2019 - Grindstone Intelligence

December 16, 2019

2020 Preview: Earnings

The end of December is coming fast. That means it’s time to finish up your Christmas shopping and start looking towards 2020 and the new year ahead. First up: Earnings.

Following last year’s tax-cut-driven 20% increase in S&P 500 EPS, index earnings have spent most of 2019 going nowhere. The top line has been steady – revenues have grown in the mid-single digits. Profit margins, though, have been under pressure. Faced with increased costs from both labor and tariffs, margins have contracted from record levels in 2018. The result: trailing 12-month profits have spent the year stuck just below $170.

Of course, equities don’t really trade on what companies earned in the past – more important is what they’ll earn in the future. Earnings are expected to grow 9.7% in 2020, aided by another mid-single digit year from revenues and a stabilization in margins. Here’s the quarterly consensus EPS breakdown from FactSet, with implied year-over-year growth rates.

The remaining question is, how accurate will those consensus estimates turn out to be? Analysts tend to be overly optimistic. According to FactSet, estimates at the beginning of the year have been, on average, 6.9% too high over the last 20 years. Last year was no different. On December 7, 2018, the consensus estimate was for 7% earnings growth, much of it thanks to the 4th quarter’s anticipated boost of nearly 12%.

The actual results haven’t quite lived up to the hype. A lackluster first 3 quarters are in the books, and while final tally for Q4 is still a few months away, it seems safe to say 12% growth is out of reach.

With that all said, it’s not impossible for actual earnings in 2020 to outperform today’s estimates. Earnings in 2018, aided by a cut to the corporate tax rate, handily outperformed initial expectations. So did index EPS in 2004, 2005, and 2006. In 2020, it seems growth outcomes are dependent on a resurgence in global demand – the Energy, Industrials, and Materials sectors are set to lead the rebound.

While it’s true the estimates for each sector have ratcheted lower since the end of September, the U.S. consumer remains healthy by all accounts. If Friday’s trade deal stands the test of time, the uncertainties that have held back capital spending could dissipate. A true trade resolution could be a stabilizing, if not re-energizing, force for S&P 500 earnings.

The trend over the coming months should tell us a lot about where the year is headed.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

December 9, 2019

Interest Rates: Trend Change or Mean Reversion

The yield on 10-year U.S. Treasuries stood at 3.23% on November 7, 2018. Over the next 10 months, bonds rallied, and that same rate fell all the way to 1.44%, reaching a nearly 3 year low on August 27. Now, with the 10-year at back above 1.80%, it’s time to ask ourselves: is the bull run in bonds over?

This is how I see the bear case for bonds.

Rates bottomed just below 1.5% in 2012 and held that low during the global recession scare of 2016. We held that low again in August of this year, momentum diverged positively, and the yield has since set a series of higher highs and higher lows. This bounce off 1.40 area will play out exactly like the two previous occurrences, and rates will continue rising toward the high end of this 6-year range. Near-term resistance lies at 2% – the 38.2% retracement of the 2013 to 2016 decline and the breakdown level from earlier this year. A break of the multi-month uptrend line would be the first sign of trouble, but price action above 1.50% would simply aid in building a long-term base to rally from. The bear case won’t really be in trouble unless we see a meaningful break of the 2012 lows.

Bond bulls see things a bit differently.

Rates started setting 5 year highs in late 2018, but then momentum diverged negatively, and the new highs turned into a false breakout. With the ensuing drop below the 200-day moving average, bonds entered a new bull market. Yields trended sharply lower until August, when momentum diverged positively and set up a mean reversion. On the ensuing bounce, rates failed to get above the 38.2% retracement from the 2013-2016 decline and are still below a downward sloping 200-day moving average. Momentum is still stuck in a bearish range, and now that yields have reverted to the mean, it’s time for the next leg of this bull market to begin. If yields get back above 2% for an extended period of time, the bull thesis will be in trouble.

November 25, 2019

The Future of Monetary Policy

Remember when the hottest question about negative interest rates in the United States was their legality? Here’s former Federal Reserve Chair Janet Yellen addressing the issue in a 2016 congressional testimony:

“We decided not to lower interest rates, the IOER, to zero or into negative territory, and we didn’t fully look at the legal issues around that. I would say that remains a question that we still would need to investigate more thoroughly.”

