January 9, 2018

Records, Records Everywhere!

Not only is 2017 ‘in’ the record books, the number of record and near-record events of 2017 will itself likely go down as a record. Most all of the records are accompanied by the qualifiers ‘longest,’ ‘highest,’ ‘lowest,’ ‘first,’ ‘largest’ and the often occurring ‘since,’ as in since 1928, 1981, 1994 etc. While most had to do with strings of things, such as longest streak of new highs or longest streak without a 3% correction, our favorite statistic to chew on is the news that China in the years 2011-2013 used more cement than the U.S did in the entire 20th century! Yeah, nothing to do with 2017, just an awesome statistic to chew on.

The mantra for 2017 was buy the dips; it is just that there were no dips to buy as the averages never corrected, not even a measly 5%. As we begin 2018, we believe that the S&P 500 is closing in on nearly 400 days without a 5% correction, the longest streak ever.

While 2017 provided no dips, there were key rotational events. The first major one came in March when we noted that we were at a ‘critical juncture.’ At the time, there were fears of the Fed tightening as the general perception was the economy was underperforming; it was deemed fragile enough that investors were quite wary of rising rates. From March 1, Transportation stocks sold off to a six month low by mid-May; the US dollar went into a downtrend into early September; yields broke down and weakened into early September; the Dow Industrials slid into mid-April with its largest correction of the year, albeit only 3.4%; Small Caps went to marginal new highs in June/July but were essentially unchanged as late as mid-September; group activity remained mixed with the all-important semiconductor sector performing well, but the financials, reflecting the decline in interest rates flattened out, again, until mid-September. Note all the Septembers, a time of important trend reversals.

We asked in late June “The big question is can the market absorb a Technology selloff by rotation into the likes of Energy, Small Caps, Financials and Infrastructure?” The short answer is yes it could and it did. The Banks started a run in June as did an array of Infrastructure plays. Many Techs, especially high-flying Google, Apple and Amazon flattened out in a corrective phase only to break out to new highs in October fueled by earnings reports that caught analysts by surprise. We didn’t lean on Banks or Infrastructure but we did mention that the Energy complex “now appears worthy of a trade.” Crude rallied from roughly $42 to $62, lifting an array of Energy plays along with it.

Rotational strength of Bank and Infrastructure stocks began to make sense when considering the rise in the five-year government yield. From a low around 1.6% on September 8, the five-year yield was in late November breaking out of its narrowest and longest sideways movement going back to at least its peak in 1981 by moving to a nearly six-year high (the ten and 30-year were non-confirming, thus flattening the yield curve). We appeared to be finally moving into the anticipated era where rising rates were not to be feared but were welcomed as an indication of a strengthening economy, a perception given gravity by the anticipated tax cut legislation. It could also, however, be heralding in the end of a roughly 37-year bull market in bonds (remember bond prices go down as yields go up). The inflation boogey man hasn’t yet reared its head but it is now an item to be more closely following. To that end, we’d suggest you put the Fed’s new Underlying Inflation Gauge on your radar. It, like the two GDP models we follow, is a quantitively-based model that removes interpretation bias. You can find it here. It is currently suggesting a bit higher inflation than widely perceived.

Another key rotation was to higher expected fundamental economic growth rates as evidenced by the rise of the phrase “synchronized worldwide growth.” On the latter, Q3 2017 was the second quarter in a row that all 45 OECD countries reported year-over-year growth in GDP. Our favorite Fed models (here and here) are now expecting Q4 2017 GDP growth of 2.7% and 3.97%. Corporate earnings have rebounded and are expected to get a boost from tax law changes. Watch closely the next earnings cycle that gets under way later this week; watch for not only how well earnings might be coming in relative to expectations (that is a game management’s have well learned to manipulate), but watch stock reactions; rallies on positive news would be good while negative responses to good news would be cause for concern. We would agree that there are no ‘immediate’ signs of recession. Many are talking about the flattening yield curve, but while a negative yield curve (long rates below short rates) has presaged recessions, it has also raised false flags. On the rate front, we’d refer you to the above-mentioned Fed model on inflation.

While the fundamental outlook has improved, there was in 2017 an important rotation in Fed policy. In mid-June, the Fed announced another ¼ point hike in the Feds Funds rate, but they also, to the surprise of many, stated they would “begin implementing a balance-sheet normalization program this year.” Though announced in June, the total assets of all Federal Reserve Banks didn’t begin to fall until mid-August. Reserves then fell to a three-year low in late November, nearly precisely the moment the five-year yield moved to a six-year high. Hmmm … We subscribe to the adage that nothing bad happens unless the Fed tightens too much. We must, however, admit that our crystal ball is a bit fuzzy on just when that might be. What we do know is the Fed is, has been really since late 2014, in a tightening cycle, so ‘mistake risk’ is on the rise.

While clearly not a crystal ball, we do, as you know, look a lot at the behavioral aspects of the market for clues. To that end there was also some rotation, and we must submit not for the better. Back in September, we saw an abundance of headlines and stories suggesting a measure of bearishness. The number of stock fund managers who were underweight US stocks was at a 10-year high; there were consistent reports of outflows from US stock funds, and we read that the bearish bet on small-cap futures was the highest since 2008. Note this was at a time that the major averages were beginning to accelerate their advances and move to new highs. We then read with interest in mid-October that while a poll of big money managers showed them to be 61% bullish, they reported that their clients were only 18% bullish. What an incredible spread!

