What Would Worry Us

With the increased uncertainty about the Fed’s rate hike timetable, stocks have been volatile and are digesting the possibility of a Fed tightening sooner than expected. We are not concerned about a possible 25 basis point rate hike and do not believe that alone will cause the economy to falter.  The Fed will not raise rates unless they expect U.S. growth is ready to support it.  Stock indexes realize this so corrections along the way should be limited to 4.0 to 7.0 percent and are buying opportunities for long-term investors.  We see a 60.0 percent chance of a rate hike after the election.

Our clients have asked us what would cause us to worry about a bear market.  A combination of several of our indicators turning bearish would cause our composite to decline to below 30.0 percent.  Some events are much higher interest rates and inflation, an inverted yield curve, stock overvaluation, or a recession. Currently, it would take the Fed to aggressively raise rates to engineer a recession. 

A healthy signal for stocks is the continuation of deals – there have been over $176 billion in deals over the past two weeks.  Most recently was the $4.3 billion deal with Global Infrastructure Partners and Gas Natural SDG.  

INDICATORS 

Our proprietary stock market indicator composite remains at 77.0 percent. As a review, the indicators in our composite are grouped into four categories: economic cycle, monetary, valuation, and sentiment.   Our economic cycle indicators are worth 20.0 percent in our composite.  They include the year-over-year change in the index of leading indicators (ranked neutral) and industrial production (bearish).  Our monetary indicators are worth 24.0 percent.  Included are the three-month bill rate (bullish), interest rate momentum (bullish), the yield curve (bullish), and the money supply (bullish).  Valuation is worth 25.0 percent and is ranked bullish. Our sentiment indicator is worth 31.0 percent and is comprised of bullish advisors (neutral), the Bloomberg financial conditions index (bullish), the ECRI weekly index (bullish), and the junk bond ratio (bullish). It is the overall weighted level of all our indicators that determine our bearish signal. 

One of our cycle indicators, industrial production—output of mines, utilities, and manufacturing—fell 0.4 percent in August (-1.1 percent y/y).  We rank this indicator bearish since it has been on a downtrend for a year and a half.  The decline is due to the previous weakness in global demand, the previously strong dollar, and low oil prices.   We look for an improvement in industrial production over the next year as these hindrances reverse.

Valuation remains healthy.  S&P 500 earnings continue to surprise on the upside by 70.0 percent of companies beating estimates in the second quarter, and information technology showing the most earnings beats.  The consensus for S&P 500 earnings next year is 133.0, but we are using a conservative estimate of 126.0.  With that, our P/E model indicates an 18.3x fair value P/E.  Therefore, fair value for the S&P 500 price index is 2,305, a 7.0 percent gain from here.

Positively, the number of bullish advisors declined to 49.0 percent this week – the third consecutive weekly decline from bearish levels.  Lower bullishness is considered good for stocks because it signifies there is more cash available on the sidelines waiting to be invested.  This cash further fuels stocks so we rank this indicator neutral-minus.

As bonds are pricing in the higher possibility of a rate hike, the 10-year Treasury bond yield rose over 20 basis points and the junk bond yield rose about 15 basis points over the week.  Our junk bond yield to the 10-year T-bond yield indicator has been flattish this week, but still on a downtrend (Chart 1). Since this ratio has an inverse relationship with the S&P 500, we rank it bullish.

The Bloomberg financial conditions index (Chart 2) fell slightly this week, but its trend is higher.  We look to this indicator as a good measure of the health of the financial industry.  We continue to rank it bullish.

The economic cycle research institute weekly leading index (ECRI, Chart 3) is bullish.  We look to this index for indication of changes to the economic cycle. It rose for the fourth consecutive week.  This confirms our belief that a recession is not likely for some time.

ECONOMY

Economic stats point to improving global growth with the rising OECD global LEI and global composite PMI.  This reflects the rebound in oil (Brent oil is up +70.0 percent in six months), narrowing credit spreads, the rebound in the US rig count, and continued monetary stimulus. Brexit has not adversely affected UK employment, which was feared by investors. The UK’s manpower survey has been unchanged for three years and unemployment claims fell in August, to record low levels.   China’s indicators have improved with increases in vehicle sales, government expenditures, bank loans, bank deposits, and retail sales. This is important for the U.S. economy since China is the third largest export partner with the US and an increase in demand in China will positively impact the global economy. 

U.S. real median household income rose 5.2 percent in 2015, the first time above 5.0 percent since 1967. Labor markets are firm with good payroll readings, low unemployment claims, record high job openings, good gains in the participation rate, and an improving jobs outlook - all are key for the economy’s stability. The Fed's beige book report indicated that economic activity expanded modestly across most districts.  U.S. retail sales declined 0.3 percent in August, as the warm weather caused consumers to spend their time away from purchases, but is up 1.9 percent (y/y).  However, non-store retailers (online sales) have had a 10.9 percent increase (y/y) indicating a change in consumer buying habits is at hand. Strength in consumer spending is important for the growth in GDP and has helped the economy grow even with the drag of lower oil prices, the strong dollar, and an inventory correction in the second quarter. 

The PPI, a broad measure of prices including services was flat (m/m) in August, and at the same level from 2 ½ years ago.  However, the CPI rose 1.1 percent (y/y) in August and the core CPI inflation accelerated to +2.3 percent (y/y). Energy is no longer a drag on prices, and medical goods and services are rising. This report will put inflation back on the Fed’s mind.

RECOMMENDATION 

Table 1 lists all the sectors in the S&P 500 with their associated ETFs.  For those interested, we also list the ETFs that seek a return that is 1x, 2x, and 3x the return of the index for a single day. They should be used for short-term trades only. The S&P weights are indicated for all the sectors as well as our recommend weights.  

We underweight those sectors that we do not expect to have superior returns to the S&P 500.  We believe the weighting for each issue should be based on one’s individual situation and preference. 

SECTOR ETF RECOMMENDATIONS

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