A time for caution and enthusiasm

**first published on Real Money 7.25.16**

The S&P 500 closed Friday at 2175.03, a new, all-time high close. Even though it was a low-volume summer day, there is still much to learn from it — and all of last week’s market action.

With a market that keeps pushing to new highs without a decent pullback, there is as much cause for concern as there is for enthusiasm. As bullish as I am about the market — and the U.S. economy in general — I would be remiss in my duties as an analyst to not sound a note of caution here. As the saying goes, no one ever went broke taking profits.

With that said, I still believe that markets will trade higher from here, but there will be a period of consolidation. This consolidation will be a healthy respite that allows the major indices to form a technical base for the next move higher. The market has had a great run since the February lows, and the pieces are in place for another run higher, but it won’t be a straight line up.

Last week’s market action was encouraging — in part because we finished at an all-time high, but more because of how equities reacted to external factors. Even with the macro uncertainties of the Turkey coup and a near 5% drop in oil for the week, equities managed to trade off of the positive earnings and economic news we received in the U.S.

So far this earnings season, we have had great reports from significant names across a wide range of industries. One company that reported excellent earnings last week, which did not receive enough attention was Cintas Corporation (CTAS) . Cintas is a service provider to the services and manufacturing industries. Its primary business unit provides uniform rentals and facilities services to automotive, health care, education, food services and gaming businesses, amongst others. Facility services include the cleaning and upkeep of properties, air ventilation maintenance and providing towels and safety mats for shops and restaurants.

Cintas just reported fourth-quarter earnings, which completed a record year in terms of revenue and earnings per share and also raised its guidance for next year. Fiscal 2016 sales were up 9.6% from 2015 while net income was up 15.1%. With 2017 revenue expected to grow at least 5% and a current market cap of $11.2 billion, we are looking at a large-cap name with solid growth prospects. The key takeaway from Cintas’ strong performance is that it is a direct reflection of the health of the U.S. business environment.

On the economics front last week, we had the most-comprehensive housing market data point there is: existing home sales (EHS). As the National Association of Realtors note, EHS account for roughly 90% of total home sales, and are currently on their best annual pace since February 2007.

This is significant, because of the drastic difference in lending standards between pre- and post-housing-crisis lending. Before the housing crisis, lending standards were very lax and sometimes almost nonexistent for some borrowers. These irresponsible lending standards led to a sharp increase in home sales — and ultimately the collapse of the housing market.

Today’s lending standards are very stringent, which makes the high level of home sales that much more impressive. Now we actually have a housing market that is based on qualified borrowers, and is thus sustainable. Our housing market is running on both a high quality and quantity of transactions. Strong EHS data is also another reflection of the health of the U.S. economy — and further justification for this bull market to keep going.

Now we head into one of the most important weeks for earnings data. We are getting reports from tech and retail heavyweights like Apple (AAPL) , Facebook (FB) , Alphabet(GOOGL) and Amazon (AMZN) , among a whole slew of industrial and health care names.

For Apple, market consensus seems to be expecting bad news stemming from slowing device sales. We could certainly see that, but I’m expecting to see a pickup in their services-based revenue, which help makeup the “Apple ecosystem,” to offset that decline. In general, the market is pretty much priced for perfection, so any slight miss from some big names will probably give us the consolidation period we are looking for. There is also plenty of economic data to look forward to this week, with the FOMC meeting, ending on Wednesday, getting the most attention.

While a rate hike is warranted when looking at how the economy stands, it’s a rather unlikely possibility. With that said, let’s see what Mr. Market brings us this week.

Consumers at it again..

“Man is a perpetually wanting animal” is a quote from the seminal work A Theory of Human Motivation by the famous behavioral psychologist A.H. Maslow in which he succinctly captures and predicts consumer behavior. It is this perpetual wanting which also defies many economists’ fears of a deflationary scenario where consumers hold off purchases in hopes of lower prices. The fact is, if people have the ability to consume, we will. This allows us to see consumption as mostly a function of ability (employment) because the motivation to consume is already there. Using Friday’s healthy retail sales print as a starting point, we can see that consumption has increased as the economy and labor market have strengthened even as some goods prices have declined. For example, in the last cycle, real retail sales grew 9.8% from trough to peak. Whereas in the current cycle, real retail sales are up 20.5% and still climbing from the trough. Factoring in the significant price declines in commodity prices and some consumer items like electronic goods, the large rise in sales shows that overall consumption is meaningfully higher.

biz cycle 7.17.16

Even using an apple to apple comparison and keeping the cycles at the same length or using the same 2001 trough would yield a 17-19% gain for the current cycle. So you can see how robust this cycle really is. Supporting this increase in consumption has been a tighter labor market as evidenced by declining weekly claims data throughout both periods. Claims are currently sitting at an all-time low when you factor in the growth of the labor force.

claims 7.17.16

Looking at the above claims chart, it’s very difficult to say that we are in recession or even nearing one as many in financial media seem to think we are. We would need to see claims levels rise nearly 60% to the 400,000 area for the recession alarms to go off. The good news is that we can watch this on a weekly basis and adjust our thinking accordingly.

The true driving force behind employment and thus consumption is obviously business activity. For a services based economy like the U.S., the Ism® Non-Manufacturing Survey (NMI) is the best gauge we have. The most recent report for June came in at a solid 56.5 up 3.6 points from its last reading. Within the NMI, the business activity index was up to a high 59.5 while the new orders component was even better at 59.9. These are both very healthy levels and should help to bring up the employment index going forward as well.

ism 7.17.16

Looking at the NMI in context of claims and retail sales data, it’s safe to say that we have an economy that is steadily moving along. Adding in the better-than-expected results for Industrial Production and Capacity Utilization which we got last week, we can see the previously lagging manufacturing sector starting to catch up. While manufacturing represents a small part of the economy, it will still be welcomed assistance for the consumer and services sectors.

