Research.LeutholdGroup

The approach of Halloween brings thoughts of jack-o-lanterns, scary movies, and buckets full of candy. The season also marks the time when investors finally give up the ghost on the optimistic, even wishful, earnings forecasts made early in the year.

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With promised breakthroughs on Brexit and the trade war miraculously occurring on the same day, few pundits now believe the market is anywhere close to an important peak. (A peak in the S&P 500, that is, since peaks occurred long ago in the ACWI, MSCI Emerging Markets, NYSE Composite, Value Line Arithmetic, S&P MidCap 400, and the Russell 2000.)

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The Momentum style—in which investors buy what has been going up recently—represents an optimistic, hopeful, “I’ll take some of that” mentality. The Low Volatility factor entails a pessimistic, fearful outlook in which investors want (or need) to stay invested in stocks but desire downside protection in case the market performs badly.

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Style rotation! Regime change! Market action of the first two weeks of September coaxed the few remaining Small Cap Value managers off ledges from New York to San Francisco.

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This week’s massive stock market leadership flip has certainly remedied some of the breadth weakness we discussed in this month’s Green Book. But we can’t help wonder whether the move is analogous to performing a transplant on a 95-year-old. The patient might survive the surgery, then die while under anesthetic.

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Executive summary (for those leaving early for the holiday weekend): No.

We’ve found no reliable relationship between swings in the U.S. Dollar and subsequent variations in U.S. economic growth.

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There’s an old Wall Street adage: “When the wind blows hard enough, even the turkeys fly.” A sophisticated meteorological instrument known as the “price chart” says the wind died down considerably beginning in January 2018

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Market bulls remain mystified by the lack of enthusiasm for stocks given the proximity of U.S. indexes to all-time highs. They view this relative indifference as a contrarian positive—the “wall of worry” argument.

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Mild-mannered and humdrum on the surface but a superhero underneath—that’s Clark Kent and, in recent months, the Low Volatility factor. Low Vol stocks are unexciting by definition, and the factor’s current holdings focus on utilities, REITs, and insurance companies.

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Will this economic cycle end with “fire” (overheating) or “ice” (a whiff of deflation)? Interestingly, hedges against both outcomes have performed well in recent months, with both gold and Treasury bonds spiking. For many reasons, though, we believe the U.S. expansion is more likely to end in a deflationary bust.

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Factors provide investors with the ability to shift their portfolio’s characteristics to fit a particular economic and market outlook.  Value might look appealing under one set of conditions while Quality might be more desirable in another. We developed a research platform that analyzes various drivers of factor returns, summarized in Exhibit 1. 

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As global rates have taken a precipitous dive the last few months, it’s been hard not to hum “Limbo Rock.” And just like Chubby Checker, we’ve been asking our screens “How low can you go?” on a daily basis.

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Yesterday’s S&P 500 new all-time high triggered a few simple internal studies we’ve used to help shape second-half expectations for the stock market.

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We think the current economic cycle is more likely to end in a deflationary bust than with a bout of late-cycle “overheating,” and analysts and investors should recognize that such a cycle ending could be especially difficult to detect.

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It’s hard to grow profits when an economy’s resources are already fully employed, a fact we highlighted when the U.S. Output Gap turned positive several quarters ago. Therefore, the first quarter drop in NIPA corporate profits, reported yesterday, shouldn’t have come as a surprise.

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What a difference a year makes! In early 2018 we were celebrating 20% earnings growth, driven by a strong economy and the massive corporate tax cut. Sales were rising at a double-digit rate and the tax burden was shrinking dramatically, setting up one of the best earnings years in history.

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Even our staid and august firm isn’t above a little Game of Thrones clickbait.

After nineteen years in the wilderness, an old king has returned for his throne. The House of Microsoft is once again the most valuable company in the S&P 500 and, as of last month, is the sole occupier of the “4% Club” (i.e., weighting in the index).

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Late in the cycle, blue chip indexes like the DJIA and S&P 500 can fool investors by hiding subtler deterioration in the broad list of stocks. That’s been underway in the last couple of months, but it’s nothing in relation to the divergence that’s opened in the commodity market, where there’s an almost 20% YTD performance gap between the headline S&P/GS Commodity Index and its non-Energy components (Chart 1).

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Emerging Market equities have been modest underperformers during the current rally, but they’ve marshaled enough strength to trigger a new low-risk BUY signal on our VLT Momentum algorithm at the end of April.

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Crude oil and the U.S. Dollar Index accomplished a relatively rare feat by moving to simultaneous six-month highs earlier this week (Chart 1).

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The 1999 leadership parallels we discussed in the latest Green Book remain intact—U.S. over foreign, Growth over Value, and Large over Small. Small Caps have given up most of the “beta bounce” enjoyed in the first two months off the December low, with one Small Cap measure—the Russell Microcap Index (the bottom 1000 of the Russell 2000)—undercutting last year’s relative strength low and those of 2011 and 2016.

