By George Tkaczuk, MD, MPH
As we enter the 4th quarter of the year, stock indexes are at or near their all-time highs. While it would be normal for stock prices to meander around these levels and/or consolidate these gains, it is worth noting what economic events keep reinforcing a strong stock market.
The economic data remains robust to support further growth
1) Leading Economic Indicators (LEI) for the U.S. increased 0.4 percent in August to 111.2 (2016 = 100), following a 0.7 percent increase in July, and a 0.5 percent increase in June. The leading economic index is now well above its previous peak (March 2006, 102.4).
According to Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board, “the leading indicators are consistent with a solid growth scenario in the second half of 2018 and at this stage of a maturing business cycle in the US, it doesn’t get much better than this. The US LEI’s growth trend has moderated since the start of the year. Industrial companies that are more sensitive to the business cycle should be on the lookout for a possible moderation in economic growth in 2019. The strengths among the LEI’s components were very widespread, further supporting an outlook of above 3.0 percent growth for the remainder of 2018.”
It is important to note that the LEI has turned down before every recession for now LEI is still trending upward.
2) Final Report on Q2 GDP growth came in at a strong pace at 4.2% annual rate. Corporate profits grew at 3.0% a healthy 7.3% in the past year. Q3 GDP growth looks likely to continue at this 4% rate. The unemployment rate is at a low 3.7%. This kind of strong economic data should continue to support a strong stock market, and even suggests the market is undervalued.
3) The National Federation of Independent Business NFIB Small Business Optimism Index soared to 108.8 in August a new record in the survey’s 45-year history, topping the July high water mark of 108. The August survey showed unfilled job openings at record highs, an increase in the percentage of small business owners saying it is a good time to expand, with strong inventory investment plans and capital spending plans. According to NFIB President and CEO Juanita D. Dugan, “today’s ground-breaking numbers are demonstrative of what I’m hearing everyday from small business owners – that business is booming. As tax and regulatory landscape changed, so did small business expectations and plans. We’re now seeing the tangible results of those plans as small businesses report historically high, some record breaking, levels of increased sales, investment, earnings, and hiring.”
4) According to Factset analysts made smaller cuts than normal to the EPS estimates for the S&P 500 companies for Q3. The estimated earnings growth rate for the S&P 500 is 19.3% (down from 20.4% estimated on June 30th). The Q3 bottom up EPS estimate has dropped by 1.1%. However, this is much less than the average decline in the bottom up EPS estimate during a quarter over the past 5 years (20 quarters) which averaged a decline of 3.2%, past 10 years (40 quarters) an average decline of 4.8%, the past 15 years (60 quarters) which averaged a decline of 3.9%. In summary, the EPS estimate decline recorded during the third quarter was smaller than the 5, 10 and 15 year averages. Therefore, we expect good earnings for Q3 as they start rolling in soon.
5) In summary, as markets continue to make new highs it is normal for markets to correct and/or digest gains. This is normal in a bull market, however as long as the economic data remains robust, the underlying trend in the market should continue. Stay on track and do not let the media headlines scare you. There is a lot of noise in the media concerning interest rates. We have seen these before.
Slide courtesy of Ciovacco Capital
RCM Managed Asset Portfolio
By Christopher Chiu, CFA
Current Market Environment
During the past quarter, catalysts to the equity market still include:
(1) Domestic growth. The economy continues to grow at higher levels than in the recent past. With unemployment rates at their lowest levels in years, there are now signs of wage growth.
(2) Credit cycle. While we are in the mature stages of the business cycle, the end of the credit cycle has only now begun with LIBOR rising, and seemingly topping out. Further the yield curve has not yet inverted. We continue to look at credit spreads daily for signs of a weakening of the market. And we still have not seen them manifest (see our discussion on junk bonds below).
A number of potentially negative catalysts continue to be in the forefront during the past quarter, including:
- Rising rates. While there has been some divergence in central bank policies, there is a growing consensus among the major central banks that tightening is warranted. In the U.S. Chairman Powell has outlined the path of rates to the end of 2019. The yield curve flattened during the quarter and then steepened slightly over the last part of the quarter with yields rising on the long end.
- Over the last quarter, the administration announced further tariffs on China. Meanwhile, a proposed replacement of NAFTA has been agreed upon by the US, Mexico and Canada.
