Financial Markets Weekly: May 18th

May 23, 2018

Here's your financial markets weekly report for May 18th, 2018. Equity indices finished lower last week. With the S&P 500, DJIA and Nasdaq posting slight losses. Small caps, however, managed a 1.6 percent gain. And now represent the best performing index year to date. I guess it isn't the size of the ship after all.
Overseas, things have worsened. With Italy still the clubhouse leader at +five percent, but down four percent over the last few weeks. Most other nations are flat or negative. With India and Mexico leading the losses, at -8.1 percent and -7.6 percent, respectively.
Looking at commodities, crude oil leads the pack. Up 20.1 percent year to date.
On the fixed-income spectrum, everything has been roughed up. With Treasury, Junk and Corporate bonds down from two-to-seven percent year to date.
The plight of fixed-income investors may be the most telegraphed risk of 2018. As investors are forced to endure losses across fixed-income portfolios. Following a 35-year bull market in bonds, interest rates are now rising. And remember, there is an inverse relationship between interest rates and bond values... when one rises, the other drops.
While no honest arbiter can tell you where stock indices will be a year from now, most market observers can say with near certainty that interest rates will be higher. Translating to lower bond values. So, those holding bonds and bond funds will see bond values drift lower. Forcing them to contend with the idea that the allegedly most conservative facet of their portfolios is causing the most volatility. And potentially the biggest losses.
Consider the venerable PIMCO Total Return fund, a fixed-income stalwart in portfolios nationwide, which has lost 2.5 percent year to date. A tough pill to swallow. Especially for retirees who naively placed the lion's share of their IRA rollovers into -- what they believed were -- conservative, buoyant, fixed-income mutual funds.
Of course, Wall Street has been selling Main Street on the diversification benefits of "stocks, bonds and cash" for years. Little wonder when two or more don't work, investors are beside themselves.
Ironically, there are a myriad of fixed-income alternatives from which to consider. But most investors don't know where to look. And most advisors are too lazy to find them. Negative duration vehicles and LL bonds represent a couple options that might shield clients from falling bond values. But investors need consider this conundrum moving forward. Because rising rates will be part of the landscape for some while.
While we're on the topic of interest rates, we may have reached an inflection point in the market-economy mechanism. For the first time since 2008, short-term Treasury yields have just reached the same level as equity dividend yields. It is not even the two-year Treasury we are discussing. But rather the three-month. Now sporting a yield of 1.9 percent. The same as equities.
Not trying to sound alarmist. But the convergence of various yield rates has historically provided a strong warning of a pending recession.
That said, the world's largest asset manager has just recommended that we stick with U.S. equities. Summarizing, BlackRock believes that "fears of peaking earnings are overdone". The mega-manager believes that worries over macro concerns have overshadowed what has been very strong fundamental performance.
Further, we'd think Q1 earnings results would be enough to bolster investor confidence. With earnings season nearly complete, top and bottom-line results were strong. Especially compared to expectations.
The Q1 earnings-per-share beat rate was 67.9 percent. While the revenue beat rate was an even-more-impressive 71.6 percent. Both of which represent great results. Importantly, earnings guidance moving forward pointed towards further quarters of above-average earnings growth.
Still, don't get overly sanguine. We're not completely in the clear yet. With any number of major downside catalysts to navigate in the months ahead. Mid-term elections. Surly Democrats vying to take the House and impeach the president. Trade talks with China, Mexico and Canada. The results from the special counsel investigation into Russian interference in the 2016 election. Increasing militarization in the Middle East. And seasonal headwinds. Like the idea that we're entering what has traditionally been the worst six months of the year for stocks.
The point? You'd best have low-correlation investment vehicles in your portfolio. Learn more by reading the white paper on navigating bull and bear markets, here.
In the oil patch, Brent and WTI crude have each set new three-year highs. While their stock-index proxies sport some of the prettiest charts in the market. Since June 2017, geopolitics, OPEC's commitment to lower production and increased demand have conspired to drive oil prices higher. With the Energy Sector SPDR (XLE) up 9.97 percent on the year. Compared with a 2.5 percent gain for the S&P 500.
Though investor sentiment has drifted lower, we remain in a bull market. And the SPX Energy sector will likely log 65 percent earnings growth this year. Another 7 percent in the next. And 11 percent in the third-year estimate.
