- The S&P 500 had its best quarterly performance, +7.2%, in five years.
- The Dow Industrials and Transportation Indices “broke out” to new highs in September (Dow Theory).
- The S&P’s new Communications Services sector was formed with the addition of select technology and discretionary stocks to the Telecom sector.
- The yield curve shifted higher with the long end now at a major “technical” inflection point.
- Global indices rebounded in September in what could be the early stages of a longer lasting rally.
- A number of noteworthy divergences are developing within U.S. equities.
September was mixed for U.S. equities as the flagship Dow Jones Industrials and S&P 500 indices finished in the green with gains of 1.9% and 0.4%. On the flip side the leading Nasdaq 100 and Composite indices underperformed with modest declines of 0.4% and 0.8%, while Russell’s small cap R2000 and Microcap indices dropped 2.5% and 3.4% respectively. The negative returns did not tarnish the overall strong performance in Q3 which was led by the Dow Industrials and Nasdaq 100, +9% and +8.3%, and for the S&P 500 its best quarter in five years, +7.2%.
Along with the Dow’s leading performance in September and Q3, it was also the last of the major equity indices to make new all-time highs following the February correction. The Transportation Index joined the Industrials in making new all-time highs. New highs in both the Dow Industrials and Transports is one of the primary components of the 100-plus year old “Dow Theory” used to determine whether markets are still in an upward trend or not. The strong performance in equities occurred amidst the ongoing concerns including global trade, however the quarter ended on a positive note with Canada joining the U.S. and Mexico on a NAFTA 2.0 agreement.
The newly rebalanced Communications Services sector led September with a gain of 4.3%, followed by Healthcare +2.8%, Energy +2.4%, and Industrials +2.1%. The bond proxy REIT sector was the worst performer with a decline of 3%, followed then by Financials (-2.4%), and Materials (-2.3%). Healthcare was the positive standout in Q3 with a robust quarterly gain of 14%. Materials and Energy were the only two sectors in the red each with modest declines of (0.1%), however energy’s strong finish in September should not go unnoticed as the index is currently testing a major technical level representing the highs made back in December 2016 around the 575 level. The importance of this clearly defined resistance has been established from the repeated number of times it has been tested and held firm. The more times a key price level is tested however, the more likely it is to give out as buyers chip away through overhead supply. In general breakouts above multi-year price levels are often accompanied by accelerating momentum. While the underlying commodity, crude oil, is well above its 2016 highs, energy stocks have lagged meaningfully. A breakout above the 575 resistance could see strong upside follow through and help close the performance gap vs. the commodity, as well as the broader equity market.
S&P Sector Reallocations:
In late September, 23 companies with a combined market value of $2.7 trillion were reclassified by into new S&P sectors. A new sector, Communication Services, was created to replace Telecom, which had only three stocks - AT&T, Verizon, and CenturyLink - and had diminished in importance. S&P populated this new sector by moving stocks from the Information Technology and Consumer Discretionary sectors.
The sector reclassifications mostly affected tech and media stocks and included Alphabet, Facebook, Activision Blizzard, Electronic Arts, Take-Two Interactive Software, and Twitter. Media and entertainment names moving out of consumer discretionary and into communication services included CBS, Charter, Comcast, Walt Disney, Discovery, Dish Network, Twenty-First Century Fox, Interpublic Group, Netflix, News Corp, Omnicom, TripAdvisor, and Viacom. The new sector is now oriented toward high-growth names than the old high dividend paying “bond-proxy” telecom sector. eBay also was moved from tech into consumer discretionary.
Despite the significant change in sector weights, much of the market impact of the change was mitigated by the fact that some index fund and ETF providers had already begun to rebalance well in advance while others were expected to roll in the changes over time. Active managers have the option to decide when (or whether) to mimic the S&P sector changes. All of the companies remained in the S&P 500 so the changes only affected sector classifications.
One impact of the move is the outsized weight of Tech in the S&P 500 has been reduced from 26% to 21%. The chart below shows the weight of each S&P sector both before (9/20/2018) and after (9/21/2018) the reclassifications. Most sectors saw little change but the new Communications Services group commands a 9.9% weight, up from 2.0%.