It appears the investigation has been completed since then. In recent months, amid the Fed’s first interest rate easing cycle since the financial crisis, FOMC members have been forced to address questions about negative interest rates again. The focus now, though, has turned to their effectiveness. The minutes from the October FOMC meeting gave us some insight into how Fed officials are thinking:

“The briefing also discussed negative interest rates, a policy option implemented by several foreign central banks. The staff noted that although the evidence so far suggested that this tool had provided accommodation in jurisdictions where it had been employed, there were also indications of possible adverse side effects. Moreover, differences between the U.S. financial system and the financial systems of those jurisdictions suggested that the foreign experience may not provide a useful guide in assessing whether negative rates would be effective in the United States.”

Of course, the ‘jurisdictions where it had been employed’ is code for Europe and Japan. The European Central Bank was the first to take rates below zero, followed by the the Bank of Japan in early 2016. Meanwhile, the Fed succeeded in raising rates by more than 2% before being forced toward an easier approach. The FOMC still has room to work with, but the average easing cycle has seen rates cut by substantially more than 2.5% – enough to push the Federal Funds into negative territory for the first time.

Judging by the committee’s comments, it doesn’t look like we’re headed there in the near future. The minutes continued:

“All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States.”

With the zero lower bound so close, and little, if any, support to send rates negative, it’s no surprise the Fed is exploring it’s other options. Balance-sheet tools are clearly the preferred mechanism for future support.

“Participants generally agreed that the balance sheet policies implemented by the Federal Reserve after the crisis had eased financial conditions and had contributed to the economic recovery, and that those tools had become an important part of the Committee’s current toolkit.”

But the balance sheet discussion didn’t stop at simply supporting prior quantitative easing strategies.

“In considering policy tools that the Federal Reserve had not used in the recent past, participants discussed the benefits and costs of using balance sheet tools to cap rates on short- or long-maturity Treasury securities through open market operations as necessary.”

Though some participants pushed back on this last policy option, the push-back was mostly technical in nature – namely, concerns about how other policy tools, like the Federal Funds Rate, would be adversely affected.

In conclusion, the members pledged to continue their review of alternative policy options over the coming months, but opined that fiscal policy would be an important factor during any future downturns. Government spending has been a recurring subject among central bankers, with new ECB head Christine Lagarde using a speech last week to echo her predecessor’s calls for fiscal stimulus to support the European economy.

In a world that seems to be more politically divided with each passing day, it’s hard to know how fiscal policy will unfold. But with or without help, it sounds like central bankers are willing to do whatever it takes.

November 11, 2019

Third Quarter Earnings Update

Third quarter earnings season is almost in the books. With 90% of S&P 500 companies reporting, FactSet Research estimates the index eps will print a year-over-year earnings decline of 2.4% – its third consecutive contraction. Looking ahead, the fourth quarter is unlikely to be much better, with growth indicated to be below zero once again.

The earnings picture stands in stark contrast to healthy stock market returns this year, returns led by Information Technology. Surprisingly, Tech has been one of the largest drags on the earnings front, outperforming only Energy and Materials stocks in that regard. One reason is Tech’s heavy exposure to the rest of the globe, where economic activity has weakened relative to our own economy. Companies with a domestic tilt have clearly done a better job maintaining earnings in Q3.

Still, a market near all-time highs indicates optimism about the future. The average estimate for bottom-line growth in 2020 is almost 10%, and each quarter of next year is expected to grow more quickly than the one prior. Of course, analyst estimates have a tendency to be revised lower over time. Excluding the tax-cut-fueled boost to eps in 2018, earnings growth has disappointed initial estimates in every year since 2011.

When it comes to 2020 though, we have reason to be even more skeptical than usual about analyst estimates. Companies, especially those with a global industrial presence, are plagued by an uncertain economic and geopolitical environment. They’ve called out global weakness and have been hesitant to give 2020 forecasts themselves.

WW Grainger Inc: “While the global demand environment continued to weaken, our U.S. and endless assortment businesses gained share…” said DG Macpherson, Chairman and Chief Executive Officer.