- Global growth. On the global front, growth in Western Europe has slowed and parts of the emerging world now contend with weaker currencies versus the strengthening dollar.
Gov’t, High Credit Corporates
The Fed continues to raise the Fed funds rate as inflation is currently at or above its target. It has signaled that it will continue to raise rates incrementally for at least the next two years with the Fed fund rates projected to rise at least to 3.25-3.50% range by end of 2019. Bond prices, especially longer dated issues, have held steady after declines earlier in the year. We remain underweight longer dated corporate holdings in the mutual fund program and overweight an allocation to floating rate bonds.
Among corporate bonds, high yield continued to perform for Q3. Credit conditions still remain good.
With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may continue for an extended period. Investments in the high yield market represent riskier investments along the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility; but, it will also be among the fastest to recover in any recovery of credit markets. We anticipate making a return to this allocation after prices have declined significantly at the end of this credit cycle (see discussion on junk bonds below).
Recent developments in Large Caps and Strategic Knight
Equity markets began the year on an upswing, spurred by the implementation of pro-growth policies. Lately, though they have only advanced slightly higher after correcting in February.
In the Strategic Knight portfolios, we remain heavily invested in the large cap tech sector. We think companies such as Amazon have an overwhelming competitive advantage in their respective spaces. We do not see these size advantages, which have been enabled by the Internet, changing in the foreseeable future. The one risk that has become greater is future regulatory risk. While the legislative process is a slow moving one, various thought leaders continue to express concerns about the size and influence of large cap tech on competitive markets. Without new competition, it’s hard to see how this negative press diminishes in the future.
Ironically, regulations placed on large cap tech are likely to decrease competitive conditions over time and further embed these incumbents, as regulation tends to increase burdens on any new market entrants.
Small and Mid-Caps
During the past quarter small and mid-caps generally underperformed after overperforming last year.
In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. We view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.
Junk Bonds in the Past and Present
While junk bonds, or high yield bonds as they are often called, are a major source of corporate and municipal financing, they are a somewhat recent financial innovation. Conceived by Michael Milken in 1980s as a way of financing leveraged buyouts, today the junk bond market allows companies with shaky balance sheets to receive financing that they would not have received through more traditional means. For investors, junk bonds provide an opportunity to invest in a higher yielding instrument that does not exist with safer debt.
Companies today often use junk bonds as a way of funding expansion both internally and externally. Companies such as Bausch & Lomb, formerly Valeant Pharmaceuticals, have used junk bond financing as a way to expand through acquisition. Widely known brand name companies such as Telsa and Netflix have used them to grow organically, Tesla to create expand production lines of their new model 3 sedan. In the case of Netflix, the buying spree of original programming the company has undertaken in recent years has been mostly financed through the junk bond market. (In 2015 Netflix spent $5B on original content; $6B in both 2016 and 2017, and planned to spend 8B in 2018.) The takeaway is that though companies may not show a great history of profitability and though their balance sheet may already carry a great deal of debt, where they see an opportunity; junk bond financing provides them with the opportunity to try to upend markets.
How Risks to Hold Junk Bonds Are Mitigated
Of course, companies with shaky balance sheets and loaded with debt are at a higher risk of default. This is why a higher yield is necessary to entice investors. For investors this higher risk of default risk can be mitigated through one of the tenants of modern portfolio theory, namely diversification. By incorporating a high yield issue into a portfolio of less risky or noncorrelated assets, an investor would be able to take on the risk of a high yield bond and in the meantime average out a higher yield on the overall portfolio.
Market indicators for Junk Bonds
The performance and safety of junk bonds depends on the financial performance and credit worthiness of the companies that issue them, but both also depend on the underlying health of the economy. And when the economy begins to perform poorly, the market for junk bonds will also be one of the first to do poorly as well.
One indication of this is the spread, or interest rate difference, between junk bonds and Treasuries. According to the Merrill Lynch, High Yield option adjusted spread on CCC rated issuance, when spreads widen by more than 4% (or 400bps) over the last twenty years, it may indicate that the junk bond market which has already faced major declines will face further declines. When does the junk bond market bottom?
Finally, one indication of the junk bond market bottoming historically has been when the percentage of defaults in the high yield bond market exceeds 10%. If you were a seller of junk bonds, that may be a signal for you to get back in.