That’s What Makes Markets..

“That’s what makes markets” is an old Wall Street expression that describes how different perspectives of buyers and sellers come together to facilitate trading throughout capital markets. And just as perspectives of value vary for any given asset, so do perspectives on the economy. What shapes these views is an analysis of a number of different economic metrics which are framed by the analyst’s own personal biases. With there being so many different metrics available and with everyone having their biases, it’s easy to see why there are so many different views on the economy at any given time. However, there are two fundamental elements of any developed market economy that rise above biases and whose strength or weakness determines the economy’s overall health, and those elements are employment and consumption. To quote Keynes from his seminal book, The General Theory of Employment, Interest and Money, which dealt with the symbiotic relationship between employment and consumption, Keynes stated, “Consumption, to repeat the obvious, is the sole end and object of all economic activity.” With the idea that sustained consumption is the goal, it’s interesting to think that Keynes may have found the current US economy with its services and consumption based model to be the ideal economy. So, with market turbulence driven this past week by soft manufacturing and services data but coupled with strong employment data, we find ourselves once again facing economic crosscurrents. When facing these crosscurrents, it becomes critical to focus on the basics like employment and consumption and to also understand what is driving the negative data. Because, when we look at the soft manufacturing data from last week in the context of its own historical fluctuations and along with the strong employment and consumption backdrop, we see that the economy is in good shape and not falling into recession as financial media would have one believe.

Looking first at employment, we got another solid month of job growth in the September nonfarm payroll report from Friday. With the unemployment rate falling to 3.5%, a level not seen since 1969, the case for being at full employment has clearly been made. September job creation also saw a continuation of growth in the services sector and further refinement of services jobs into more sustainable and higher wage professional and business services (PBS) positions.

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In addition to the gains in PBS, the leisure and hospitality services (LHS) sector also had strong gains for the month. Financial media is usually quick to discount gains in LHS jobs in a derogatory way as low wage / low quality jobs when what those gains really show are strength in consumer discretionary spending i.e., consumption. This strength is also evidenced in the strong earnings and guidance just announced by Cintas. Cintas’ primary businesses provide uniform rentals and facility services to the food services, hospitality, and gaming industries in addition to healthcare, automotive and others. Cintas had unadjusted/adjusted revenue growth rates of 6.7%/8.3% respectively, improved operating margins and raised the entire range of its revenue and earnings guidance. All of this helped send the stock to its all-time highs in September. When a company like Cintas, which has significant visibility into discretionary spending oriented industries, is comfortable raising its guidance, there is clear strength in those industries and by default strength in consumption as well. Then, just by looking at the most recent quarterly data of inflation adjusted personal consumption expenditures, we can see consistently positive growth.

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Thus, by taking the employment data, Cintas’ earnings and PCE data, we can wade through some of those crosscurrents and see that healthy employment and consumption are acting as strong support for this economy.

Now, lets look at the weak manufacturing data last week which caused quite a stir in the market. The ISM manufacturing report posted its second month in a row of contraction with 9 of 10 of its subcomponents all with readings under 50. All around, it was a weak report. Commentary in the report was also downbeat, citing trade war and tariff related issues as weighing on demand and sentiment. All that said, the most important factor to understand here is that manufacturing accounts for just 11.3% of GDP, while services are 66.6% based on final Q1 2019 GDP data. Also, many of our manufactured goods like jet engines, industrial machinery and other high-tech goods are not substitutable so the downside here is fairly limited. Next, when we look at the history of the ISM report, we see that a month or even several months of contractionary data do not always lead to a recession. For example, if we use the most recent multiple month contractionary period which lasted from October 2015 through February 2016, we see that the data rebounded, and recession did not ensue. Looking through series history, there are 6 more instances of 5 consecutive months of contraction where recession didn’t follow until at least a year and a half later.

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To put that in perspective, there were 11 official recessions throughout series history and 4 of them had expansionary months that preceded the recession start. The point of all this is to say that there isn’t a statistically significant relationship between two consecutive contractionary months and a recession. Therefore, we really need to let the data play out quite a bit more before extrapolating anything serious about the manufacturing part of the economy.

On the services side of things, the ISM Non-Manufacturing (NMI) report came in down from last month but still well in expansionary territory with a 52.6 headline reading. Unlike its manufacturing counterpart, the NMI had 9 of 10 components all in expansionary territory with some having actually ticked up from last month. The commentary also had some references to trade war and tariff issues but still had an overall positive tone to it. One remark stood out in particular:

“While Chinese tariffs are understandable, they are impacting our supply chain decisions. We are actively pursuing alternate sources for our China-based production. At this point, we have not passed on tariff costs to our customers, but we are evaluating all options.” (Other Services)

This comment lends itself well to the subdued inflation that we’ve seen since the tariffs were started and the overall low inflation we’ve had in general. It also goes to the heart of the trade war and what will ultimately bring China to the negotiating table, which is significant job and revenue losses from supply chains relocating. That said, going back to the strong guidance from Cintas, we could certainly see a rebound in the NMI going forward. Taking both ISM surveys in the context of hard data like weekly unemployment claims, it’s more probable that the recent downticks in the ISM data are more a function of natural month-to-month volatility, which is inherent in those surveys, than it is a true sign of a momentum shift. As weekly claims continue to show significant labor market strength in a near real-time frequency, a significant downturn in business activity just hasn’t happened yet.

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All in all, we see that the underpinnings of the economy are solid. Unfortunately, the crosscurrents of trade wars and tariffs continue to batter the market. So, for now, we can rely on the resiliency of the services / consumption based economy to carry us through the storms. However, should the situation with China continue to escalate, we need to be vigilant and flexible with our investment positioning so that we don’t fall victim to Keynes’ most famous quote: “The market can stay irrational longer than you can stay solvent.”

