Zeller Kern’s Investment Monitor

A Tale of Two Views for the Market

August 28, 2018

By Steve Zeller                           

As we push through the third quarter of 2018, U.S. stock indexes have pushed above their previous highs posted in January. As of the market close on Friday, August 24th, the Dow Jones Industrial Average was up 5.90% year-to-date, the S&P 500 is up 8.87% (including the re-investment of dividends), and the NASDAQ is up 15.10% (source Morningstar.com). Clearly the tech rally has led the way. The last four weeks or so, has been the high point for the last 7 months, as we rallied a strong single digit performance upward. Bonds, however, remain lack luster, as the Barclays Aggregate Bond Index is down -.84% (Including interest). Also, the MSCI EAFE International Equity Index is down -2.55%, and the MSCI Emerging Market Index is down -9.35% year to date.                                            

S&P 500 Year to Date


Clearly U.S. stocks have been the winner for the year, so far. On a contrarian note, net “short positions” for gold had reached a 25 year high, according to some estimates, which reflects record negative sentiment. What this translates to is a potentially attractive opportunity for some contrarian investors, though this is not a published recommendation.

So let’s cut to the chase and ask  - “what’s in store for the market, moving forward for the rest of the year?” Well, no crystal ball here, but we can certainly discuss some thoughts on both viewpoints, meaning the “bullish” outlook (optimistic view of rising stock prices) and “bearish” outlook (negative view for the market).

On the bullish side of things, the stock market appears to be thrusting past its previous highs posted in January. Although it took seven months to do so, it has finally done so (we were somewhat surprised that it did). For those portfolio disciplines that have remained invested, it has paid off for you, excluding any weightings in bonds or International equity markets, which have been clear losers for the year, along with gold.

Our “Dynamic Allocation Growth Portfolios” have been strong winners as well, with two of the growth portfolios out performing both the S&P 500 and the NASDAQ 100 Index, so far year to date. For those who aren’t familiar with those particular portfolios, they’re designed to allocate into areas, that our models find most favorable for potential returns including equities, bonds, utilities, cash, etc. – Certainly, get a hold of us if you’re interested in learning more.

From the bullish perspective, investors will continue to fuel the market upward due to the improving economy, deregulation, new tariff agreements, and certainly the benefits of continued share buy backs by major U.S. corporations, as they continue to utilize their excess cash and purchase back outstanding shares of stock.

Share buy backs have hit an all-time high. When companies buy back their own shares of stock, fewer shares are in circulation, and if demand for that stock remains the same or rises, the price for that stock will rise. According to an article posted by CNBC, share buybacks are projected to reach over a trillion dollars in 2018. Although that’s good news in the short run, it may spell trouble for 2019, because it is doubtful that would continue. By the way, can you imagine what the per share valuations and metrics would look like if we still had the same amount of shares outstanding as we did say two years ago? But, if corporations are profitable enough, it warrants them rewarding shareholders. That’s a benefit to the investor that is willing to be a shareholder.

Other great news from U.S. companies that helped fuel the market, or support it (mutual funds have seen a negative outflow of $57 billion this year), is the metrics that are measured on a per share basis. These metrics are also directly impacted by share buybacks, because revenue per share, earnings per share, price to earnings ratios (P/E ratios), margin per share, etc., are all inflated when outstanding shares are purchased. Yes, in a way, that is some “hocus pocus” reporting. But, that being said, revenues, profit, employment, capital expenditures, dividends, are all up, and that is a good thing. The S&P 500 revenue growth is up +9.8% in the second quarter, which is a strong number.

Plus, you can’t help to notice it, but travel around the country to practically any city, and “the cranes are in the air”, so to speak, meaning commercial construction has gone wild. Two cities that I have visited, that impressed me with the commercial construction and development, was Nashville and Denver. I was in Denver last week for a “Business Exit Planning” conference and was able to spend some time there and talk to folks. Crane activity is heavy, and neighborhood redevelopment is rampant with all kinds of stores and restaurants popping up. Nashville, of course, was amazing. This is also reflected in durable goods with orders remaining robust, with the July Durable Goods number, though being down -1.7% month-over month, it has accelerated to +9.2% year-over-year. Durables Ex-Aircraft & Defense remains at a new cycle high of 9.7%, alongside further acceleration of the 2-year average, according to Hedgeye.com

All of this is fantastic, and it’s great to see, for a change. The key takeaways for the outlook for the economy, reported by the St. Louis Federal Reserve is a favorable one, with strong corporate profits, healthy financial market conditions, accommodative monetary and fiscal policies, which fueled brisk economic growth in the second quarter. According to many forecasters, U.S. real economic growth in the second half of 2018, should average close 3%. Also, the St. Louis Fed’s forecasting model predicts that increases in the consumption expenditures (PCE) price index will slow, perhaps, over the next 12 months, indicating a slowing in inflation.

The St. Louis Fed mentioned in their report that headline inflation, moderated due to a slowing in the growth of energy prices

Strong demand for labor has fueled a modest acceleration in labor compensation, and record low unemployment. Average hourly earnings are inching upward, but real average hourly earnings is barely moving. According to a recent report from the Bureau of Labor Statistics, in July, real average hourly earnings was unchanged from June to July, seasonally adjusted, with a 0.3% increase in wages combined with a 0.2% increase in the Consumer Price Index. Real average hourly earnings decreased 0.2%, seasonally adjusted, from July of 2017 to July of 2018.