As we head into the week, we have a lot of earnings reports and economic data points to look forward to. Monday morning, we have Bank of America and IBM reporting earnings. Both have had their woes but also may have turned a corner. So far JP Morgan and Citigroup have posted strong quarters so BAC shouldn’t be too far behind. There will be plenty more technology, industrial and consumer names reporting to fill out the rest of the week. On the economic front, we have several housing market data points and some manufacturing data as well. Unfortunately, we have a new macro situation in the form of the Turkey coup which will add extra volatility in the days to come. However, as of this writing Sunday night, the futures have just opened and the S&P’s are up 6 points from the close, which pretty much says the real turkeys are the folks that were selling everything at 4:45pm on Friday when the Turkey news broke. Well, let’s see what this week brings!

Live and learn

“Live and learn” is one of those succinct yet incredibly meaningful sayings that we often hear but don’t pay enough attention to. This past week in markets was certainly one of those times that we all could learn a lot from. In fact, if last Friday after the Brexit referendum vote, someone had told me that the S&P 500 would close over 2100 the following Friday, I would have questioned their sanity in a rather colorful way. As it turns out, it’s my sanity that should have been in question as the S&P went on a strong rally starting Tuesday all the way to the close on Friday to finish at 2102. While we didn’t have any official Brexit news from the EU or the U.K. to justify the rally, we did get a vote of confidence of sorts from the FX and equity markets. The GBP was able to regain its footing and stay flat against the dollar while the Euro managed to gain a little ground. This stability seemed to come from investors taking a more sanguine look at potential Brexit outcomes and their implications. This improved view allowed equities to rally across Europe and in the U.S. with some markets posting their best weekly gains in years. I would attribute some of this improved outlook to the points I touched on in last week’s writing and what other Wall Street analysts pointed out this week about the trade relationships between the U.K. and the rest of the EU (mainly Germany). These relationships are so significant that it behooves all parties to come to a cordial agreement. In terms of the actual Brexit campaign, there have been some changes as well. Since the referendum vote, the remain and pro-EU voices across the U.K. and Europe have become more vocal and made their presence more known. Attesting to this was a march in London this weekend which garnered lots of media attention in support of staying in the EU. If nothing else, the referendum has certainly sent a clear message to EU leadership that changes must be made to strengthen the union for the long term. While Brexit may eventually happen, I have a feeling that it will be a watered down version that allows all sides to save face and will end up being a positive for markets in general.

With the obligatory Brexit analysis out of the way, we can take a look at some good and rather interesting data we got about the U.S. economy this week and the big week coming up. As much in the rear view mirror as it is, the first quarter GDP final revision we got on Tuesday deserves a mention. Q1 GDP was revised up to a final 1.1% from its originally reported .5% on primarily stronger exports. This is significant because improving exports, which were nearly flat in 2015, would be a great addition to our current GDP that is being driven almost entirely by consumption. Building on Q1 GDP data is the export component of the national Manufacturing ISM® Report On Business® which ticked up a point to a healthy 53.5 as well as being its fourth month in a row of expansion. As it stands now, the overall ISM index which came in at 53.2, its highest since February 2015, would equate to a 3.2% GDP if annualized. Within the ISM index, all the components were in expansionary territory except for inventories which did still rise for the month but remained in contraction. Also of note in the report were the gains in new orders to a very healthy level of 57 and employment which pushed back into expansionary territory to 50.4. That said, I would not try and extrapolate gains in ISM employment to gains in the upcoming nonfarm payroll (NFP) report. We’ve seen enough NFP reports to have learned that it marches to its own drummer. The fact still remains that the U.S. is a services based economy, but the growth in exports are a welcome tailwind for the economy. Should export growth persist, this will certainly add to the top line of S&P industrials / exporters and result in significant earnings growth and greater shareholder wealth thanks to all the stock buybacks done over the last couple years. I think the CFO’s who implemented all these buybacks will be the last ones laughing after having been ridiculed for “manufacturing” earnings throughout this cycle.

Along with the solid ISM report came the Chicago PMI, which is a 60/40 services to manufacturing weighted index, at 56.8 from its previous contractionary level of 49.3. Even though the report is regional, it still gives good insight into a major business hub of the Midwest. The report showed strong growth in new orders and order backlogs with employment being the only component in contraction. Taking the June PMI report in context with the previous couple months of less robust reports, this could be a case of payback along with some outright improvement. We’ll have to wait till next month for confirmation. Still, when looking at this and the ISM report, the economy is in good shape as we head into the second half of the year. It’s important to keep in mind that we are well into this expansionary cycle and that steady levels of activity and employment are what we are looking for.

Heading into next week, we have two significant data points. First up is the services version of the ISM manufacturing report, the Non-Manufacturing ISM® Report On Business® or NMI. The NMI is the best gauge of the services sector available and warrants close attention. Last month’s report came in at 52.9, down from 55.7 which was a bit worrisome. Given what we have seen on the manufacturing side of things and the persistently low unemployment claims data, I am expecting a bounce back in the report. Next up, on Friday we have the almighty nonfarm payroll report. This report has truly become an enigma as of late with its completely unpredictable results. However, as statistically flawed the report may be, it still holds sway over the markets and the Fed. Personally, I’ll be more interested to see what the weekly unemployment claims data have to show on Thursday. So, having lived through and learned from the markets’ behavior last week, we are well prepared to deal with upcoming volatility. The fact is the game hasn’t changed, but it’s our mindset that does need to change. Therefore, stay focused on the actual data and try not to fall into the hysteria that financial media is so good at creating. Otherwise, we haven’t learned a thing.