 

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions.

No mysteries in finance…

While mystery has always been a great seller to the masses in terms of books, movies and TV shows, it’s unfortunately also a top seller in financial media. We can see this with all the frenzy surrounding the dreaded inverted yield curve and this past week’s repo market mania. Both were events presented as mysterious and nefarious in nature, but when analyzed with some technical knowledge and common sense, both become perfectly explainable and are not actually harbingers of the next recession or crisis. In reality, both events are just a result of supply and demand for different assets in their respective markets by participants conducting normal business. So, by working through these “mysteries” and having the FOMC meeting behind us, we can now focus on the positive economic data that was out last week which is what will ultimately drive this market higher.

Looking at the situation of the inverted yield curve, we can break this down into two basic parts. First, is the Fed pushing up short term rates through its policy decisions and second, is the bond market pushing down long-term rates from sheer demand for treasury securities.

A close up of a piece of paper Description automatically generatedThe front part of the curve is the easiest to explain with the Fed having embarked on its rate hiking cycle back in December 2015 and driving the Fed Funds rate from essentially zero all the way up to the 2.25-2.50 range In December 2018 and thus taking market based short-term rates with it. So, while the Fed was performing its economically justified policy adjustments on the front end of the curve, the rest of the curve was being held down by a confluence of forces:

As a result of the financial crisis, significant regulatory actions were taken on financial institutions in order to mitigate systemic risk. Regulatory actions like the Dodd-Frank Act and Basel 3 Accord have forced institutions to hold a larger proportion of their assets in high quality liquid assets (HQLA) so that in the event of another crisis, they could be more easily liquidated to raise capital and not become a tax payer burden again. As seen in the chart below, these higher quality holdings have nearly doubled since the crisis.

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Because treasuries are already considered a vital component by institutional asset managers due to the treasury market’s unparalleled liquidity, the additional regulatory demand has generated a significant source of downward pressure on rates.

Next, we have an interesting situation of persistently low inflation helping to keep rates low which is unique to this economic expansion. In the past, economic expansions that approached the length of our present one have always been associated with rising inflation and sometimes very strong inflation. However, thanks to recent technological advances ranging from fracking, smartphones and open source software, to name just a few, there has been an unprecedented increase in productivity without an equivalent increase in prices. With fracking allowing the US to go from being not just the world’s largest oil consumer to also being the world’s largest producer, the reduced energy costs have helped anchor inflation while providing significant benefits throughout the economy. These technological advances along with a consumer shift in preference towards experiences versus goods has also helped to keep prices in check. It is this persistent lack of inflation that has been an ongoing point of discussion at the Fed and also a stated reason for ending this hiking cycle at the January 2019 FOMC meeting.

Lastly, we have the concept of relative value which has been another source of downward pressure on rates. Relative value describes a bond investors preference to always seek the highest yielding (return) bond with the best credit (likelihood of receiving that return) in a related group of bonds. So, in the case of treasuries, the comparable (relative) bonds would be those of similar developed sovereigns, which is primarily the European Union. With some EU sovereign yield curves having gone mostly negative and even being less credit worthy than the US, it’s easy to see why the US is such a great relative value and why foreign holdings of treasuries have risen significantly since the end of the crisis.

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Thus, by taking the confluence of forces acting to keep long-term rates down along with Fed policy changes pushing short term rates up, we can see why the yield curve was literally pushed into inversion by various market participants and not by omniscient investors who had “divined” that a recession is imminent. Even research which concludes that yield curve inversions precede a recession by some amount of time are spuriously correlated at best because of the significant events that happen in that time span that do actually cause a recession. All of this is not to say that yield curves do not provide any information because they definitely do. Rate curves are the fundamental basis for valuation models across multiple asset classes and are an invaluable economic metric. However, thanks to global quantitative easing and low inflation, rates have been anchored in such a way that some of the curves’ descriptive ability has been muted.

Moving on to our next mystery, let’s look at the spike in overnight (REPO) funding rates that occurred last week. As a quick primer in its most basic form, the repo market is where investment banks and other leveraged participants secure funding for their trading and investing activity. The repo market allows institutions with excess cash, like money market funds, insurance companies, corporations, banks and sovereign wealth funds to lend that cash to institutions that need it on a daily basis. These cash loans are collateralized by high quality securities like treasuries and are grouped into a category called general collateral (GC). For this exercise we will only refer to the spike in GC rates even though there were spikes across the spectrum of money market rates. Here is a brief history of GC rates from before last week and through it:

With some definitions and history out of the way, we have an understanding as to what happened. Now, the question is why did it happen? Similar to the confluence of forces that helped drive the yield curve inversion, there were several issues that came together to drive the spike in GC which could have been avoided had the NY Fed been more in tune with the markets. It turns out that the immediate cash shortages were driven by corporations withdrawing cash from the market to pay for tax liabilities and newly auctioned treasury securities that had to be paid for by various investors. There was also speculation that Saudi Arabian related funds withdrew cash in light of the bombings over the weekend. Then, on a larger-time frame, cash has been regularly drained from the market as a result of Basel 3 regulations which went into full force in January and that essentially forced global systemically important banks (G-SIBs) to hold enough cash to be able to cover a 30-day period without any need for funding in the event of another crisis. As things unfolded on Monday, the NY Fed was able to get its processes running to add the needed liquidity to the market and the situation was eventually fixed. But before the NY Fed was able to remedy things, financial media had already begun speculating that this situation was a redux of the spike in funding rates that happened during the crisis and that a new crisis was upon us. However, the major difference is that the funding problems back then were driven by the sudden introduction of counterparty risk into a market where it was previously inconceivable that a major US investment bank would become insolvent and that some collateral might actually be worthless. All one had to do last week was look across different asset classes to realize that this funding issue was limited in scope because other markets were functioning with a risk-on tone to them as opposed to the total calamity that existed during the crisis. It’s funny how media always seems to fill in the knowledge gaps with fear.