Cummins, Inc: “While we expected to see a moderation of demand in the second half of the year, sales have weakened even faster than we anticipated,” said Chairman and CEO Tom Linebarger.

A. O. Smith Coporation: “We face headwinds in our markets in China, and we anticipate that those headwinds and elevated channel inventory levels will remain through the fourth quarter,” Kevin Wheeler, president and chief executive officer.

Parker Hannifin Corporation: “We have revised guidance based on the impact of the closing of the LORD Corporation and Exotic Metals Forming acquisitions and softening macroeconomic trends,” Chairman and Chief Executive Officer, Tom Williams.

BorgWarner: “Global light vehicle production expectations remain volatile, particularly
in China.”

Caterpillar: “In the fourth quarter, we now expect end-user demand to be flat and dealers to make further inventory reductions due to global economic uncertainty,” Jim Umpleby Chairman and CEO.

Meanwhile, the U.S. consumer has been the most resilient part of the economy over the past year. Bricks and mortar retailers make up the bulk of earnings releases over the next two weeks, as Walmart, Home Depot, Target, Lowe’s, Macy’s, and Kohl’s, among others, are all set to report. They’ll give us key insights into whether the environment has changed.

Assuming it hasn’t, Jamie Dimon, chairman and CEO of JPMorgan Chase, said it best:

“The consumer remains healthy with growth in wages and spending, combined with strong balance sheets and low unemployment levels. This is being offset by weakening business sentiment and capital expenditures mostly driven by increasingly complex geopolitical risks, including tensions in global trade.”

November 4, 2019

Europe’s Time to Shine

For the last 10 years, the U.S. stock market has been the belle of the ball. American investors enjoyed an historic rally off the 2009 lows, but European stocks lagged behind. Now, the STOXX Europe 600 may finally be ready to join the party.

For 20 years, the index has struggled with the area near 400. Fresh highs could mark the beginning of a major bull market. Will this finally be the time it can break through? Here’s a closer look.

Prices are now just above the mid-2017 peak. That level was exceeded briefly in early 2018, but the subsequent reversal has taken nearly 2 years to repair. Momentum isn’t showing extreme bullish strength, but looking at price only indicates the STOXX 600 is ready to move higher.

The CAC 40 is confirming the strength out of Europe. After a strong October, the French index is setting multi-year highs.

Like the STOXX 600, momentum is not showing quite as much strength as price, but divergences don’t mean anything until they’re confirmed by a reversal. For now, the CAC 40 is healthy as long as it holds near-term support.

The German DAX is trying to resolve higher, too, despite weak economic data.

This group has rallied back above the 2015 peak, and now sits within a few percent of a record. The area near 12300 should act as support on any pullback, but Europe bulls want to see a break above 13700 for confirmation.

The FTSE 100 is in a similar place, though it underperformed during the most recent run-up.

The 2015 highs are key support for this Brexit-affected index. Falling below could do serious damage to the broader European index. On the other hand, breaking above the 4-month downtrend would be a sign of resilience, and could spark a rally back to the high-end of the 3-year range.

If new highs are contagious and spread from the France to Germany and the U.K., the whole of Europe could be headed much higher.

October 28, 2019March 1, 2023

The Truth About Long-Term Stock Market Returns

Since the inception of the S&P 500 in 1928, stocks have delivered an outstanding annualized return of 10%. You read that right. Ten percent per year. To everyone with a 90-year time horizon that invested all their money in a zero-fee, tax-free, and non-existent index fund, then rode out the turmoil of the Great Depression, WWII, the Dot Com crash, and the 2008 Financial Crisis, reinvesting dividends and never selling along the way: Congratulations. You crushed it.

For the rest of us (that is, everyone), it’s time to face reality. As investors, many of us have been conditioned to believe that 10% per year is not only possible, but a near-certain outcome if we just stick to the plan. It’s a comforting thought. The truth can be harder to swallow: 10% per year is not quite the same as 10% every year. Moreover, you don’t have 90 years to leave your assets untouched, and you probably won’t sit by and watch your retirement account get cut in half without taking action. In short, just playing the game doesn’t mean we’re entitled to double-digit returns over our investment horizon.

