"Positive thinking will let you do everything better than negative thinking will" - Zig Ziglar
Distractions continue to hound investors. The markets have a way of making investors fearful whether stocks are up, "they can't rise any further, can they?" or down, "surely the worst is yet to come, right?" It's always something, which is what makes the markets both fascinating and frustrating.
What really matters are corporate earnings. On that score, the situation looks encouraging as we look out to the end of this year. The stock market is a leading economic indicator and will tell us in advance what’s in store for the economy going forward.
It should be quite obvious by now that the market determines what is important and what is not. It will do so more accurately than pundits, analysts, and the army of investors who believe they can outwit the market.
That's the way it has been for decades, and will continue to play out that way. Market participants will invest based on their own interpretation of the news events of the day. However, the price action of the market will clarify what is important, and what is not, far better than any individual can.
Listen to the market, and listen closely. Successful investors are in sync with what the market is telling them. It’s simple, if a market participant is not listening to the message, they are going to suffer constant under performance.
This year is yet another great example of listening. The quick drop in the major averages in January sent a message. The market had gone up too far too fast. During the consolidation period, it was thought that the market TOP was in. Not so fast. The decline found support and started to put in higher low after higher low. The problem was so many didn't have the patience to see that through.
This was a clear message that there was no major decline around the next corner. All of that was happening with a backdrop of negatives, the primary one, the global tariff issues. Some investors decided to listen to that instead of watching what the price action was telling us. A mistake.
For sure the market has spoken once again with across the board new highs posted. Expectations matter more than the news itself. Whether it be for the positive or negative, markets move on change, not absolutes. The stock market is forward looking, so what’s already priced in matters more than what any pundit will tell us about a news event. By the time an investor figures out how the latest “issue” will impact their portfolio, the market has already sorted that out.
The human mind typical likes to seek out patterns. This is why trends and momentum occur in the markets. During times of stress, there are a lot of investors that don't want to pay attention to any of these patterns. They get caught up in the headlines and whatever discipline may be left goes out the window.
Of course, we all know that all trends will eventually end. It’s just very difficult to know when that sea change will take place. That doesn't stop many from trying to anticipate when the turn will take place. Plenty thought the turn was last January, and they started to position their portfolios more defensively back then. The S&P is up 14+% from the lows put in back then.
Now there are calls for the economy and the markets to roll over in 2019, and if not, then for sure in early 2020. They could be right, but if they are indeed preparing for that now, they may very well find themselves alongside the folks that did the exact same thing in 2014, 2015, 2016 and last January.
Those folks put themselves in a position where they had to make more decisions, which in reality did not have to be made. The ONLY group of investors that are in the pilot's seat are those that listened to what the market was telling them, and didn’t try to outwit the market, by anticipating anything.
In early July with a backdrop of negative news, the S&P was struggling to make a new high, then weakened. There were plenty of comments left for me explaining how it was time to be cautious, time to lighten up. In their view, the odds favored the downside, and they were adamant about that mindset.
Since the stock market was not showing any signs of a trend change, I didn’t see it that way. Along with the other major indices, the S&P went on to make new highs a month later. Sheer luck, a coincidence, I think not. It was all about listening. Some did, some didn't.
LPL Research assembled a recession watch indicator showing low risk for a recession in the next year.
Markit final U.S. Manufacturing Purchasing Managers’ Index registered 54.7 in August, down from 55.3 in July. Chris Williamson, Chief Business Economist at IHS Markit:
"Manufacturers reported the smallest output rise for almost a year in August, suggesting production growth could be as weak as 0.2% in the third quarter. Exports remain the key source of weakness for producers, with foreign orders barely rising in August after two months of modest declines. The strongest growth is being seen in consumer-facing companies, reflecting robust domestic demand, in turn linked to the strong labour market and buoyant consumer confidence, though even here growth has slowed.”
ISM Manufacturing index rolls in at 61.3 versus the estimate of 57.5. Comments from the panel reflect continued expanding business strength. This is a new 14-year high and is the second highest going back over two decades.