Overall, inflation is now outpacing wage growth. According to Factset.com, although inflation has remained subdued with total annual CPI growth averaging 1.7%, we are now seeing CPI creep up with the July year-over-year CPI being up 2.9%. Average hourly earnings averaged 2.7% in July, year-over-year.

Nevertheless, corporate profits are increasingly robust, and the forecast for inflation remains relatively tame. As corporate profits stay strong, at least for the remainder of 2018, many good things should come out of that, as a result.

In the short run, it appears that the market will continue to move upward. But the stock market is forward looking and the question is when the final high will be realized of the current Bull market which has now set a record for duration.

This brings us to look at the “bearish” viewpoint, which is plausible. Even though it seems that the odds are low for a “bear” market happening over the next few months, there is certainly the case that it may come to fruition over the next few quarters.

First of all, market valuations are not cheap. The FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) and tech stocks, overall, are very expensive from a historical viewpoint -  Although Google, Apple and Facebook appear to be the most reasonably valued from a P/E ratio, with current multiples of around 53, 20, and 27, respectively (source: Yahoo Finance). However, Netflix’s P/E ratio is around 162 times earnings and Amazon’s P/E multiple is at 153. The overall P/E ratio for the S&P 500 is at 24.06, which is historically expensive. Keep in mind, that the current P/E ratio is reflecting all of the share buybacks, and has made the market appear less expensive.

Furthermore, as we have mentioned in the past, the Shiller P/E ratio now at 33, which is above where it was at the height of the market in 1929, when it reached 32.6 (source: Gurufocus.com).

This has an indication that the market is certainly getting riskier, from a historical standpoint and does warrant caution, in our view.

Another main point to take note of is that the economy is arguably slowing. Although the first estimate for second quarter GDP growth came in at 4.1%, which is the highest growth in almost four years, arguably short-term factors drove the growth. With the rise in short term rates by the Fed, ongoing tariffs, etc., an overall consensus is predicting an easing in growth, with some estimates for GDP to slow to a 2.9% rate in the third quarter, and 2.6% in the fourth quarter. Furthermore, quarterly growth is expected to slow an average of 2.2% in 2019.

Another interesting chart to examine is published by mcoscillator.com, which tracks architecture billings to gain insight on the economy moving forward. The observation is somewhat troubling, with the latest data from the American Institute of Architects (http://www.ala.org) that shows that architecture billing is slowing and headed downward. The other warning sign is the blow off in lumber prices.


We will see how all of this pans out from the standpoint of our economy, but this adds to the argument that the stock market could be headed into riskier territory and produce a prolong decline or significant correction.

The other factor that is posing significant risk is the current debt mania that we are in, globally speaking, and that we have reminded our readers several times in the past. According to the St. Louis Federal Reserve, total debt across all sectors, domestically, is now approaching $70 trillion. That’s right, $70 trillion. When or if this debt begins to contract, it will severely dry up liquidity, prices will fall, and the economy would severely contract.

With the stock market now at a record in duration, and the economy in its 10th year of expansion, it is reasonable for investors to be vigilant and pay attention to managing risk, moving forward.

Looking back on last week

The S&P 500 managed to advance 0.62%, closing at an all-time high at 2874.69. This was a penetration of the January 26 highs. This all occurred despite political uncertainty, trade ambiguity, and further expectations of rate hikes this year.

As for the other major averages, the Nasdaq and the Russell 2000 also notched new records, adding 1.7% and 1.9%, respectively, while the Dow climbed 0.5%.

Last week started on a positive note as Monday and Tuesday advanced a quarter of percent per day. Wednesday and Thursday were flat ahead of the releases from the Jackson hole meeting. On Friday, the S&P advance 0.86%, representing the entire positive returns for the week.

There is still a bit of a rotation going down as there were four declining sectors. They were Consumer Staples (-1.8%), Utilities (-1.4%), Telecom Services (-0.7%), and Real Estate (-1.1%).

Friday’s action was very robust as it opened stronger and continued to trade higher into midsession. It sold off briefly but rallied back to close at an all-time high above the January 26 high at 2872.87 with the close of 2874.69.

The futures and overnight activity are positive suggesting that we will start off stronger on Monday’s opening. The key level on the upside is 2881.35. A penetration will set the tone for a move towards 2888/2894.

Along with the new highs came some new upward objectives on a short-term basis. The target for the upside is now 2924/2951. On an intermediate basis, the target is 2973/3039. And on the monthly or secular charts, the upward projections are for 3322/3623.

Based on the analysis across all major trends, all signals are for higher prices as we complete August and get ready to begin September. It looks like the next 6 to 8 weeks should be positive, moving at least to the minimum of 2924/2951.

On the interest rate front, the 10-year notes continued to decline early in the week but finished up slightly. Yet, it does appear that the market is bottoming and we should see higher yields moving back toward 2.85/2.90%. A move above 2.90 will indicate a retest of the 3.016% level. On the downside, it appears that 2.78% should be the extreme. Last week has a 60% probability for it being a low.

Best Wishes,

Zeller Kern Investment Committee