While looking at sectors we continually discuss how tech has driven the market higher, which is true when we look at the S&P 500 and Dow which are influenced by much larger companies. But, if you consider the Russell 2000, the story changes quite a bit. Financial Services companies, Health Care and Consumer Discretionary stocks all have greater weight in the smaller index that has returned 10.5% YTD vs. the S&P 500’s 9.0%. Clearly smaller stocks march to a different drummer.
The Dow has lagged the S&P 500, Nasdaq Composite and Russell 2000 since January but finally caught up in September and achieved a new record high of 26,743.50 on September 21st. Below is a look at the YTD contributions of different Dow constituents as of 9/28/18.
As expected the Federal Reserve raised rates for a third time with Chairman Powell describing a goldilocks scenario of strong growth and stable inflation in the accompanying press conference. Markets are now pricing in a 73% probability for a fourth rate hike in December, per Bloomberg. Rates trended higher throughout September with the 2-year Treasury Yield gaining 18.5 bps to 2.82%, which is nearly double the 1.48% level just twelve months ago. The 10-year Yield rose to a high of 3.11% before closing the month at 3.05%. The multi-year chart of the longer dated 30-year Yield is quite striking. Since mid-2015 there is a well-established top at 3.25%, just 5bps higher from where the long yield resides today. This clearly defined three year resistance line is now converging closely towards the rising trend line from the 2016 lows. As previously noted breakouts from multi-year bases are often accompanied by powerful momentum and this particular setup is rather “textbook”. A move above 3.25% could trigger such a reaction.
Consumer confidence highest in 18 years: A strong economy or a market peak?
Consumer confidence for September was reported at 138.4, above expectations and at the highest level since September of 2000. Consumer confidence peaked at 144.71 in January of 2000 and first saw similar levels to today in 1999. Does this suggest the rally can continue for two more years?
According to FactSet earnings growth for Q2 S&P 500 EPS was 25.0%, with revenue growth of 10%. In Q2, 80% of S&P 500 companies beat EPS expectations, better than the one-year average of 75% and five-year average of 70%. This is the highest since the data began being compiled about 10 years ago. In addition, 72% have surpassed consensus sales expectations, below the 73% one-year average but better than the 58% five-year average. In aggregate, companies are reporting earnings that are 5.0% above expectations, below the one-year average of +5.6% but ahead of the five-year +4.4% average. In aggregate, companies are reporting sales that are 1.3% above expectations, above the +1.2% one-year and the +0.5% five-year averages.
A main driver for the market has been the consecutive quarters of 25% earnings growth. Looking ahead to Q3, analysts expect 19% earnings growth and about 8% revenue growth. And the slowing trend is expected to continue into Q4 2018 and Q1 2019 with earnings growth rates of 17% and 7% respectively. These are still healthy numbers for the market compared to year-ago quarters but investors will begin to question if profit margins can hold up if revenues slow, wage costs rise, inflation is tame and tariffs begin to take a bite. Whether this hurts valuations remains to be seen.
One thing to watch is the guidance for the upcoming quarter. According to the latest data from FactSet, out of 98 companies offering guidance for Q3, 74 companies have issued negative guidance. The ratio of 76% is higher than the 5-year average of 71% and above the 53% average of 1H 2018. Note that over half the guidance for the first two quarters was negative despite the strong showings overall. Companies with negative comps tend to want to get out in front of it, so the guidance so far does not mean Q3 can’t be strong, but it’s something to watch, especially for companies that sell into China.
Buybacks have supported the market as has been widely reported. Reuters reported in late September that according to analysts, not enough shares are replacing those withdrawn from circulation as buybacks, cash-based M&A, and company de-listings drain investable equity from the market. Thomson Reuters data showed primary listings added ~$126B in shares between January and August this year but this was swamped by buybacks, which are on pace for about $1T in 2018. The article went on to day that new multinationals are also less capital-intensive, and firms like Facebook require less start-up money. As more global savings are directed to investment funds, inflated valuations may be here to stay.
Buyback activity shown below. In Q2 for example, companies announced $434 billion in share repurchases, nearly doubling the previous record of $242 billion in the Q1, according to market research firm TrimTabs. Companies also issued a record $112 billion in dividends during Q2. This accelerates a recent trend. With dividends, capital returned to shareholders has exceeded $1T for the past two years. One concern: through June 30, buybacks for S&P 500 companies were $367 billion, while capex totaled $317 billion.