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Corporate profits were outstanding last year, but even the benefit of a 40% cut in the top income-tax rate wasn’t enough to lift the net profit margin back to the all-time high of 10.6% established in early 2012. Still, the latest 10.0% figure is more than a percentage point above the 2007 cycle high and about two points better than any other cycle high.

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The “Expectations” component of the Consumer Confidence survey has been wobbly in the last few months, but the latest report, released on Tuesday, showed the first meaningful hit to consumers’ “Present Situation” since the stock market first began to struggle 14 months ago (Chart 1).

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We thought Jerome Powell’s “Christmas Capitulation” would be tough to beat, but he accomplished that two days ago with what could be called his “Spring Surrender.” That, in turn, has rekindled hopes of a stock market melt-up along the lines of 1998-99, which, as old-timers will remember, followed a late-cycle correction that was nearly identical to the one seen last year.

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U.S. equity valuations remain considerably higher than those of any major foreign market, but there’s no denying they’ve improved from the cyclical peak made in January 2018. That’s true across the capitalization spectrum, and on the basis of both normalized and non-normalized fundamentals.

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Our earnings waterfall analysis for the fourth quarter tells a story consistent with the entirety of 2018: earnings growth was fantastic, boosted by the twin drivers of strong sales growth and a lower corporate tax rate. Chart 1 spotlights the quarter’s tally, which produced a healthy sales growth number despite some economic weakening.

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With all the excitement over the Fed’s shift in rhetoric and the excellent subsequent market action, there’s a danger of losing sight of the broader cyclical backdrop for U.S. stocks. Remember, the economy is still operating beyond government estimates of its full-employment potential, and it’s not as if the Fed has actually eased policy—as it did successfully at a similar late-cycle juncture in the fall of 1998 and (ultimately unsuccessfully) in the summer of 2007.

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Momentum is a smart beta factor that gives investors excellent upside participation in rising markets. Most other smart beta factors are defensive plays, so Momentum is the place to be in strong upward moves. Momentum filled that role admirably in recent years, rising 56% from 2016 to the September top, compared to an average of +26% for the other major factors.

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Currently, the collective intelligence of Wall Street is predicting 6% S&P 500 EPS growth in 2019. It’s also the 61-year average annual growth rate for the index, so how wrong could it be?

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The passing of investment legend John Bogle has brought forth many well-deserved tributes to his professional accomplishments. He was a tireless champion of passive investing and the founder of The Vanguard Group which, as more than a few investors don’t realize, also manages almost $1 trillion in active funds.

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Donald Trump is thought to have been born with a silver spoon in his mouth, and the economic circumstances prevailing at his inauguration two years ago might have further perpetuated that view. The U.S. economy had already been in recovery mode for 7 1/2 years, and the bull market in U.S. stocks was about to celebrate its eighth birthday.

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There’s an old saying that bear market rallies look better than the real thing, yet the upswing off December lows looks even better than the typical bear market rally.

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We wrote in the January Green Book that the S&P 500 Christmas Eve low did not have the “right look,” in that: (1) there had been no sign of “smart money” accumulation beforehand; and, (2) downside momentum was also at a new low for the entire correction. Smart money buying is measured by the Smart Money Flow Index, which evaluates trends in first half-hour market action (considered to be more emotional and news-driven), and the last hour of trading (viewed to be more informed and institutional in nature).

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The S&P 500 has again shown its mysterious ability to defy the conventional bear market threshold, with the decline into its Christmas Eve low becoming the fourth one in the last 30 years to halt just shy of the magic -20% figure.

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Investors have just suffered a negative wealth effect that will likely work to tamp down inflation over the next year.

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It’s been one of the worst years on record for diversification, with our hypothetical All Asset No Authority (AANA) portfolio down 7.2% YTD through yesterday. That’s the second-worst year for AANA since 1972, and there’s probably not enough time left for performance to undercut 2008 (-24.9%) for the bottom spot.

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Headlines surrounding the U.S. housing market have recently fixated on sputtering home sales; declining affordability, thanks to the combination of rising mortgage rates and sky-high home prices, is to blame.

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A massive drop in corporate tax payments lifted the third quarter NIPA profit margin back to the 10% level for the first time four years. But while we try not to always view the glass as half empty, we find it troubling that margins remain well-below their 2012 highs (10.6%) in spite of this one-time windfall.

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Whatever one’s preferred leftovers from yesterday’s feast, the odds are good you’ll find them more appetizing than the slop served up by global asset markets this year. Stocks have obviously been turkeys, but all the surrounding trimmings that help diversify a portfolio have proven anything but complementary to the main course.

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While the consensus view remains that October’s stock market rout was “healthy” and “overdue,” we think it was  more likely the first leg down of much larger decline. But it’s still worth reviewing the improvement in valuations that market losses and this year’s excellent fundamentals have combined to produce.  

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