“Demand remains strong, with the New Orders Index at 60 percent or above for the 16th straight month, and the Customers’ Inventories Index remaining low. The Backlog of Orders Index continued to expand, at higher levels compared to the previous month.”
“Consumption improved, with production and employment continuing to expand, at higher levels compared to July, despite shortages in labor and materials.”
“Inputs (expressed as supplier deliveries, inventories and imports) expanded strongly due to continuing supply chain inefficiencies, positive increases in inventory levels and a slight easing of imports. Lead-time extensions, steel and aluminum disruptions, supplier labor issues, and transportation difficulties continue, but at more manageable levels.”
Construction spending rebounded 0.1% in July after tumbling 0.8% in June (revised up from -1.1%), while the 1.3% May gain was revised down to 0.7%.
August ISM Non-Manufacturing report handily exceeded forecasts, coming in at a level of 58.5 versus consensus estimates for a reading of 56.8.
The 201,000 August U.S. nonfarm payroll gain tracked assumptions, but 50k in downward revisions left some to ponder if this report was weak. The unemployment rate held steady at 3.9%, one-tenth of a percent higher than expectations.
Average hourly earnings rose 0.4% month over month, beating consensus expectations which were looking for a 0.2% increase. Most notable in the report was the year-over-year change in average hourly earnings. This rose to 2.9% in August, the fastest pace since mid-2009. Monthly hours-worked figures are poised for a 1.4% growth pace in Q3, after rates of 2.8% in Q2 and 2.1% in Q1, leaving a solid growth path for hours-worked.
The three-month average of job gains stands at 185k. The overall job market remains strong, and in my view, this latest report confirmed that.
According to Genworth Financial, more first time homebuyers are entering the market.
First-time homebuyers accounted for 36% of single-family home sales in Q2, highest share for a second quarter since 2000.
For decades the United States has directly, and indirectly, subsidized global growth. The U.S. has provided never ending direct aid to foreign countries, but the largest subsidies have been indirect.
The U.S. had the lowest average tariffs compared to other developed countries in the world. Our average tax rate was the highest in the world. America, the world's biggest consumer, has helped those countries grow. By holding corporate tax rates higher than most other countries, the U.S. has subsidized non-US growth.
This is all about to change and maybe we are seeing the effects of that already. Cutting the U.S. corporate tax rate to 21% and boosting tariffs on select countries and products is removing a huge subsidy to growth for the rest of the world.
Make no mistake about it, the U.S. is the dominant economy in the world and when it stops subsidizing foreign countries, there will be ramifications. We have already seen how the global stock markets look in comparison to the U.S. The scene is bear markets making new lows versus a strong bull market making new highs here. Not a single PMI was sitting below 50 anywhere in the world as the year kicked off; now almost one country in five are below 50, a large change in just a few months. Some will argue coincidence, yet the inclination here is that it is an effect of the U.S. taking control of the situation.
At some point it will force change around the globe, and that change will be for the better. The world order is being challenged and that pressure will force changes. Once all of this is worked through the system, investors could very well experience another round of global economic expansion similar to when Reagan decided to cut taxes, and other countries stood up and took notice.
No one knows exactly how this will turn out. The status quo is being challenged. Change is difficult, but it will be necessary. Right now the U.S. markets are signaling the benefits of the changes in policies that have already taken place here. I believe the rest of the world follows suit.
Markit Eurozone Manufacturing PMI was reported at 54.6, unchanged from the earlier flash-estimate, but down from July’s 55.1. That is the slowest growth since November 2016. Chris Williamson, Chief Business Economist at IHS Markit:
“Eurozone factories reported a further solid production gain in August, but prospects dimmed further as growth of new orders hit a two-year low and worries about the outlook deepened. The slowdown in demand compared to the surging pace of expansion seen earlier in the year is being driven primarily by export orders rising at the slowest rate for nearly two years. Some of the slowdown in exports can be attributed to the appreciation of the euro since earlier in the year, but companies are also reporting signs of demand cooling and risk aversion intensifying.”