Source: Yardeni Research, Inc.
The strong outperformance of U.S. stocks has some wondering if they are overvalued compared to the rest of the world. The FT discussed whether a global rotation is currently underway, noting the S&P 500’s performance relative to the rest of the world has reached its most extreme since at least 1970. The S&P 500 trades at a historic 2x premium to the rest of the world on a book value basis, while its P/E premium to the MSCI World ex-U.S. index is also around a record. The divergence has led analysts to begin paring back their U.S. exposure, and fund managers say they are finding more enticing opportunities abroad.
Some cite late-cycle concerns include the latest BAML Fund Manager Survey showing investors overweight U.S. equities by the most in three years. The survey also showed 50% of investors believing the divergence in the global economy will end with a growth deceleration in the U.S., while 28% the gap will close with an acceleration in Asia and Europe.
Also, the WSJ reported that U.S. shares are trading at a 12% premium to the MSCI All Country World Index of 22 developed market and 24 emerging markets which is the biggest divergence since 2009 reflecting the relative strength and growth prospects of the U.S economy compared to international markets. Some investors are concerned that the premium could leave the U.S. market vulnerable to a pullback. However, we note that U.S. stock indices are heavily tech weighted, which has been a winner, while other international measures have other sectors like banks and industrials so the comparison is not necessarily apples to apples.
In September the WTO cut its forecast for goods trade volume growth to 3.9% vs. a 4.4% estimate in April. Separately, Bloomberg cited a DHL report which said its trade barometer weakened in September, dropping to the lowest since 2016 and indicating a slower pace of growth in the months ahead.
After five consecutive months in the green, the U.S. dollar Index (DXY) was flat in September and maybe not so coincidentally global indices recovered from what so far had been a very difficult 2018. While Turkey and Russia saw gains of 7.8% and 7.3%, the larger focus has been on the world’s second largest economy, China.
In the last week of September the MSCI announced it is considering an increase in the cap weighting of Chinese A shares, from 5% to 20%, that would take place in two stages in 2019. MSCI may also expand the number of securities eligible for index membership to include equities listed on the tech-heavy ChiNext board. At the time of the announcement the Shanghai Composite (SHCOMP) had just come off its best weekly performance in 2.5 years, +4.3%, which may explain the relatively modest 1.4% gain in the three sessions following MSCI’s announcement. The technical setups of both the SHCOMP and the Hang Seng indices, which we have been highlighting over the last two months MID BLOG 8/7 , MID BLOG 9/13 , MID BLOG 9/18 , are near term constructive and suggest there is more upside ahead.
Currently in the U.S. there is very low risk of a recession around the corner. However in addition to the U.S./non-U.S. performance gap, there a number of emerging divergences worth keeping on the radar which may suggest a pullback is possible. As the Dow Industrials and S&P 500 made fresh all-time highs in September, a stark contrast is seen in momentum (below chart, lower panel) on both the weekly and monthly time frames whose RSI have been making lower highs. The same can be seen on the weekly time frames of the Nasdaq indices. While “bearish divergences” over longer frames can go on for months, they often signal stocks are in the later stages of the market cycle.
The Russell 3000 is one of the broadest U.S. equity indices and just 58% of its members are trading above their 200-day moving average vs. 75% in January. For the S&P 500 only 65% of its members are above the 200-day vs. 84% in January.
Also, within the Russell 3000 there are a decreasing percentage of companies making new 52-week highs while the percentage of new 52-week lows is making near five month highs.
Another concern is only five of the eleven GICS sectors are in the green on a YTD basis including the financials. The S&P 500 Financials Index, the NYSE Broker-Dealer Index, the KBW Regional Bank Index, as well as the Nasdaq Community Bank Index are all trading below their 200-day moving averages. Also concerning is the iShares homebuilder ETF, ticker ITB, which is down more than 23% from its January highs and finished the month at its 2018 lows.
Despite the aforementioned warning signs, the economic and corporate outlook in the U.S. remains constructive and equities are in a bull market. The fiscal stimulus, deregulation, and generational tax reform are fueling the U.S. economy and driving global outperformance. Concerns exist with persistent Fed tightening, a flat curve, a strengthening dollar, trade with China, and an overseas slowdown which may come home to roost at some time, but for now the U.S. is performing and consumers are spending.
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