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Back on the Expansion Road

It has taken the US market two months to recover from the deceptive path laid out by Janet Yellen and the Federal Reserve at their September meeting.  At that time, they stood at the intersection of Expansion and Contraction streets and nearly blocked the expansion path directing all traffic down the contraction path.  Everyone knows, you should not fight the Fed right?  Well after 60 days of strong earnings and very clear expansionary economic reports as well as 9% rally in global markets, it seems their directions weren’t great and we’re now breaking down their verbal blockade.  This Fed is the most gutless I have encountered in my career and I have no confidence that they will make tough choices or the right choices when they need to.  We’re on our own now and we plan to ignore the Fed almost completely in the months ahead choosing to believe the evidence that stands tall.

 

Quality of This Rally

 

It’s been a little while since I sent an update so let’s get caught up.  The quality of this rally has been good on all fronts.  Breadth, volume, upside thrust, % of stocks above 50 day moving averages, and leadership all suggest this rally is more than just a snap back bear market move.  Even small caps have joined the party.  Now, no market is without some risk and I still see some concerning trends in the tell tale High Yield corporate bond sector which tripped back to a sell signal last Friday.  I also see a disturbing concentration of buying enthusiasm in the likes of Amazon, Netflix, Facebook, Google and Apple.  So while I see expanding breadth and participation, the price action in the S&P 500 is acting much stronger than the markets as a whole on the back of a few mega caps stocks.    Bespoke had a lot to say about this in their weekend report where they showed that the top 50 largest stocks in the S&P 500 are up +8.5%, while the bottom smallest 50 stocks are still down -14.1% YTD.  That is an enormous difference by historical standards and its sort of a mathematical miracle that the index itself is positive at all.  Nevertheless, the majority of evidence still points to the fact that the rally off the lows on September 28th has been more than just a bear market bounce. 

 

Now that the benchmark indices have rebounded all the way back to the very highs of the year (or within 2%), we should expect some new downside volatility.  I’m a bit late in saying this as the Dow is down 200 points as I write and slipping negative again YTD.  This is the place where the bears will try to push the market lower and take short positions.  It is the place where some (including ourselves) will sell weaker positions and use the pullback to fine tune portfolios toward new or persistent leadership.  On Friday, we sold our consumer staples funds, real estate funds and our most liquid High Yield corporate bonds.  New buys to replace those positions are ready to go.

 

Renewal of the US Dollar Uptrend

 

The US economy is doing just fine and the employment report on Friday was a BIG thing.  No only did the non-Farm payroll numbers blow out expectations (to the upside), but we are now seeing real and robust wage inflation.  We have been expecting this and now its hear.  At full employment, the only dial that can really budge is wage growth, which for every one, should be a wake up call that real inflation is coming perhaps for the first time in nearly a decade.  Bonds responded as they should and tanked.  The US dollar responded as it should and rocketed higher by 2%.  I won’t comment on what the Fed may or may not do.  This environment is the very track we were on until May of this year when weakness in China and weakness in the minds of our Federal reserve, worked to convince us that the global expansion was done.  Not so.  The expansion track is well worn from mid 2012 and still in place, but this time we have a few developing side paths.

 

Sector Strength and Weakness

 

One sector that needs specific attention is some developing weakness in the consumer discretionary stocks.  Again, Amazon, Apple, Netflix and their friends are members of the consumer discretionary sector, which seems to float higher every day.  But underneath these big names, there is plenty of carnage.  For instance,  Walmart is down 33% from the highs this year, almost the same number YTD.  Here it’s not a story of big versus small but of an entire sector that is under heavy selling pressure, EXCEPT for a few names.  We are sellers of the entire consumer sector from this point forward.  I was also surprised to learn that the consumer discretionary sector typically peaks on Thanksgiving Day.  So while we’re all at the malls snapping up discounts on Black Friday, you should be quietly dumping your consumer discretionary stocks.

 

On the flip side, we have financials and banks that are experiencing the opposite affect. This sector is springing higher under the hood with small cap names leading the charge and yet the sector as a whole hasn’t yet inspired us on the surface.  We are buyers of the financial and banking sectors from here on out using pullbacks to find entry points.

 

Energy is also carving out a new path in the expansion theme as most energy stocks clearly bottomed in September and are now in new bull market as defined by a 20% rise in prices.  We added several energy names to our portfolios in the month of October (2nd, 5th, 13th and the 28th).  Meanwhile the price of crude and other fossil fuels (nat gas, coal, etc), continues to lag and drag on the back of still strong oversupply issues.  Why are energy stock prices rising when the raw commodities are stuck?  Here in lies the leading and lagging nature of markets and economy.  We don’t know why!  And we won’t know why but we can assume that prices of energy stocks have already factored in the supply side concerns and are looking across to tighter supplies and rising demand.  Energy can do well from this extreme oversold condition as the average bull market run for the sector is historically 65%, meaning we are potentially only 1/3 of the way there. 

Industrials and Materials sectors are also participating now as well offering stock pickers some nice options with very low valuations, very high free cash flow and high dividends.  We have also take positions here but with small allocations and specifically to domestic producers and manufacturers.   

 

Things that look ugly to us are those that are recession trades, fear trades or sectors that expand only during periods of very low or falling interest rates.  Here we have real estate and REITS (We sold them on Friday).  We have utilities, healthcare, and consumer staples (also sold on Friday).  We also have Gold and Silver, which I suggested, would be a trade at best.  Gold should probably be sold as the US dollar uptrend seems to be reaffirmed. 

 

With the rising US dollar, we also need to be very careful and non-committal to international holdings or companies that derive a lot of their revenue overseas.    Remember currency issues are a big driver of profits and returns.   In the next earnings cycle, you can bet big multinational companies are going to point to strength in the US dollar as a cause for weak earnings.   Domestic small caps should likewise surprise us to the upside in the first quarter of 2016. Of course, one can also just buy the rising US dollar as an investment, which we have also done in our “alternatives” basket of holdings.   We do still like China despite their very rough six month performance.   We believe China is in a secular bull market and increasing their share of global GDP every year.  It is our view that their stock market simply got ahead of the economy and has since reverted back to a more sustainable level.  The 30% plus pullback provided us with an entry point for Asia and we continue to hold those securities despite the move in the US dollar.  In this case, we will give it the benefit of the doubt. 

 

So there is a lot going on with as many new opportunities as there are places to lose money.  All ships are not rising with the tide and this clearly takes more work and persistence to keep your money invested in the right places.  Frankly we don’t have much to show for the effort (yet) in terms of positive gains for the year but neither do we have any major disasters in any strategies.  Given the minefield facing investors this year, I’m grateful for that.

 

Stay tuned; the markets are going to be a bit bumpy in here.

 

Have a great week

 

Sam Jones