Throughout all the wild swings last week that started with what looked to be a significant market drop due to the Saudi Arabian oil field bombings, there was still some good news delivered. We got a strong industrial production (IP) report for August which also supports the idea that the weak ISM manufacturing reading earlier this month was a one-off driven by Boeing related issues. The IP report saw strength in business equipment, construction supplies and mining output. Then we had a Philadelphia Fed manufacturing report that showed healthy readings in new orders, production, shipments and employment data. There was a jump in the prices paid / received data in both current and future expectations readings that could be reflecting tariff-related effects, so that will have to be monitored. Given the strong IP report and solid Philadelphia Fed data for September, a rebound in the national ISM and Markit manufacturing surveys could be in store for September. On top of the solid manufacturing data was a second month in a row of a pickup in existing home sales (EHS). EHS, which account for 90% of total home sales saw increased buyers taking advantage of lower rates. The continuing lack of inventory is still holding sales back though as the market awaits homebuilders to complete new projects. With mortgage lending standards significantly stricter than what they were back before the crisis, the economic health and sustainability of purchasers today is something to note as an additional tailwind for this expansion. Last, but certainly not least, we got another week of historically low unemployment claims. And unlike the inverted yield curve, weekly unemployment claims are a reliable recession indicator. This week’s claims came in at an historically low 208,000. We need to see that number get above 300,000 and stay there before we start taking the R-word seriously. Overall, the data from last week indicates that the soft spot the economy had throughout the summer is firming up as we head into fall.

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Having worked through the inverted yield curve and repo market madness we’re now ready to face a new week with earnings season right around the corner. We have plenty of A-list economic data to look forward to and what is certainly no mystery, more China trade war news to swing the market back and forth.

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions in Boeing.

An Economy Sustained

Sustainability is a popular word in today’s media and is a part of an abundance of freshly-coined terms which deal with climate change and how we can all be better stewards of the earth. And in the highly charged social environment we are in, some of the ways being proposed to achieve this environmental sustainability would be to end the use of fracking, fossil fuels and the partaking of our favorite bovine. While the merits of these proposals are outside the scope of this discussion, one thing is for sure, and that is that a hurried implementation of them would be an end to our economic sustainability. Now, putting aside the frightening thought of a meat-less football season, we can look at the strength and sustainability of our economy that was evidenced in this past week’s data. With financial media doing its best to keep pushing the recession narrative, which so many have predicted for so long and that it’s still right upon us, the actual data shows the contrary. In reality, what we are seeing is the resiliency and sustainability of our modern services and consumption based economy.

Unfortunately, the term services economy is usually thought of as being limited to the leisure and hospitality sectors when it actually includes technology, finance, education, healthcare and others. The primary reason why we have enjoyed such a long expansion is that our economy has moved away from a manufacturing / exports base towards a services / consumption one. By doing so, the economy has become more sustainable and less susceptible to exogenous economic shocks which makes for longer business cycles. The chart below shows the consistent growth and smoothness (sustainability) of services versus goods-producing employment throughout this transition.

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That said, if we group the existing NBER business cycles to reflect this transition, a transition which is supported by the dramatic growth in services employment, we can see how the average business cycle has significantly lengthened.

In addition to the dynamics which have supported a longer cycle, we are also seeing an evolution of the services labor force into an even higher skilled and sustainable one. For example, in the August employment report there was a loss of 14,800 General merchandise store jobs and an addition of 14,800 Professional and technical services jobs. This is not to say that people are simply switching positions but that there is an overall transition occurring in the labor force as a result of changes in business trends.

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Then, as the table below shows, in the top five employment growth areas, four of them are services sectors which also account for nearly 55% of private sector employment by themselves. This is all important to note because financial media tends to only point out the job losses.

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So, while some scoffed at Friday’s employment report as being weak, when the data is taken in the context of a labor market at full employment, job openings (JOLTS) still near all-time highs, unemployment claims near all-time lows, and with a 3.2% rise in average hourly earnings, the 130,000 jobs created is just fine. It’s the details and trends in the report where the true strength lies.A screenshot of a cell phone Description automatically generated

Since services account for just over 80% of total private employment, we see why the strong ISM Services (NMI) report we got last week is so important, especially versus its manufacturing counterpart. The August NMI came in with a solid headline reading of 56.4%, up 2.7% from last month and handily beat expectations. The new orders component came in at its best reading of the year at a very high 60.3% with various types of labor being reported in short supply.

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Even though some survey respondents expressed concerns about tariffs, the overall commentary was describing a positive and growing business environment. Taking this report along with the strong services employment data and low weekly unemployment claims, we see how healthy and resilient the US services / consumption based economy is. In the absence of trade war noise, it’s this data that can propel equities higher.