Much like the last 10 years, the long-term history of the S&P 500 price index (below) has been marked by periods of uptrends and consolidations. Over the long term, market participants benefited from extended periods of outstanding growth, but sometimes invested for years without meaningful asset appreciation.

True, dividends would add to the return during the stagnant periods shown above, and it’s not entirely fair to exclude them. Then again, it’s not entirely fair to exclude inflation either. Inflation doesn’t get much attention anymore, especially when talking about investment returns – for that we can thank the Fed and 25 years of core CPI readings below 3%. But since we’re analyzing 100 years of historical data, not just the last 25, we can’t afford to ignore it. So what happens if we included both dividends and inflation? We still see extended periods of time where stocks provide no meaningful appreciation in purchasing power.

Each data point in the chart below represents the annualized real total return for the S&P 500 over the preceding 20 years. (The underlying equity and inflation data go all the way back to 1871, courtesy of Robert Shiller’s online database.)

No less than 4 times in the past century, equities provided less than 1% in real return per year for a 20-year period. For plenty of savers, 20 years is longer than their investing life! And though the annualized real return over the entire dataset is a respectable 6.9%, the 3.9% average achieved over the most recent 20-year period should remind us just how volatile returns can be. Mr. Market doesn’t care about our retirement plans. He doesn’t owe us anything.

To be sure, stocks are still one of the best long-term wealth generators, but investment returns are cyclical. They can come in bunches or not at all. Going all in, crossing your fingers, and hoping for the best might make you rich – but hope isn’t much of an investment strategy.

October 21, 2019

Healthy Rotation

Outperforming only Energy stocks, Health Care is the second-worst performing sector this year. Last week, though, saw Health Care rise 2%, more than any other sector. Could that be a sign of more strength to come?

Here’s Health Care relative to the S&P 500 over the last 5 years. The ratio peaked in mid-2015 and declined for the next 18 months. That December 2016 low has since been excellent support.

In September, we saw that level get tested once again, and once again, the level held. Momentum diverged positively at the lows, and now the ratio is trying to break the downtrend from June. To be sure, the sector is still in a downtrend for the year, but this is a logical place for a big turn higher.

On an absolute basis, Health Care is coiling up for what could be a major move.

Prices have gone exactly nowhere since January 2018, but momentum did manage to stay out of oversold territory on the most recent decline. If we see a break of the downtrend line, the 261.8% extension from the 2015-2016 decline is easily within reach. On the flip-side, a resolution lower would need to hold $1000 or risk going all the way back to the 2015 highs.

For the last few years, Health Care has been led by both Equipment and Supplies, and Life Sciences. The former is still in a clean uptrend.

Midway between extensions from the 2015 decline, prices have consolidated over the past few months. New highs are only one good day away, while it would take a drop below $1500 to do any real structural damage to the chart.

Life Sciences has been almost as strong, but a false breakout in June followed by momentum falling into oversold territory warrants bit more caution.

The industry has been prone to false starts over the past 5 years (2016, 2018), but has continued to stair-step higher. A move back above resistance at $650 would suggest more highs are in store. A failure here would put momentum in a bearish range and make $575 a critical level for keeping the long-term uptrend intact.

If we’re going to see Health Care as a whole lead the market, though, we’ll need some help from other, larger, industries. Biotech might be the best hope.

Biotech held the December 2018 low during a July retest, and momentum stayed well out of oversold territory during the decline. Now, prices are breaking a year-long downtrend line and trying to get above the 200-day moving average.

There’s nothing here to indicate we’re going to break out of the 5-year range, but with the upper end of the channel about 20% away, there’s plenty of room headroom. Especially compared to pharma.

Pharmaceuticals stocks continue to hold the area around $650. There’s plenty of support there going all the way back to 2015, but the last few years have been a choppy mess.

Over the past few weeks, the group has set some higher highs and higher lows, signaling a potential move back to the high end of the range. Unfortunately, the high end of the range is only 5% away – probably not enough to move the needle for the whole sector. Positive momentum readings should be supportive, but prices have to get back above $710 before we can get too excited about longer-term prospects.

The final industry, Health Care Providers, is stuck in a consolidation as well.

Compared to Pharma, the Providers had a less-robust bounce in June and July, and have been setting lower highs since late last year. Support at $800 held in August, and momentum stayed out of oversold territory, but these stocks are rangebound until they aren’t.

