Financial Markets Weekly: April 27th

May 8, 2018

Here's your financial markets weekly report for April 27th, 2018. Earnings season has not disappointed. Leaving investors puzzled as to why such positive results have not reignited animal spirits.
With 53 percent of the S&P 500 having reported thus far, 79 percent have beaten estimates. Should this average hold up, then it will be the best quarter for upside surprises since FactSet started tracking the numbers in 2008. In the aggregate, estimates are beating by 9.1 percent.
And yet, stocks have continued in a sideways consolidation pattern since having set their late January highs. Having now developed a technical wedge pattern that portends an inevitable breakout. Though nobody knows whether that breakout will be higher or lower.
What's this market trying to tell us?
On the economic front, Q1 GDP increased at a 2.3 percent annualized rate. Beating the 2.1 percent estimate but representing a slowdown from the 2.9 percent pace of Q4. Consumer spending weakened. Jumping just 1.1 percent after growing 4.0 percent in Q4 as a slowdown in credit growth, higher gas prices, and an ongoing wait for meaningful wage growth all weighed on sentiment.
Laksman Achuthan of the Economic Cycle Research Institute (ECRI) has been extremely accurate in predicting economic slowdowns past. He called the 2001 recession. And the 2008 recession. And today, he's forecasting an economic slowdown. One that shows the global leading economic indicators drifting from their cycle highs. And slowing economic growth around the world.
Couple that trend with the idea that global central banks are now tightening monetary policy (quantitative tightening, or QT) as opposed to easing monetary policy (quantitative easing, QE), and the world's economy is left in a precarious position. Achuthan believes the pullback in economic growth will adversely affect the global economy. He's just not sure how much. And has not specified whether such a slowdown will lead to a global recession.
But money managers have gotten the message. As the latest Global Fund Manager Survey from Bank of America Merrill Lynch was entitled, "The Silence of the Bulls."
The survey was designed to provide an idea as to how fund managers are thinking right now. And right now, they're scared. CNBC explained that the latest survey represents bad news. Fund managers are worried that the market has peaked for this cycle.
What's more, individual investors are scared.
For the first time since Trump was elected, more investors expect the stock market to fall than to rise. So reads the monthly survey by The Conference Board, an independent research company.
And Bespoke Investment Group underscores those sentiments. Reporting a dramatic shift in the public's attitude toward stocks.
Three months ago? Confidence was at record levels. With more than half expecting higher prices. Now only 32.7 percent of the public expects higher prices. That's the fastest serious downshift in 30 years. Equity bearishness has risen from November's multi-year low of 19.9 percent to 33 percent today. Marking the first time since the 2016 election that more consumers expect stocks to drop than rise.
Still, fret not, gentle reader. Has not our contrarian nature helped us to profit in similar situations gone by?
All the aforementioned negativity represents good news in the aggregate. Look no further than the five similar three-month stretches since 1987 when the percentage of U.S. investors expecting higher prices fell sharply. The S&P 500's ensuing one-, three- and six-month returns were all positive on average.
Bespoke points out that what makes the current decline in market sentiment noteworthy is that the composite of economic sentiment remains near its highest level since January 2001. Not that the economy and the stock market always move in lockstep. But, the current disparity between the public's view on both is abnormal. And such spreads tend to narrow over time. With the most likely outcome being a move lower in economic confidence paired with a move higher in market confidence. Simple mean reversion at work.
Economic confidence drifting lower while stock indices drift higher? Works for us.
Economic data has been good. But not stellar. Last week saw just over half of 24 major economic indicators exceed forecasts. With housing as a standout. And consumer confidence high.
But the public tends to misread economic data. Failing to remember that economic data paints a portrait of what just happened. While the stock market constantly speculates on that which is to come.
Currently, investors are trading as if all the good earnings news is priced in already. Of the stocks that have reported this season, those beating EPS estimates have gained just 0.46 percent on their earnings reaction days on average. While those that missed EPS targets have fallen 3.86 percent. Simply reporting inline EPS has resulted in an average one-day stock price decline of 1.76 percent. Of course, this is what happens in bearish stretches of a market cycle. And will continue to be the case until the market is forced from the current consolidation wedge pattern in which it's trapped (see above chart).