As for the ISM Manufacturing (ROB) report that spooked the market last Tuesday, we need to understand how ISM calculates its indices to see what could have driven the drop into contraction. Basically, ISM weights all the responses it gets by the sector’s contribution to GDP. In this month’s report, we see that the drop in the PMI was primarily driven by drops in new orders and employment. Within those two components, it was the Transportation Equipment sector that was the most heavily weighted sector with the most negative responses. Given the issues plaguing Boeing and its supply chain, it’s likely that it’s these idiosyncratic issues that are especially weighing on the indices. With August car sales having come in well so far, it makes Boeing related issues a heavy favorite to be the culprit for the ISM decline. With that said, we can see from other survey respondents that tariffs are an issue, but that businesses are still trudging along. The takeaway here is that it’s a given that the manufacturing side of the economy will always be especially susceptible to external forces but thanks to American product superiority in many of our exported goods, even that decline will be limited.

The question becomes, so now what? The S&P is trading 22x trailing earnings and 17.9x 2020 estimates which have already come down 5% since March due to trade ware fears. Those valuations are arguably low given the low rate and inflation outlook. We also have a Fed that is committed to cutting rates with Powell stating that he was concerned about low inflation in his remarks from Switzerland on Friday. With an easy Fed, the stage has been set for a strong market and potential multiple expansion. Now, the obvious worry left is China.

When we look at the deteriorating economic conditions in China, the known issues alone are clearly serious. The PBOC finds itself facing inflation as a result of its weakening currency along with a shortage of USD’s from reduced export revenues. The PBOC needs USD’s to pay for commodities, USD denominated debt and for other external funding needs like its One Belt One Road projects. From a purely financial perspective, it behooves China to reach a deal because without one, F/X issues could put them in dire straits. Then the job losses from supply chains leaving adds the additional threat of civil unrest from unemployment which is something we know Beijing has no appetite for.

Next, there are purely domestic issues like the African swine flu outbreak and the Hong Kong riots. China is the world’s largest consumer of pork and has seen its hog population reduced by at least 30% thanks to the ASF outbreak that has been out of control for over a year. Because of this, pork prices have spiked over 70% and food importers have had to import beef from Australia and South America. Given Beijing’s history of covering up issues, it’s most likely that the ASF outbreak is much worse than what has been reported. This issue is also made worse by a weaker Yuan.

Finally, we have the civil unrest in Hong Kong that could result in China losing its crown jewel developed market asset and its best connection to the financial world. Should there be military action that unofficially makes Hong Kong the same as China, then Hong Kong would no longer be trusted as a global marketplace and the loss would be devastating to China’s financial future. This is why we have not seen full scale military operations yet and why there is hope for a peaceful solution.

However, even with all of these issues, it could still be possible that China will stay true to its dictatorship history and crush any rebellion and let its people endure any hardships as long as they may last. The reality of all these issues may have been what led to Beijing’s willingness to reach out about a trade deal last week, which makes it seem that the moderates in Xi Jinping’s inner circle may be gaining some traction and cooler heads may prevail. We will have to wait and see what comes out of the planned October meetings. So, given current market valuations, a dovish Fed and a healthy economy, there’s plenty of justification for the market to sustain its upward path, but the ability to withstand the headwinds of a prolonged trade war remains to be seen.

 

 

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions in Boeing.

Seeing value when others don’t…

“Beauty is in the eye of the beholder” is a famous line from an old Irish novel written by Margaret Hungerford that lends itself well to our current market and, of course, to the St. Patrick’s Day just passed. While Hungerford used the phrase to allow her novel’s character to respectfully and wisely describe another character’s appearance, we can use it to find value in today’s market that many others choose not to see. With the S&P just getting its head above a range that’s been in place since mid-October, we could now be at the beginning of a run to new highs. So, with many financial media pundits focusing on the always imminent recession, investors can look at the data to see some rather attractive aspects of this market.

Beginning with the foundation of every economic expansion, we have employment. A couple metrics that have been showing a strong labor market are weekly unemployment claims and JOLTS data. As was previously and more deeply discussed in The Bull’s Case for 2019 , weekly claims are a near real-time metric where any kind of broad sustained economic slowdown would show up first. Until claims retake the 300,000 level, recession talk is simply unwarranted. Then, looking at claims along with job openings, we get a much more robust picture of the labor market. JOLTS data which was just released last week saw three major BLS industry groupings, education and health services, leisure and hospitality services and mining and logging hitting their series highs while total openings came in at just under a record high.

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Jolts claims 3.16.19

The above data is showing a labor market that is poised to tighten further and push wages higher, which is a combination that reinforces the virtuous cycle of employment, consumption and economic growth. Especially indicative of the growth in consumption is the record level of openings in the leisure and hospitality services sector. Unfortunately, many in financial media are quick to discount the L&H sector as being low wage, low value jobs. That is a very myopic view which misses the importance of these roles and what they say about the overall economy. Setting aside the facts that L&H service positions can be rather lucrative in certain locales and that a person’s work ethic can make any role valuable, an increase in L&H employment reflects an important aspect of a growing economy which is strong consumer discretionary spending. Consumer spending is one of the main drivers of economic growth while the discretionary sector alone accounted for nearly 10% of S&P operating earnings in 2018.

Next, we have growth in mining and logging employment where we are seeing the renaissance of the American energy industry taking place. With the US moving from being the world’s largest consumer to the largest producer of oil, the economic impact has been significant and underappreciated in terms of future CapEx spend and employment opportunities. Thanks to fracking, we have unleashed massive reserves of not just oil, but also natural gas. The US is now on its way to becoming a dominant player in the nascent liquified natural gas exporting business. In fact, the EIA estimates that LNG exports are expected to double by the end of 2019, a move that would make the US one of the world’s top exporters. In short, the liquification of natural gas allows significant amounts of energy to be shipped throughout the world. However, the process of converting gas to liquid and back again requires substantial investment in equipment and labor. Those investments are currently underway throughout Texas, Louisiana and Georgia. With China being the world’s second largest LNG importer, LNG investments are sure to be looked upon favorably by the Trump administration. Given all of this and that consumer discretionary and energy sectors make up 13% of 2019 S&P earnings estimates, it’s easy to see some appealing opportunities if one chooses to.