To sum it up, Health Care on a relative basis is at a logical place to begin outperforming. The sector has coiled up for a major breakout, and three consolidating industries will decide the fate of the group as a whole. Biotech, Pharma, and Health Care Providers are all near the bottom end of long-term ranges – poised for either a bounce or a major resolution to the downside. Meanwhile, Health Care Equipment and Life Sciences have led the sector for much of the last 5 years and remain in uptrends.

September 30, 2019

A Risk Appetite Assessment

The S&P 500, Dow Jones Industrial Average, and Nasdaq are each within a few percent of their all-time highs, yet for the last 6 months, stocks have struggled to break through overhead resistance with any conviction. The Cumulative Advance/Decline Line indicates that breadth is at least adequate, and sentiment readings are far from stretched, but still, prices remain largely stagnant. One problem could be a lack of risk appetite. Strong equity uptrends are generally a reflection of increased risk-taking from investors, and ratio analysis is a great tool for gauging the appetite in the current environment.

The debate over Growth and Value has dominated the investment landscape for decades. Growth stocks certainly led the way higher during the dot com rally of the late 1990s, but then led on the downside as the bubble popped. The tendency of Growth to outperform during uptrends has been apparent in recent years as well.

The ratio of S&P 500 Growth to S&P 500 Value rallied from 2013-2015 as stocks broadly advanced, but then declined from late 2015-2016, a period where equity markets struggled to set new highs. Growth bottomed relative to Value at the end of 2016, and stocks soared in 2017. The ratio climbed all the way through the Dot Com high of 1.57, but then stalled at the 261.8% retracement from the 2015-2016 decline. The August decline confirmed a bearish RSI momentum divergence and got to its most oversold level since 2016.

In short, this multi-year trend of Growth outperformance is on life-support. The ratio needs to work off its momentum problems and recover the 2000 highs, or this false breakout could be just the start of Value’s strength.

Other flavors of domestic equities are showing a lack of risk appetite as well. Simply comparing the Consumer Discretionary sector to Consumer Staples yields similar results to those above. This ratio is great because it just makes sense: the numerator is the equivalent of buying a new car, and the denominator is buying toothpaste – people are only doing the first when times are good.

Like Growth/Value, Discretionary/Staples made it all the way back to 2000 highs in 2018. But the ratio put in a bearish momentum divergence in the third quarter of that year and has struggled ever since. Momentum is stuck in a bearish range, and the current ratio is below its 200D moving average. While clearly not in an uptrend, we’ll have to see a break of last year’s lows to get more negative on this relationship.

Small cap stocks relative to large caps have moved sideways for much of the last 5 years. A strong 2016 was followed by weakness in 2017, but the period since mid-2018 has been especially weak.

Momentum, too, has been decidedly negative since March, and not even a sharp September rally could break the ratio’s downtrend. Support from the 2007-2009 lows, just above 0.50, is a logical place to try and find a bottom, but for now the trend is down.

Looking abroad, the ratio of Emerging to Domestic markets is another great measure of risk-appetite, and it’s sending a similar message. The false breakdown in early 2016 was a near-perfect indicator of the bottom in U.S. equities, and four years later we’re back to the same key level. The 2019 downtrend is very much intact, and momentum has been stuck in a bearish range for most of the year. Technicians argue that the more times a level is tested, the more likely it is to break. This is the fifth (sixth?) attempt to get through 0.70 – a breakdown here would be point towards further risk aversion by investors.

On the other hand, momentum diverged positively at both the July and August lows, and has yet to get oversold during the September decline. We’ll want to see a bounce and break of the most recent swing high to confirm the divergence, but a bounce off of multi-year support might make some sense.

Risk aversion hasn’t been limited to equities either. The bond market is significantly larger, and investors have favored Investment Grade Corporate Bonds over their riskier counterparts since the fall of 2018.

High Yield bonds took the brunt of the 2015-2016 decline in stocks, but then ripped higher over the next three years. When stocks began to fall again in October of last year, High Yield began to to underperform, too. In August, the ratio fell below the 2014 swing high – a sign of more bad things to come. But buyers came to the rescue and pushed the group back above the key support level. Momentum even managed to get overbought on the recent rally, but the ratio has more work to do. It’s still below a downward sloping 200D moving average and the downtrend line from the highs. The false breakdown might have been the key turning point, but we’ll need to see more bullish evidence before calling this a broken downtrend.