Caixan China Purchasing Managers Index, a composite indicator designed to provide a single-figure snapshot of operating conditions in the manufacturing economy, posted above the neutral 50.0 level at 50.6 in August. However, this was down from 50.8 in July and signaled the weakest improvement in the health of the sector since June 2017.
Dr. Zhengsheng Zhong, Director of Macroeconomic Analysis at CEBM Group:
“The Caixin China General Manufacturing PMI slipped to 50.6 in August from July, marking the third straight monthly drop and its lowest level since June 2017. The subindexes for new orders and output both remained in expansionary territory, with the former falling and the latter climbing up. This showed cooling demand and strong supply existed at the same time across the manufacturing sector."
“The employment sub index, remaining in contractionary territory, dipped to its lowest level since July 2017. The subindex for new export orders inched up despite remaining in contractionary territory, implying a still-grim export situation.”
Nikkei Japan Manufacturing Purchasing Managers Index, a composite single figure indicator of manufacturing performance, registered at 52.5 in August. This was compared to 52.3 in July. Joe Hayes, Economist at IHS Markit:
“Japan’s goods-producing sector continued to record growth at the midway point in Q3, extending the current stretch of expansion to two years, the longest since the global financial crisis. Survey data signalled a moderate improvement in the health of the sector, supported by an accelerated influx of new orders.”
“That said, survey data indicated the upturn in demand was domestic led, with export sales falling over the month. Potential escalations in trade conflict also contributed to a softening of business confidence.”
Markit Canada Manufacturing Purchasing Managers Index dropped fractionally to 56.8 in August, from 56.9 in July, to signal the weakest overall improvement in business conditions since May. Christian Buhagiar, President and CEO, SCMA:
“Canadian manufacturers continued to boost their production volumes in August, with the latest upturn the fastest since the end of 2010. However, a slowdown in new business growth meant that the headline PMI dipped to a three-month low. The latest survey highlighted that steel and aluminum tariffs pushed up input costs and acted as a headwind to export sales in U.S. markets. The rate of input price inflation was the steepest for almost seven-and-a-half years, which underpinned another strong increase in average prices charged by manufacturing companies.”
GAAP versus non-GAAP. Plenty of debate on this issue, as some analysts are making the statement that it's all about financial engineering and deraigns aren't what they appear to be. Well, before I go any further, let me just say the S&P is near record highs and I can assure you the profits are very REAL. So if one wants to hang their hat on financial engineering as their excuse to sit on the sidelines, enjoy the scenery.
The second-quarter earnings reports were quite unique in a number of ways. We witnessed the smallest difference between non-GAAP EPS and GAAP EPS for the DJIA Since 2016.
While all publicly traded U.S. companies report EPS on a GAAP (generally accepted accounting principles) basis, many U.S. companies also choose to report EPS on a non-GAAP basis. There are mixed opinions in the market about the use of non-GAAP EPS. Supporters of the practice argue that it provides the market with a more accurate picture of earnings from the day-to-day operations of companies, as items that companies deem to be one-time events or non-operating in nature are typically excluded from the non-GAAP EPS numbers.
Critics of the practice argue that there is no industry-standard definition of non-GAAP EPS, and companies can take advantage of the lack of standards to exclude items that (more often than not) have a negative impact on earnings to boost non-GAAP EPS.
As of last week, all of the companies in the Dow Jones Industrial Average have reported actual EPS for Q2 2018. The second quarter marked the lowest number of companies in the DJIA reporting non-GAAP EPS that exceeded GAAP EPS since FactSet began actively tracking this metric for the DJIA in Q1 2016. As a result, the median difference between non-GAAP EPS and GAAP EPS for all 23 companies was 5.4%.
Since Q1 2016, the median difference between non-GAAP EPS and GAAP EPS has been 13.6%. Thus, the second quarter marked the lowest median difference between non-GAAP EPS and GAAP EPS since FactSet began actively tracking this metric for the DJIA in Q1 2016.
FactSet Research Weekly Update:
Earnings Scorecard: For Q2 2018 (with more than 99% of the companies in the S&P 500 reporting actual results for the quarter), 80% of S&P 500 companies have reported a positive EPS surprise and 73% have reported a positive sales surprise. The percentage of companies that reported EPS above estimates for Q2 2018 was above both the trailing 1-year average and the trailing and 5-year average.