Moving on to the business activity that supports employment demand, we can look at the highly regarded ISM Report On Business that produces a monthly analysis of services and manufacturing activity. Given that the US is a services and consumption based economy, the ISM Services report is a great resource for gaining insight on industry factors like new orders, prices and employment. The February report came in with strong headline and internal components. In fact, the new orders component at 65.2 (readings > 50 = expansion; < 50 = contraction) was the 4th best print in series history while the overall business activity index had its 6th best print in history with a 64.7 reading.

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  ISM Services*  
Component Series Average 2019 Average
Business Activity 57.2 62.2
New Orders 56.6 61.5
*Source: ISM; Series starts in July 1997

On the manufacturing side of things, we see healthy expansionary business levels but not as elevated as the services data.

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This is understandable as the US economy has long since transitioned from its manufacturing / export base to a highly sustainable services / consumption model. However, since a revival of our manufacturing industries has been a focus point of the Trump administration, we have seen a clear uptick in manufacturing activity since the election.

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This pickup has been a welcomed additional tailwind for the economy, but it’s also not something that could really derail overall growth should it subside in the future. Since the top non-agricultural goods exports are in aircraft, industrial machinery, auto parts and high-tech goods where the US is often the only or best supplier, US companies are well positioned to survive economic slowdowns.

Using the ISM provided GDP equivalent, blended services and manufacturing data is showing a heady 3.5% growth rate thus far for Q1. With services and manufacturing data both well in expansionary territory, we see more evidence as to why recession talk is inappropriate and that the economic picture is rather eye-catching for those open to seeing it.

Now, as we head into the end of Q1 with solid economic fundamentals in place, we need to look at overall market valuation. The S&P is currently trading at 17x 2019 operating earnings and 18.6x trailing. 2018 saw earnings multiples contract with the Fed raising rates and market expectations for further tightening. As we have seen already, the Fed is most likely on hold for all of 2019 with maybe one rate hike if inflation were to move meaningfully higher. As I have stated in prior writings, thanks to significant advances in technology, we are enjoying a strong economic expansion with subdued inflation. With a dovish Fed in play for 2019, the dollar should come off its highs and simultaneously help the roughly 50% of S&P earnings generated from non-dollar sales and also give a bid to EM risk assets. With that said, 2019 should see multiple expansion along with earnings estimates being raised in the second half of the year. Even a 19x multiple on today’s estimates would add 10% to Friday’s S&P close. Given that the current expansion is coupled with benign inflation, low rates and the most pro-business administration arguably ever, there is clear justification for earnings growth and multiple expansion. Assuming that China trade issues slowly work out through the year, this market could really turn into something beautiful for the bulls in the end.

 

 

 

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG

The Bull’s Case for 2019

Is the bull back? Did he ever leave, or was he just ignored while investors focused on various sources of volatility such as trade wars, rising interest rates and Italian banks? Whatever the case, investors lost sight of all the positive market drivers that have been in place and still support the bull narrative headed into 2019. While prudence demands looking at all risks, it’s focusing on actual earnings and economic data which is the key to navigating stormy markets. Even though spiking Italian bond yields and the possibility of a Euro collapse can be distracting, the fact that the S&P is currently trading at 17.2x 2018 blended operating earnings and just 15.5x 2019 estimates is what should be investors’ focus looking into next year. Given that the Q3 earnings theme was about a strong dollar driven sales headwind being offset by robust business demand, we can see top and bottom line growth gearing up for solid gains as FX risk can be managed in the short term but also reverses itself over the long term. The important point here is that solid business demand is not just reflected in healthy earnings and guidance but also in business activity metrics. The highly regarded ISM Manufacturing and Services surveys have shown a strong expansion all year with October’s data no exception. In fact, ISM research shows that October manufacturing and services data translate to 4.5% and 4.1% respectively annualized GDP growth versus the 3.5% Q3 growth just reported. Then we have the NFIB Small Business Optimism Index which is right near its all-time highs. Small businesses have responded very well to tax reform and deregulation by increasing their hiring and CapEx spend. Even as the “late cycle” narrative has just morphed into an “end of cycle” story, business activity and guidance show that we are still in an expansionary period.

Forming a virtuous cycle with healthy business activity is the strong labor market we currently have. Driving today’s labor market are historically low unemployment claims, record high job openings and a quits rate showing strong employee leverage in attaining better opportunities. It’s all these attributes that support strong consumer confidence and continued consumption.

claims 11.7.18Weekly unemployment claims are a great metric for labor market health thanks to its near real-time frequency and hard data basis. Because claims are often a financial lifeline for cyclical workers and are filed as soon as a job ends, we can look to this series to see any softening of the labor market. Thus far, there are no signs of that. Furthermore, if we look at claims data in the context of job openings (JOLTS), we see that claims can still grind lower and break below the 200K level.

Jolts 11.7.18

The JOLTS data series, one of former Fed chairwoman Yellen’s favorite metrics, does a great job in capturing the liquidity of the labor market. Greater liquidity in this context is defined by the high level of openings and voluntary turnover (quits) we are seeing.

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Overall, the data is showing that the labor market can tighten further, wages can still rise, and the economic expansion can continue.