Current energy sector EPS estimates represent by far the best number among all S&P sectors. And though the earnings number is outsized due to a rough stretch from 2014 to late 2017, with a P/E of 18x forward earnings, this sector remains inexpensive, assuming earnings come through. More attractively, the sector's dividend yield is 3.56 percent on forward numbers. And 8.4x cash flow versus a 2 percent dividend yield on the S&P 500 and its 11.2x cash flow reading.
Following all the sector's tumult these last few years? One helluva turnaround story! Those who'd continued to short the energy stocks have learned a powerful lesson this last year: assets can lose value for a lifetime. But, once they're cheap, hated and in an uptrend? Mean reversion can't be far off.
In the nation's capital, a recent audit reveals continuing shoddy cybersecurity measures at the IRS. Stating that the agency hasn't accurately cataloged all the components of its highest value hardware and software systems. Nor does it have an exact count of who has privileged access to its most sensitive systems.
Further, the IRS also likely isn't patching software vulnerabilities on its highest value assets within the 30-day timeframe required for federal agencies. And because the agency doesn't maintain historical data about patching, however, it's difficult to say for certain how long vulnerabilities remain unmatched.
Bottom line? Government agencies with access to the most sensitive U.S. taxpayer data continue to lag woefully behind their private sector counterparts. Leaving taxpayer data vulnerable to hackers, foreign governments, terrorists and myriad other bad actors.
Now, a look at geopolitics.
Two weeks ago, President Trump pulled the plug on the Joint Comprehensive Plan of Action (JCPOA). Terminating the agreement designed to keep Iran's nuclear ambitions in check over concerns that Iran was using much of its newfound economic clout to sponsor terror (Iran is the world's largest state sponsor of terror) and unrest from Syria to Yemen. Worth noting that many of Iran's neighbors doubted that the JCPOA had ever prevented Iran from moving - albeit more slowly - towards its nuclear ambitions.
The consequences of last week's decision?
New investment in Iran, from both Asia and Europe, will slow if not cease because of the new U.S. sanctions. Economic forces are being set in motion which will cause significant problems for the Iranian regime. Especially considering that Tehran's military activities in Syria, Lebanon, Gaza, and Yemen have much increased since the JCPOA was signed.
With less oil to sell into the markets, Iran's cash flow will diminish. As will, hopefully, its status as the world's leading state terrorism sponsor.
Regarding those who argue that Iran is now set to resume its nuclear program? The "locals" in the Middle East do not believe that Tehran ever stopped. But that they simply sent remnants of the program further underground. And we believe Iran's neighbors, those scrutinizing the Islamic Republic most closely, probably know best. They report that Tehran continued to move ahead on its nuclear ambitions even after the agreement was signed. Moreover, the JCPOA was never air tight enough to ensure that the mullahs weren't still building a bomb.
More recently, the tariff truce established this week was welcomed news in D.C., Beijing and on Wall Street. And don't think for a moment that these talks are not tied to North Korea.
Trump has tied everything together. National security. Economics. Trade. Tariffs. Intellectual property. Tech. And energy.
It's likely that the tariff treaty will now set the stage for North Korean talks. Moreover, the truce could help the U.S. farm bill to pass. And boost equity markets at a time when shares have been consolidating.
Though Europe remains agnostic on the situation between D.C. and Beijing, they are livid about the Iran sanctions. And the enthusiasm with which D.C. has pursued them. Clearly, tough sanctions are coming. With or without EU support.
All of which, by the way, will be bullish for oil, energy stocks and inflation.
Finally, Venezuela's government -- which uses more gimmicks than a traveling carnival -- conducted another sham election over the weekend. "Re-electing" Nicolas Maduro, who has managed to destroy the nation's economy, ruin Venezuela's energy sector while global oil prices have shot higher, and starve large swaths of the population. Otherwise, he's done a fabulous job for the Venezuelan people and will remain in office for a second term.
You can either enjoy the absurdity, or drown in it. Stay tuned for your next financial markets weekly update...
Financial Markets Weekly Recap
Major indices finished mixed last week. The DJIA lost 0.47%. The S&P 500 fell 0.54%. The Nasdaq fell 0.66%. While small cap stocks gained 1.23%. 10-year Treasury bond yields rose 8.8 basis points to 3.059%. Gold closed at $1,292.60, down $25.70 per ounce, or 1.95%.
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