For stocks to move higher, we’ll probably need to see more appetite for risk in the markets. The safety trades have clearly been in control, but several of the relationships above could be at bullish turning points. More concerning would be a loss of leadership from Growth stocks, which had managed to lead even as the other ratios faltered. However things resolve, the next few weeks should be fun to watch.

September 23, 2019

A Technician’s Financial Stability Report

The S&P 500 is still struggling to break out of its multi-year consolidation pattern. One reason for the index’s inability to rip higher has been a lack of participation by one of the largest and most important sectors: Financials

In January 2018, the Financials sector finally made it back to the 2007 highs, but they failed there and have yet to make a serious attempt at new highs. Here’s a look at the last 5 years.

The 261.8% extension from the 2015-2016 decline has been the key resistance level for more than a year now, and we’re seeing another test right now. Getting above it could be enough of a catalyst to send the group through the decade-long resistance at $510, but until then, there’s no trend.

The Banks are the largest industry group, and their signature is similar. If they succeed on this test of the 2019 highs, the 261.8% extension from the 2015-2016 decline will be in focus, and the 2007 highs at $415 will be within reach. Another failure here could mean another retest of $300, which has been a critical rotational level for almost 3 years.

The Diversified Financials look the same, too. The 2007 highs are at $820, but as long as the group is below $700, there’s clearly no uptrend in place.

Insurance is the smallest industry group, but it’s certainly been the standout. Like the Banks and Diversified Financials, Insurance stocks failed near their 2007 all-time highs in January 2018. But unlike its two counterparts, Insurance has been unstoppable for much of 2019, ripping to a new high in June, and then holding the breakout during the August retest. With prices above a rising 200-day moving average, this is now an established uptrend. The next extension lies at $486, with the swing lows of $415 acting as key support.

If the Banks and Diversified Financials industry groups join Insurance in breaking key resistance in the coming weeks, the Financials sector could be strong enough to drive the whole market higher. In the meantime, I’ll be watching for clues in the bond market – the two industries in question have historically had a moderate, positive correlation with rates.

What do you think?

September 9, 2019

A Manufacturing Contraction – Now What?

According to Tuesday’s PMI release from the Institute of Supply Management, the manufacturing sector is officially in contraction. The 49.1% reading is the first below the 50.0% flat-line in 3 years and is clearly trending in the wrong direction, but what does that mean for the economy and for stocks?

The Manufacturing Purchasing Managers Index has existed for more than 50 years, so we have a decent data set to work with. The PMI has signaled contraction during each of the 8 recessions (grey) since 1960. But getting below 50% hasn’t been enough. There have been 9 periods (red) where the manufacturing sector contracted but the overall economy continued to grow. If the past is any guide, we’ll see readings in the low 40s if this contraction in manufacturing spreads to the rest of the economy.

The Business Employment component of the survey fell below 50.0% during August as well. Like the PMI, though, we’ve seen lower results even during the current economic expansion, and a recession would likely warrant this measure falling into the 30s.

The weakest areas of the ISM Report are in orders. New Orders are at their lowest since 2012, a level that has only been reached a handful times outside of recession.

And if you’ve been following trade developments over the past 2 years, it shouldn’t be too surprising that Export Orders are weak. Still, the August drop marks the second-worst period since this survey began in the late 1980s.

Historically, the ISM Survey has been a pretty good coincident indicator for both S&P 500 revenues and trailing 12-month price performance. True to form, stock market returns have been below average for much of the last year. Should we continue to see the PMIs fall, it wouldn’t be surprising for equities to decline as well.

On a brighter note, the ISM Non-Manufacturing survey results from Thursday improved to 56.4% in August, and hasn’t been below 50.0% since 2009. More often than not, the two surveys (Manufacturing PMI and Non-Manufacturing PMI) trend together, so we shouldn’t expect the divergence to last long. As long as they’re in conflict, though, the overall direction of growth will be cloudy. I’ll be keeping a close eye to see which of the two trends wins out.