One asset class not trapped within a sideways pattern? Interest rates. Which are rising. And will continue to do so for some time into the future.
Clients often ask when rising bond yields might inhibit stock market growth. Well, the following table by Cycles Research demonstrates that rising American bond yields do not necessarily spell the end of rising stocks. Especially if yields rise due to economic growth which translates into higher corporate earnings. This is precisely the environment we have in the U.S. now.
Leading us to ask: could 2018's big surprise (there's always one!) be that 10-year Treasurys yield between 3.5 and 4 percent even as the S&P 500 climbs above 3,000? It's been a long time since the U.S. has had an economic/market environment like this. But historical data shows it can happen.
Moreover, we do not believe there will be a recession this year. If only because of November's election. Recessions rarely occur during election years. As there is generally plenty of government spending. And an administration that continues to pine for higher share prices.
Of course, not everyone's been pining for share prices to rise.
Since 2014, seven large tech companies have accounted for more than 60 percent of the S&P 500's gains. These are Amazon, Netflix, Nvidia, Facebook, Alphabet, Microsoft and Apple. At least five of these have appeared ripe for short sales throughout much of their climbs due to super-enhanced valuations. However, shorting them was the equivalent of stepping in front of a speeding locomotive. Which is exactly what famed hedge-fund manager David Einhorn (Greenlight Capital) did. Choosing to short Amazon, Tesla and Netflix throughout most of last year. Even as Amazon climbed 56 percent. Netflix gained 55 percent. And Tesla added a paltry 45.70 percent.
The underlying message? You can be really smart. A really successful. But don't ever lose sight of the fact that stock valuations can remain at stupidly elevated levels for irrationally long periods of time. Turning an otherwise prescient call into a losing proposition.
Which is to say, the path to being right is littered with the bankrupt carcasses of obstinate, inflexible investors. Despite the volatility, most of tea leaves we track reveal a positive landscape for equities. One in which all risk-management tactics should be employed. Yet, positive all the same.
And while equities have been volatile, small-cap shares have been quietly closing in on new highs. Perhaps mean reversion is handing the torch back to the smalls after nine years of large cap dominance. Further, small cap equity gains often serve as a sign of continuing economic vitality.
Geopolitically, unforeseen progress appears in the offing with the formerly intransigent North Korean regime. As former CIA director cum Secretary of State Pompeo recently convened with counterparts from North and South Korea. The meeting was meant to lay the plumbing for a real discussion on North Korea's de-nuclearization to be held this summer. And initial reports scored it a success.
This was followed by an historic state visit to South Korea by the North's Kim Jong Un.
We have other, less direct but no-less empirical evidence as to the North's serious mindedness.
During an April 11th meeting of North Korea's Supreme Assembly, Choe Ryong Hae, Vice-Chair of the NK Central Committee, described North Korea as a strategic power and a global military power. He did not mention NK as a nuclear power. Which, given the source of pride the nation's burgeoning nuclear ambitions have been, is news in and of itself.
In 2012 and 2013, the North Korean constitution was amended to include language which supported NK becoming a nuclear power. Vice Chair Ryon Hae would have been well within standard NK orthodoxy to refer during his speech to NK as a nuclear power, or as being committed to becoming a nuclear power. He did not. Marking a diversion from the regime's standard operating procedure of the last few years.
That said, we recognize that NK has lied, cheated, misdirected and obfuscated at every opportunity these last five years. It would not be surprising to see the North playing yet another version of its incessant game of cat and mouse. But... what has been accomplished the last two months is more progress than has been made since the issue of the North's nuclear ambitions first became public. And every step forward is a reason for cautious optimism. Perhaps, even the likes of Kim Jong Un can choose to come in from the cold.
Somewhere, John Le Carre is smiling... Stay tuned your next financial markets weekly update.
Financial Markets Weekly Recap
Major indices finished down last week. The DJIA lost 0.62%. The S&P 500 fell 0.01%. The Nasdaq fell 0.37%. While small cap stocks lost 0.50%. 10-year Treasury bond yields fell 0.3 basis points to 2.958%. Gold closed at $1,323.35, down $12.25 per ounce, or 0.92%.
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