With a solid economic backdrop in place, we can now focus on the actionable part of the situation which is market valuation. While determining any valuation is arguably more art than it is science, investors can still use a historical multiples analysis to get an idea of fair valuation. So, the question becomes what is a comparable period to this market and why?

With technological advancements being the fundamental driver of this economic expansion, it’s easy to draw a comparison to the market / expansion of 1996 – 2000 when the internet came to life, with the major difference today being that companies are actually making money! That said, today’s advancements like fracking, open source software (OSS), smart phones, cloud computing and artificial intelligence have had an even greater impact on today’s economy than what drove the original tech bubble of 2000. Aside from actual earnings, the subtle and powerful differences that make the current expansion so much stronger, sustainable and yet misunderstood are the changes which technology has had on inflation and productivity.

While consumers have enjoyed lower energy prices thanks to fracking and the U.S. going from being the world’s largest consumer of oil to the largest producer, it’s been advancements in information technology that have had the most profound effects. Lower costs of various consumer goods and services thanks to advances in technology and manufacturing processes can be easily seen in retail sales data while the much more permeating effects of technology like OSS remain difficult to measure. OSS is software whose inner workings are made public and can be enhanced by the public with many applications being available for free. OSS is being used for the development of E-commerce platforms, big data projects and many other applications across multiple sectors.  Big data includes the development of artificial intelligence and something near and dear to the investing world, algorithmic trading. Investment banks have groups who use OSS applications like Python to develop trading and various analytical applications. Python, which is free to download and use, is one of the most powerful and easy to use programming languages in existence. Banks are essentially able to create incredibly complex trading algorithms and data management tools which can be used across multiple asset classes for trading and research at a minimal cost. Thus, in the case of investment banks and other corporate users developing applications with Python and other OSS, productivity has been dramatically enhanced at minimum cost. As per the BLS, productivity is measured as the units of output produced per units of input, with input defined as the cost of goods and services used in that input. Which begs the question, what happens to productivity when an input cost is zero? Is it undefined? Granted, there are always some costs associated with something like OSS, but the point here is that with the nearly unlimited potential and scalability of something like OSS, the productivity achieved today is exponentially greater than anything of the past and has been generated at a fraction of the cost. It’s because of technological advances like fracking and OSS that we have not had run-away inflation in many goods and services and why traditional productivity metrics have failed to capture the phenomenon of advancements like OSS. The net effect of these technological advances are structural changes to inflation and productivity which have caused a unique situation of having a strong and sustained economic expansion with subdued inflation and increased productivity. This occurrence has allowed the Fed to not have to act as aggressively as they previously would have at this point in the cycle. So, it really is different this time.

How we view the Fed and inflation are critical in determining whether there will be earnings multiple expansion or contraction going forward. Given that rising rates are an accepted reason for multiple contraction, that can certainly help explain the slight S&P multiple contraction so far this year while actual 2018 S&P operating earnings have risen 27% from 2017. Being that it’s correct to argue that higher rates can contract multiples through a greater discounting of future earnings, it also opens the door to looking at the overall rate sensitivity of equity which is known as equity duration.

Equity duration was presented in work from Leibowitz, Sorenson, et al back in the 1980’s as part of portfolio / risk management work and is still used today. That said, one principal of duration is that as more capital is returned to the investor, the less sensitive an investment will be to changes in interest rates. For example, bonds that have a higher coupon rate will have a lower duration while the opposite can be seen in zero coupon bonds which have significant sensitivity to rate changes. In equities, return of capital comes primarily through dividends and stock buybacks. As we all know, since the financial crisis, stock buybacks have become a staple of corporate actions. Since the crisis, Yardeni Research estimates that S&P 500 shares outstanding have fallen by roughly 8% since their highs in 2010 while the dollar amount of dividends has more than doubled for the same period! With the significant increase in buybacks and dividends, an argument can be made that equity duration has been lowered, thus making equity prices more resilient to a rise in rates. Looking at the rise in rates we’ve had and that we’ve only seen a slight contraction in multiples while equity prices have still managed to hit all-time highs, the idea of a lower duration market is supported.

All this said, what markets and investors are dealing with today is an unprecedented combination of economic growth and technological advances that have changed the traditional business cycle and its metrics. Even without technology, the transition of the economy from a manufacturing / export base to that of a services / consumption one has had the effect of lengthening business cycles as the economy has become more self-sustaining. Now that we have made such significant technological advances, the business cycle, interest rates and their long-term behaviors need to be reassessed.

Taking a potentially less aggressive Fed along with the current economic environment, markets are set up for earnings and multiple growth going forward. A less aggressive Fed will take strength out of the dollar and put developed and emerging markets at ease. We can already see a more dovish Fed taking shape in recent remarks from Fed Chair Powell. Powell has acknowledged the strength of the economy, its great potential and, more importantly, his desire to support the expansion. Investors should take solace in the fact that we have a Fed chief who is taking a very pragmatic approach to monetary policy and will not just dogmatically raise rates as the traditional Fed playbook would dictate. A dovish Fed and a lower duration equity market is a great setup for 2019.

With current S&P operating earnings estimates for 2019 and a 20x multiple which is still 3x less than the average 23x multiple enjoyed throughout 1996-2000, the S&P 500 would trade  at 3,515 or about a 30% gain from today. While this may seem overly bullish given all the “end of cycle” rhetoric going around, it’s not if investors simply listen to what the Fed chair has to say and what the actual data is showing.  Earnings multiple and economic expansion are on deck for 2019 and will get investors’ attention while the “end of cycle” narrative goes into the recycling.