Looking ahead to Q3 2018, the estimated earnings growth rate for the S&P 500 is 20%. If 20% is the actual growth rate for the quarter, it will mark the third highest earnings growth since Q3 2010 (34.1%).
For those still complaining about financial engineering, the estimated year-over-year revenue growth rate for Q3 2018 is 7.5%. All eleven sectors are expected to report year-over-year growth in revenues.
Valuation: The forward 12-month P/E ratio for the S&P 500 is 16.7. This P/E ratio is above the 5-year average (16.3) and above the 10-year average (14.4).
Individual investors continue to be in a bullish frame of mind. According to the weekly survey from AAII, bullish sentiment dropped from 43.5% down to 42.2%, which is still on the high side of the recent range. It’s also the first back to back weeks where bullish sentiment has been above 40% since February.
The EIA weekly inventory report revealed that U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) decreased by 4.3 million barrels from the previous week. That was the third consecutive week of declines. At 401.5 million barrels, U.S. crude oil inventories are at the five-year average for this time of year. Total motor gasoline inventories increased by 1.8 million barrels last week and are about 7% above the five-year average for this time of year.
Traders ignored the draw in oil inventories and focused in on the rise in gasoline inventories. That, and the fear of a global slowdown amidst the tariff commentary kept prices in check. WTI closed the week at $67.72, down $2.16 for the week.
The Technical Picture
From last week’s all-time high of S&P 2,917, the index dropped 53 points to Friday's intraday low before rebounding. Quite normal for this uptrend. The index remains above the very short-term 20-day moving average (2,868) trendline (green).
Chart courtesy of FreeStockCharts.com
Given the overbought reading for the last two weeks, a breather was in order. The 50-day moving average (blue line) which sits at 2,823 would be the next support level to watch. Investors should keep this pause and any further pullback in perspective. Since the June lows, we have seen a nice stair step pattern play out. That is far different from the parabolic rise in January. These slow and steady gains are far more positive and lasting in nature.
If the index should move to that 2,820 support area, it would be a 3% drop from the all-time high. Right now it is way too early to call the action that we have seen in September a swoon, and I don't envision the major indices heading in that direction. Harvesting profits is always a preferred strategy, but raising a boatload of cash now isn’t recommended. A drawdown to the 50-day moving average would be healthy and more than likely an opportunity.
OK, get ready, the next market crash is coming soon, and it’s going to come with rioting in the streets. Of course anything can happen, but I really wish they would put a date on some of these predictions. It takes time to build an Armageddon shelter.
Individual Stocks and Sectors
The Technology sector takes a break after setting multiple new highs during the last 6 months and everyone gets upset. Relax, any pause in the uptrend will be short lived. The earnings picture is too strong for savvy investors to start running away from this growth area of the equity market. Valuations are not stretched to the point of concern.
The index is merely responding to the tidal wave of earnings. Notice the absence of earnings in the dot com bubble years. Valuations do not appear stretched at all, prices are in line with the underlying earnings picture. The NASDAQ-100’s price to forward earnings ratio is still a little below its longer run average.
My preference continues to be overweight the sectors that are outperforming. Technology, Healthcare and Consumer Discretionary top that list because that is where the earnings growth is. In an effort to remain diversified, accumulating the lagging sectors when they are down to complement the high flyers is always a good strategy. Financials top the list of laggards.
Price action is the key to what the market is telling us, and something that should not be dismissed. In the case of the semiconductors, the price action has been weak for two quarters now. The issues appear to be worries over a global slowdown, along with end of the cycle fears, etc. While that has been noted, there is a disconnect in what the price action is forecasting, versus what the companies are telling us.
Case in point, Broadcom (AVGO) just announced another solid earnings quarter, and more importantly, the company sees 4th quarter revenue above analyst estimates.
So that leaves investors in a quandary. For now, I will lean to what the companies are forecasting, and make the assumption that the sellers are filled with fear and overly concerned with issues that may not materialize in the near term.
