November 16, 2016

Roller Coaster Election

As laid out in the inaugural InternalTrends in August, deteriorating credit markets–i.e., rising interest rates–throughout 2015 were bad for stocks (albeit the handful of headline tech stocks). The trend culminated in the January/February 2016 collapse in both credit markets and stocks. As we launched InternalTrends in August, we were pondering if we might be morphing into a period where “rising interest rates from economic strength should be welcomed.” Though noting that the credit complexes, as measured by HYG, JUNK, LQD and VWOB, were underperforming in late July, we found it “a bit more problematic that the transportation sector is lagging so badly.” The concern was based on the transportation sector being so critical to the country’s economic underpinnings. We then went on in September to note the extreme bearishness permeating the financial press, including the famous Mark Cuban quote saying that a Trump victory would be the “worst thing possible” for stocks; he also stated “I’ve put on the biggest hedge I’ve ever put on against all my equities …” On the basis of being contrarians and taking comfort in the extreme bearishness, we noted at the time that we were “certain Mark Cuban will be wrong.” We wonder what kind of bath he’s taken on his hedges? We also repeated that “… if rates rise due to strengthening economic fundamentals, that is a good thing.” We further stated, that “We’d clearly suggest being wary of the yield-seek trade,” highlighting the vulnerability of the utilities and consumer staples sectors, two of the weakest groups since the election.

With certainty, we know that pride always comes before the fall … so let’s step back a bit.

In September, we summarized that we were “suspecting” a turn toward higher interest rates. Given the rapid rise in yields post election, perhaps we will look back someday and conclude that the rate lows of July 2016 marked the nadir of the 36+ year bull market in bonds (note higher bull-market bond prices equal lower interest rates). But as can be seen in the following chart, numerous rallies in yields, equal to or greater than the last couple weeks, have not been sustained. The chart below uses a logarithmic scale so bar movements (distance from high to low of green price bars) are equalized such that percentages are the same. Note, for example, that the strong rallies in 2009 and 2013 were short lived. It appears to us that this move up in interest rates and concomitant rally in stocks is based on renewed optimism for a stronger economy. It will now have to materialize. At this juncture, we’d surmise that the Federal Reserve can now raise rates in December without damaging equities as was done last December. Oh, there could be a quick boogey man sell off, but buy it!

US Treasury 10-Year Yield (Weekly)

Chart(s) courtesy of TC2000.com

We pointed out last month, that while we continued to take comfort in the extreme negativity of many market participants, some short-term concerns had emerged, including the lack of movement (higher) in interest rates, weakening fed models of GDP expectations and language from Fed Chairwomen Yellen suggesting weaker than expected economic fundamentals. Due to those concerns, we continued to lean on the transportation sector. Transportation stocks (shipping, trucking, rail and airlines) have lagged the performance of the major averages ever since the Fed withdrew its bond-buying policy in late 2014. So it was quite noteworthy that while all other major indices were making new highs in the 3rd quarter of 2016, the transportation sector, as measured by the Dow Jones Transportation Index, not only remained well off its 2014 high, was unable to even take out the highs of early Q2 2016! Well, as can be seen in the following chart, the Transportation sector has caught on fire! To be sure, it remains short of its 2014 high, a not so insignificant caveat.

Dow Jones Transportation Index

Chart(s) courtesy of TC2000.com

We will watch the relative strength of the transportation sector (the percentage change in the index compared with the broad market as defined by the S&P 500 Index). As can be seen in the next weekly chart of the Dow Transportation Index, stocks generally do well when the transports are “relatively strong” versus the S&P 500 Index. Note the two trendlines in the bottom pane. So, when stock’s pullback, let’s see how the transports hold up. Strength will beget strength. As a quick aside, we note that Warren Buffett was recently reported to be a buyer of airline stocks. An interesting turn of events given that after having been burned by the sector he wrote in 2007, “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

Top Pane: Dow Transportation Index

Lower Pane: Relative Strength of Dow Transports

Chart(s) courtesy of TC2000.com

The Bottom Line is that a rise in interest rates, IF measured AND a result of improving economic fundamentals, is not a bad thing. To be sure, We write “IF … AND.” Higher rates will find a host of beneficiaries, beginning with financial companies who have seen their net interest margins squeezed – the difference between cost of borrowing (what they pay you on deposits) and what they earn on lending – money. Hence the strong rally in financials post the Trump election (six of the strongest 11 sectors post election are financially related). By ‘measured,’ We mean a more gradual ascent than what we’ve seen so far post election. To monitor the economic underpinnings, keep an eye on the Fed GDP models here and here and watch for the Transportation and Small Cap sectors to maintain their relative strength uptrends.

It is, at this juncture, a bit challenging to discern the nature of demand post election that led to surging stock prices. The election results were so surprising that panicked portfolio managers were no doubt quickly realigning portfolios and scampering for explanations for their clients, and, given the extreme pessimism that we’ve addressed, we suspect there was a good measure of short covering. The underlying economic fundamentals didn’t change as drastically as the market’s movements would suggest. So we expect some settling with the true nature of events becoming more discernable on weakness just as a low tide reveals the attractive seashells. Our biggest concern is that the Russell 2000 Small Cap Index is the only major average to have made it to a new high along with the Dow Industrials and that the Dow Transportation Index, though constructive as it has been, remains below its 2014 closing high. That is what we refer to as a non-confirmation, typically a condition that precludes major advances. Furthermore, when the Dow closed at a new all-time high on November 15, not a single index component was at a new high; that is a thin margin of support. On the 15th, Goldman Sachs (GS) and JP Morgan (JPM), two extremely strong stocks in recent days, closed marginally lower on the day. OK, so much for the near-term caveats.

We remain long-term constructive. The ‘action’ of the key sectors is constructive, Fed models have improved once again and, without energy, earnings have grown over the last several quarters. We speculate that the Federal Reserve can now raise rates without recrimination (unlike December 2015 when they couldn’t); they are now following the market, not leading it. While we suspect that a measure of the “fear” that we have positively embraced as suggesting we’d go higher is, though diminished, still in place. Recriminations continue to run high, and a lot of analysts remain on edge as they prognosticate a world-wide trade war. This trade-war pillar of fear will take a bit longer to dissolve, but dissolve we believe it will.

So, the election was dramatic and the market results exhilarating, but, honestly, not much has changed. Stocks did find a way to move higher and likely left a lot of investors behind–oh the insidious ways of the marketplace. If you did not heed the advice of scaling back exposure to the ‘yield’ sector or ‘bond proxies,’ we’d submit that it’s a long-term proposition, but we’d now scale back on rallies, as those sectors are likely to bounce back from their dramatic sell offs.

Natural Gas (UNG) pulled back more than the general energy complex into early November as speculative demand was curtailed by warmer than expected weather and the belief that coal might make a comeback under a Trump administration. Those short-term noise events must be viewed in the longer-term context that finds hundreds of coal-fired power plants being closed, thus fueling expectations by the Energy Information Administration that 2016 will be the first year during which the U.S. will use more natural gas than coal for electricity generation. This at a time that lower oil prices have curtailed drilling activity, thus lowering supplies of byproduct gases. The pullback has created a very oversold condition from which a bounce is likely, but there was a bit more damage to the trend in pricing so we’ll continue to hold the one half of positions recommended last month.

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