 

At the time of this posting, the author has the following positions: None

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG

Shakedown City

As we head into what is typically the slowest part of the investment year, we have markets dealing with an unprecedented situation: the US – China trade war. While much of Wall Street is on vacation in August and trading volumes seem to dry up in the summer heat, markets and investors are now being held captive by escalating tariffs and rhetoric out of Washington and Beijing. Combining thin markets, lightning fast algo-driven trading and material information being released as quickly and randomly as a tweet can be tweeted, a perfect storm of market forces has been created. To weather this trade war storm and perhaps even use it to our advantage, one needs to understand how China’s trade policies developed and how they are managed. Fortunately, with just a brief history lesson and a look back at a surreal incident between a small American manufacturer and its Beijing hosts, we can get an excellent preview of how this trade war is likely to unfold.

The crux of the trade war is the US holding China accountable for its intellectual property theft and other aggressive business practices which are clearly considered standard operating procedures throughout public and private organizations in China. These operating procedures are part of a much larger protectionist dynamic of Chinese culture that stems from China having suffered through what is known as the “Century of Humiliation.” The Century refers to the years of 1839 to 1949 when the British and Japanese empires plundered China with Japan specifically carrying out numerous atrocities during World War II. Given these terrible occurrences and the deep social scars they left in Chinese society, it’s understandable why China has taken aggressive approaches to economic development as it re-established itself in the global economy. However, now that China sits atop the world economic order, these practices need to end because they are coming at the expense of its partners.

One area where China’s protectionist policies are well defined and stand out from global standards are in its labor laws. The OECD, a highly regarded and objective international organization, produces an indicator which reviews a country’s hiring / firing policies, their associated costs and then ranks them on a scale from 1 to 3.5, with 3.5 being the most restrictive. As you can see, China’s labor protection policies are essentially the strictest in the world because they are outdone only by Venezuela! To put this in perspective, France (a known labor-friendly country) is roughly twice as restrictive as the US while China is three times that of the US.

OECD Labor Protection

 

 

It’s these labor policies and the sense of entitlement they have created that gives us an excellent view into how an escalated trade war could play out. In 2013 an American business executive, Chip Starnes, was literally held hostage for six days by his employees over a labor dispute. Mr. Starnes company, Specialty Medical Supplies, was going through a restructuring and was going to terminate some positions and re-locate others. After severance packages were given to 30 (yes, just 30) terminated employees and others were told they would be relocated, the relocated employees began demanding severance pay as well. It was then that the issue escalated into Starnes being barricaded in company facilities by groups of employees who blocked all the exits. While no physical harm was done, although sleep deprivation tactics were used, Starnes was always allowed to communicate with his family, the US Embassy and his lawyers. Throughout the ordeal, and most troubling, is that local authorities sided with the employees and allowed the situation to continue until a new agreement was signed. As outrageous as this situation would be in any developed country, it’s a perfect example of how the “shakedown” mentality exists in China and is pervasive from high-level government trade policies all the way down through locally run businesses.

Thanks to Starnes shocking ordeal, it’s safe to assume that the civil unrest and reactions to a major corporate restructuring from the likes of Nike, Wal-Mart or GM, who employ 161K, 99K and 58K respectively in China, would be apoplectic compared to what happened with just the handful of employees in the Specialty Medical Supplies case. Then we have a more recent case of civil unrest from a trade war casualty, even though it was censored in Chinese media, but news still got through on Twitter, was when a temporary shutdown of ZTE (a known supplier of technology to China’s weapons industry, not just a telecom firm) idled 75K workers. Numerous tweets were seen that detailed workers’ feelings of frustration with the government’s inability to keep the business running. So, it’s not surprising that a deal with the Trump administration was quickly reached to get ZTE back open.

Along with IP theft being a known issue which Beijing doesn’t like to discuss, is also their fear of civil unrest. In a country of nearly 1.4 billion people who are being controlled by President Xi and his Politburo, civil unrest can’t be allowed to happen. China has made giant strides in its development over the last several decades which was made possible through authoritarian and effective leadership. However, this leadership is only possible through a satisfied and passive body of people who are willing to accept strict leadership in return for economic gains. Like the Kingdom of Saudi Arabia where the citizenry is appeased through massive social entitlements, China’s leadership needs to keep the masses happy, or they could lose their grip on power.

Looking at the potential massive civil unrest that could be unleashed from a full-scale trade war, it seems more likely that Beijing will do whatever is necessary to keep businesses open and jobs where they are. So, while there will be more rhetoric out of China as the Trump administration pushes for fair trade and fair business practices, an amicable solution is the most likely outcome. While some will argue that China can retaliate with similar actions that could cause unemployment here, the American economy with its services base and dynamic nature will be much better able to handle such retaliatory responses. There will be no hostage taking in America when corporate restructurings happen, and people will find a way to persevere as we always have.

With all this said, if we take the trade war narrative out of the equation and allow investors to focus on the excellent earnings season we’re having and the fact that the S&P is now trading at just 17.9x 2018 (versus 25x seen in the 1997-2000 bull market) blended operating earnings, we see that there are a lot of good things going for this market. Now, with a Fed saying that they are close to a neutral rate, long term rates settling in with structurally lower inflation dynamics (see third paragraph) and a healthy economic backdrop, we have a market primed for earnings growth and multiple expansion…In which case, the only things shaking will be the bears.

 

At the time of this posting, the author has the following positions: None

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG

 

 

Serving up the second half..