Since the beginning of time and for the rest of it, investors will be looking for clues that a turn is coming. It is amazing, and at times comical to watch, and listen, to pundits, analysts and investors all try and put a time frame, a date to this turn. This exercise has been going on for years now, and its cost investors a truck load of profits.
There is plenty to distract investors without conjuring up scenarios that have little chance of occurring. That is inviting market participants to take their eye off the ball. When that happens, they miss the market's message.
Time once again to repeat the ongoing message. We have not had economic extremes during this recovery. The progress has been gradual, so anyone predicting a rocketship to the moon or a terrifying crash has been wrong. Gradual good news doesn’t play well in the headlines, but it’s been there nonetheless. It is as obvious as the nose on your face.
In today’s world, an investor is bombarded with information from all sides. We hear opinions of everything, everyday. That is causing people to think in terms of extremes. It seems every situation is exacerbated due to the constant barrage of information that is called the internet.
While everyone is looking around for the next recession so they can be the hero, the first individual on their block to say it first. In my view, they are on the wrong path. They are looking at inverted yield curves, interest rates, or maybe a global event. Something that will be disruptive.
What they aren't looking for is what typically ends an economic cycle and a bull market, excess. Eventually, excesses will build and there will be a boom before the bust. The next economic downturn will more than likely be initiated by excesses unless you believe this time is different. Time will tell, but those looking for a headline event to stop the bull market may be disappointed. Excesses don't come with headlines, they build up slowly while everyone is feeling fine.
It is at that time the economy overheats, inflation moves higher, and speculation is rampant. The Fed will tighten monetary policy by raising the rates multiple times in succession. Liquidity is drained from the system. Like night following day, the stock market, being a leading economic indicator, will have peaked and started to head south long before the onset of a slowdown or a recession.
It is SIMPLE logic that escapes many in the investment world. Why? They are too wrapped up with the issues that don’t matter. Looking at the situation today, it is in an investor's best interest to understand that politics may cause the market to gyrate, but Fed policy, availability of credit, economic growth, and EPS cause the market to trend over time. Right now all of those measures are positive for stocks.
It would take an economic catastrophe that NO ONE can predict to make the forecasted earnings outlook for the remainder of 2018 and the first half of 2019 not come to fruition. Arguing valuation with these forecasts and a sub 3% ten year has been a fool’s errand. We have heard all the valuation talk for 3+ years now and to date it has been totally wrong.
There could be a stall here after the run to new highs from the lows, and that would not be unusual. I suggest that it isn’t time to get bearish because we are at new highs. The probability that this is a sustainable breakout is VERY high. Ladies and Gentlemen, you are witnessing and hopefully participating in one of the greatest bull markets on record. There is more to come.
Stay invested. Aggressive investors can harvest profits on stocks that are grossly overbought. For the bears out there, that is where we get the money to pick up bargains on pullbacks. Accumulate stocks that have broken out of long bases and then become oversold. One of the biggest mistakes investors make is selling too soon in a bull market.
The last time I looked, this is still a bull market.
I would also like to take a moment and remind all of the readers of an important issue. In these types of forums, readers bring a host of situations and variables to the table when visiting these articles. Therefore, it is impossible to pinpoint what may be right for each situation. Please keep that in mind when forming your investment strategy.
Thanks to all of the readers that contribute to this forum to make these articles a better experience for all.
Best of Luck to All!
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Disclosure: I am/we are long AVGO.
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: My portfolios are ALL positioned to take advantage of the bull market with NO hedges in place.
This article contains my views of the equity market and what strategy and positioning is comfortable for me. Of course, it is not suited for everyone, as there are far too many variables. Hopefully it sparks ideas, adds some common sense to the intricate investing process, and makes investors feel more calm, putting them in control.
The opinions rendered here, are just that – opinions – and along with positions can change at any time.
As always I encourage readers to use common sense when it comes to managing any ideas that I decide to share with the community. Nowhere is it implied that any stock should be bought and put away until you die. Periodic reviews are mandatory to adjust to changes in the macro backdrop that will take place over time