This dichotomy of professional bullishness vs public pessimism was further highlighted when on the same week in mid-November, writers of investment newsletters were at near historic bullish readings (63.5% bullish; 15.4% bearish) while individual investors were actually reported to be more bearish than bullish (29.4% bullish; 35.2% bearish). Can’t quite say we can recall a greater difference! But now, as we begin 2018, individuals have come around to confirm the historic bullishness of the professionals by moving to the 2nd widest spread of bulls over bears since at least 2005. The last time it was as high was in late 2010 just as the market was about to go net nowhere for 18 months. There were rotational gains, but that was also early in what has become a rather aged bull market. These extreme bullish readings coincide with the lowest ever reading of the VIX, a volatility measure based on stock options that dates back to 1993. And, oh, we just heard of an IT support staffer quitting his day job because he’d made a million dollars on bitcoin. We were further perplexed by the news that Kanye West was giving Kim Kardashian stock for Christmas; Disney, Apple, Netflix, Amazon and Adidas; ouch! We’d be wary of these!!

We’d note that the extreme emotion of a market bottom (fear) is more likely to see a plethora of stocks hitting lows at the same time as we saw in early 2009. Bull-market tops, however, are generally more nuanced with various sectors topping out at different times such as we saw in the 1990s. That topping process stretched out over at least two years. The Advance/Decline line peaked in the second quarter of 1998 with the Transports peaking in the second quarter of 1999, the Nasdaq Composite in March 2000 and the S&P the third quarter of 2000. A caveat to the longer rotational topping process is of an old-fashioned blow-off phase where extreme bullishness and short covering lead to a more synchronized topping process. We are in fertile territory for just such a condition. IF you see remarkable volatility in the next few weeks, something like 500+ gains in the Dow or multiple 100+ moves in both directions you can safely conclude that we’re experiencing a ‘blow off’ that would likely indicate a more synchronized top.

We’d be remiss to not address the FAANG stocks, Facebook, Apple, Amazon, Netflix and Google (now Alphabet) that have accounted for so much of the Nasdaq’s superior performance. We spoke on May 22 of the overwhelming accolades that were being heaped on Amazon and suggested that from a behavioral perspective such extraordinary sentiment made us a bit uncomfortable. We concluded at the time, “This clustering of glowing Amazon media attention at a time that the Technology Sector has become very extended to the upside is raising our eyebrows. Could the Amazon end be near? … Clearly, picking a top in bull-market phenom stocks is challenging at the least, but the confluence of articles putting Amazon on a pedestal is quite disconcerting.” The stock, but two points higher on October 26 than May 22, was then catapulted to a series of new highs by the company’s Q3 earnings report. Our first reaction was, how can so many well-paid analysts get it so wrong? On another note, we were a bit dumbfounded when in late September a NYU professor stated that “I believe Google is a modern man’s god.” While not a Biblical scholar, it is hard to imagine a loftier pedestal to be hoisted upon? We believe the FAANG phenomenon, and we’d add Tesla, will end badly for many who are likely to overstay their positions.

Summary … So, we’ve had a number of transitions since mid-year 2017 that have led to a new set of perceptions/realities that really began to coalesce in roughly the September time frame. Economies of the world are growing, cyclical stocks are on the rise, short-rates are breaking out to new highs though the yield curve is flattening, the Fed is tightening but not too much and corporate earnings are once again on the rise and will get a further boost from recent tax legislation. So, the question now is will these symbiotic rotational activities bear further fruit in the nature of higher stock prices? We basically have fundamental economic strength and new highs in stock prices juxtaposed with dangerous sentiment readings and the Fed in a tightening cycle.

Much of the news appears good, and many expect the tax legislation will just make things better. Those are not necessarily wrong observations/conclusions. What one needs to ponder is how much of the news is factored into, ‘discounted’ in financial parlance, current prices? We would surmise that the sentiment picture provides a window into the possibility that a lot of the good news is factored in. So, we’d stay with our last recommendation as of mid-2016 and suggest that higher than normal cash allocations are appropriate. Not that stocks cannot be bought as evidenced by the purchase of Oaktree Capital in the recommended portfolio, but increased caution as we witness the jump in prices in early 2018 is warranted. We do expect some really good long-term opportunities in 2018 so stay tuned!

Portfolio Update:

Oaktree Capital Group (OAK) … The purchase of ½ of a desired position in Oaktree Capital Group was established on December 11 at the buy limit of $41.80. The stock briefly rallied to just over $45 but recently closed at $43.80. We are not at this time establishing a second buy point. Oaktree Capital will be a beneficiary of the next distressed debt cycle.

Vonage (VG) … the stock had a bit of a run following our picking it up in late March at $6.14 and now sits around $10. We are establishing a buy limit on the second half of the desired position at $7.26.

Kratos (KTOS) … While having rallied to near $14 after we picked it up last April at $7.52 recently closed at $11.73. We are establishing a buy limit on the second half of the desired position at $8.49.

Rexnord (RXN) … buy limit $21.21 is being maintained, but we might be raising it a bit so stay tuned.

Xerox (XRX) … we are for now pulling our buy limit of $25.88. Note this is adjusted for a 1:4 split. We just missed picking up XRX in late April 2017, and it had a bit of a run to over $34 in late September 2017, but it has generally underperformed its sector and is now exposed to too much risk. Had we purchased it, we’d be placing a sell stop for protection, but no need.

US Natural Gas (UNG) … note that current prices reflect a 1:4 split. We’re maintaining a Hold on the original ½ position.

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