As financial media hits its audience with a constant one-two punch of theoretical recession indicators in the inverted yield curve and late cycle narratives, it becomes even more important to stay grounded in the tangible economic facts. This is not to say that a recession will never happen and that caution should be thrown to the wind, but that investors’ primary focus should be on the concrete data at hand. It becomes very easy to get wrapped up in financial media’s dooms-day scenarios instead of taking the time to analyze the data which is showing a strong probability of continued economic expansion.

Looking at the flattening yield curve and the prospects of the dreaded inverted yield curve as a recession indicator takes a belief in the ability of an asset class to be omniscient. Pundits will site numerous occasions when an inverted yield curve preceded a recession when it was really a coincident indicator, not a leading one. The fact is all asset classes take their cue from all available information and are managed by individuals seeking to maximize gains or minimize risks. That said, in the past it has been inflationary shocks, political upheaval and other macro-events that presupposed Fed actions. It was these actions combined with existing economic forces at work that may or may not have actually caused a recession.

As often is the case in economic analysis, the work becomes as much art as it is science. The science behind a flattening yield curve is current economic growth and inflation while the art is inflation expectations. Clearly, market participants are currently signaling subdued inflation and expectations. However, in the real world, inflation is alive and well in housing, healthcare, education and other costs, but when it comes to asset pricing, it’s dead. This “death” is most likely a function of various financial institutions’ demand for Treasuries and a structural price change across some goods and services. The Fed’s massive accumulation of treasuries through QE and the realized effect of lowering long-term rates has been compounded by demand for Treasuries from other institutions as well. Whether it’s regulatory-driven increased capital requirements or pensions and insurance companies just managing liabilities, the bid for Treasuries has been strong as evidenced in SIFMA data. So, while strong physical demand for Treasuries has helped keep rates down, there has also been a simultaneous suppression of inflation and its expectations through technological advances. Thanks to fracking (lower energy prices), hand-held computing, open source software and social media, there has been a suppression of prices across many goods and services. The fact that the world’s most powerful and easy to use programming language, Python, and its data analysis tools like pandas are free to use, shows that there is a highly pervasive price suppressing element making its way through the economy. In the past, broad price declines were often driven by reduced demand as opposed to the healthy reasons we have today. The point here is that the yield curve isn’t signaling anything other than the current situation, which is one that is beneficial to consumers, earnings and ultimately equities.

Then we have the late cycle narrative which has been pitched in financial media in earnest for the last three years. The late cycle narrative has its roots in historical NBER data which shows that recessions tend to occur about every six years. The problem here is that as the US economy has transitioned away from a manufacturing / export base to a services / consumption base, the cycle has extended since the economy has become more self-sustaining. If we regroup the existing NBER cycles for the change to a services economy, we can see the lengthening of cycles:

NBER 5.29.17

 

Since the preconceived notion of the six-year cycle is so embedded in investors’ thought processes, it has become a mental error or bias that causes people to stick with a concept even though new data has been presented which should cause a reassessment of the old concept. In behavioral finance, this is known as conservatism bias and can also cause investors to assign a higher probability to the unlikely event (recession) and a low probability to the likely event (continued expansion).

The best way to counter the imposition of inappropriate economic analysis is to look at the data and what it’s truly showing. Instead of worrying about the potential effects of theories, investors can focus on data like corporate earnings, business activity surveys and employment data which are all pointing towards a sustained expansion.

From what we have seen so far from some major names this earnings season is that business is strong, and the outlook is good. According to Factset, with 17% of the S&P 500 having reported, the blended revenue growth rate is the best since 2011 while earnings growth is the best since 2010. Given the trend of top and bottom line beats so far, the present blended rate should end up being below what is actually reported. A particular standout in earnings which ties in directly to the strength and sustainability of our services based economy is Cintas. Cintas supplies uniforms, cleaning services / supplies and safety products to industries such as hospitality, automotive, food services, healthcare and education. Cintas just reported a fantastic quarter last week which helped propel the stock to new all-time highs and is now up 30% YTD. The earnings out of Cintas are also a great company example of the strength of the services economy as represented in the ISM Non-manufacturing (services) index. The June reading for the composite index came in at a very healthy 59.1 with new orders at 63.2. An interesting fact about the new orders index, which doesn’t bode well for the late cycle theory, is that whenever the index touches 60, it takes an average of 34 months for the composite index to move into contraction (based on ISM data up till the financial crisis since the composite has been in expansion since 2009). Then we have employment data like weekly unemployment claims which have been the most consistent indicator of labor market strength throughout the expansion. Weekly claims have now drifted down to levels not seen since 1969, and they continue to grind lower. When we look at claims data in the context of job openings (JOLTS), we can see there is potential for them to move even lower.

Jolts 7.20.18

 

So, with a solid understanding of how things stand and why the inverted yield curve and late cycle narratives are more noise than substance, we can look at where markets are headed. The S&P 500 is currently trading at 17.2x 2018 blended forward operating earnings and 21.1x TTM. We ended 2017 at 18.4x forward and 22.7x TTM so the market has gotten less expensive. Comparing today’s valuation to previous bull market expansions like what we had during 1997-2000 when realized multiples averaged 24.9x, we can see that there is justification for multiple expansion. However, it would be irresponsible to just assume that multiples must expand and that the compression we have seen so far this year isn’t going to continue. Given the pro-business policy stance of the Trump administration, a pragmatic Fed and assuming a benevolent outcome to trade issues, it seems more likely than not that multiples will experience some expansion. Even if multiples stay flat from here and using current earnings estimates, the S&P would trade up to 3,318 or a 24% gain on the year. That would certainly serve up some smiles for investors who stuck with the data and not the noise.

 

At the time of this posting, the author has the following positions: None

Marco Mazzoco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG