, which I had traded at higher prices not long ago. Another industrial that was down only slightly Tuesday, and that has rebounded sharply from its recent sell-off low, is Deere (DE). Most of its business is in the US, and restrained oil and commodity prices tend to lead to more production. DE is often a strong late-cycle stock. I peg DE to have a 14X forward P/E with its core North American market only now reaching mid-cycle. DE reports soon; pending that, I continue to project a $200+ peak price for this cycle, from a current $145.

Value stocks

What comes in favor if the Fed wins again? Often, it is low P/E, neglected value stocks. In the financial sector, a flattening yield curve hurts lenders that borrow short term and lend long term, so banks are not my first choice here. However, asset managers or custodians can show rising earnings with a flat yield curve, and their 11-13X forward P/E's may allow the stocks to regain energy. Not for the first time lately, on Tuesday I went long three value financials that are performing well, both technically and fundamentally, Bank of New York Mellon (BK), State Street (STT) and Morgan Stanley (MS). BK and MS are to some extent in turnaround situations; BK is especially interesting to watch, as its new CEO came from Visa (V), where he did a stellar job. Doing the same at the highly venerable BK might prove rewarding for shareholders. All these stocks have begun to join AAPL and MSFT in providing market leadership, and just settled back Tuesday with no special attention from sellers.

Many other names that are below the radar of most investors, and that certainly get little play in the financial media, have these sorts of P/E's and could provide alpha. If the scenario proposed herein works out, I would expect the home builders (ITB), which are depressed again, to set new highs.

Special situations

A company that would be badly served by the Fed tightening way too far and causing a recession is GE (GE). Because GE needs to sell assets, it benefits from the continued "lower for longer" interest rate theme as well as a strong economy. A Goldilocks scenario of disinflationary growth is fine for its turnaround plan.

GE has begun to act better, outperforming the SPY Tuesday and actually holding even with it on a 3-month basis. It barely reacted when GE took the blame for a manufacturing failure on a key system in the USS Gerald R. Ford, which could result in a costly claim against GE. Maybe investors are now focusing on my view of GE, which is that is was so badly run in Jeff Immelt's time that there is a great deal of margin, and eventually sales, upside.

If investors stop chasing chip stocks with 15X price:sales ratios, then GE, with a 1X P:S, may find more people paying attention.

GE's "partner" in the jet engine duopoly, United Technologies (UTX), is suddenly a special situation. The hedgie Dan Loeb, as well as Bill Ackman, have each recently asserted that if UTX splits into three pieces, substantial shareholder value will be generated. UTX is yet another basic industries name that does best in a Goldilocks situation. So there is now a second reason to think of UTX.

Finally, a return to basics can benefit Berkshire Hathaway (BRK.B), which is heavily domestic in its business operations and has lots of cash to allow it to find a reasonably-priced acquisition target - of which I see several.

Concluding points - examples of changing leadership as the Fed tightens

As I have discussed, I went from about zero cash (very bullish) to around 33% cash around the late January market high. I've now begun to find reason to have more, and different market exposure, though cautiously despite the number of fresh buys listed above (some profits were taken recently, freeing up more cash).

Two examples of prior Fed tightening cycles may be relevant to the concept of thinking of a market of stocks rather than a stock market right now.

In the fraught year of Y2K, the SPY made a double top, in March and August. Yet the internals were very different. The tech stocks (QQQ) and large cap growth (DIA) were fading by spring, and the neglected Old Economy stocks mostly bottomed in and around March when the prior leaders peaked. That's

In this current "cycle," 2011 showed a similar pattern. The SPY peaked for the year in Q2 2011 around $137, regaining that level more than a year later. But while some leaders, such as AAPL, remained leaders, mostly the make-up had changed from the oils and weak dollar plays to utilities (XLU) and other types of stocks. The major change was that the Fed stopped QE 2 in June. I analogize that sharp withdrawal of stimulus is similar to a tightening program.

Each time, the bulls who in 2000 were projecting endless growth were blindsided, and so were the dollar collapse bears in 2011. Leadership changed, though secular growth stocks ranging from AAPL to a number of others carried on.

Perhaps, just perhaps, something similar to the Y2K and 2011-2 experience could be in train now. Close attention to relative strength of stocks, and actual documented business results - not just hope for future success - may allow both alpha and protect from being caught in yesterday's winners.

And, cash continues not to be trash in my view; institutional money market funds are already yielding more than 2%.

In summary, Tuesday's action had some positives. A number of depressed industrials such as GE, CMI and PCAR resisted the downtrend, GLD began to break down, and the 30-year T-bond held in the rough middle of its 5-year range. The Fed thus may be winning, as it tends to do at its own pace except when a war requires it to face force majeure and print, print, print.

Soft landing, anyone?

Thanks for reading and thinking about this potential course for the economy and the markets, and if you wish, for sharing any of your thoughts and positions.

Author's note: This article was submitted pre-open Wednesday; futures have been quiet from Tuesday's close.

Disclosure: I am/we are long AAPL,BK,BRK.B,CAKE,CMI,DE,GE,MS,MSFT,PCAR,STT,UTX.

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.

Additional disclosure: Not investment advice. May take short term profits in some of the above names if given the opportunity by Mr. Market.