Rising 10-Year Yield Puts Investors On Pause Despite Robust

Rather than living up to its history as one of the best months for stocks, April proved to be a disappointment this year despite robust year-over-year Q1 corporate earnings growth of roughly +20%. But there were some interesting developments nonetheless. In spite of investors’ apparent desire to start rotating away from the mega-cap Tech leaders and the Momentum factor into the neglected market opportunities, it is clear that some of the FAANG juggernauts still matter…and wield plenty of clouts. Witness the market’s reaction to Facebook (FB ), Amazon.com (AMZN ), and Apple (AAPL) earnings announcements as each dazzled beyond expectation. Nevertheless, I think the fledgling trend away from a narrow list of market leaders and into a broader group of high-growth market segments with more compelling forward valuations will soon resume. Likewise, while I still think full-year 2018 ultimately will see a double-digit total return on the market-cap-weighted S&P 500, with the index closing the year north of 3,000 on the back of historic earnings growth (even with some P/E compression), I also think a well-selected portfolio of attractive “growth at a reasonable price” (GARP) stocks has the potential to perform even better.

This is what we at Sabrient seek to do with our proprietary GARP model, including our monthly all-cap Baker’s Dozen portfolios as well as portfolios for small-cap growth, dividend income, defensive equity, and stocks that tend to thrive in a rising interest-rate environment. Another way to find clues about near-term opportunities in the market is to track the buying behavior of corporate insiders and the sell-side analysts who follow the companies closely, and for that, we employ our proprietary “insider sentiment” model. Also, I still like small caps to outperform this year, and indeed smalls have outperformed large caps over the first four months, with Energy, Healthcare, and Financial sectors showing the greatest relative outperformance among small caps.

As for the current market climate, after the big January market run-up had run its course following passage of the tax bill, investors have spent the ensuing few months struggling to assess the “new reality” of higher volatility, gradually rising rates, political posturing around global trade, and a rotation from the long-standing mega-cap Tech market leaders. Would asset classes indeed return to “normalcy,” in which equities rise comfortably along with interest rates, like they used to do back before central banks began “easy money” policies that jacked up indebtedness and asset correlations across the board? What is the new relationship between stocks and bonds (and interest rates)? Will there be a “Great Rotation” out of bonds and into stocks? A rotation out of bonds would drive up yields, and a rising risk-free rate for a hugely indebted world is a scary prospect for equities on a discounted cash flow basis. So, as the 10-year yield has hit the 3.0% level and mortgage rates have reached the highest levels since summer 2013, equity investors have hit the pause button. But I continue to contend that there is plenty of demand for both debt and equity securities such that Treasury Bonds will catch a bid at current levels, slowing the ascent of longer-term rates, while equities rise in line with robust corporate earnings growth, albeit with some compression in P/E multiples versus last year.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model remains in a neutral posture during this period of consolidation and testing of support levels. Read on…

Market Commentary:

The period from 2009 through most of 2016 was characterized by a sole reliance on monetary stimulus (ZIRP and QE), which in my view used asset inflation to underpin the economy but failed to stimulate wage/price inflation or anything more than lethargic economic growth. Moreover, this broad asset inflation was also largely characterized by asset correlation in which both stocks and bonds appreciated as the “easy money” flowed into both (except during 2013). However, under “normal” economic conditions, interest rates are pushed up (and bond prices fall) during periods of economic strength as the Fed seeks to control inflation and prevent the economy from overheating, while equity prices rise. But investors today seem to fear that our heavily-indebted US and foreign economies aren’t prepared for such normalcy under the assumption that the resulting rise in interest expense (government, individual, and corporate) will overwhelm all else before wage and personal income growth even have a chance to get off the mat.

Even as some of the bigger worries regarding North Korea and trade wars have subsided, investors have remained defensive. And that behavior in and of itself has some analysts worried. For example, JP Morgan has just published an investor guide for getting defensive, as it thinks the market’s tepid response to robust earnings is foreshadowing problems ahead. The bank believes the economic growth cycle may end in 2019 while real rates collapse, so it says investors should underweight equities and increase their holdings of gold and long duration bonds.

But in my view, despite some investor trepidation, conditions could hardly be better for equities. As I have often stated, I still expect to see higher stock prices for the next few years (albeit with some P/E compression or “normalization”) as a stronger “boom cycle” kicks in – rather than the slow, plodding economic uptrend (supported only by monetary policy-induced asset inflation). Because we haven’t seen the usual “boom” part of the boom & bust cycle, it is likely to me that the “bust” stage has been postponed, as the expected “busts” manifested in a corporate profit recession and a lengthy capex recession, stagnant wages, and falling labor participation, which were masked by the Fed-driven asset inflation.

S&P 500 companies have been delivering earnings above estimates at a record pace, with nearly 80% of companies topping consensus estimates (the highest percentage since 1999). Year-over-year, Q1 EPS is up around +20%, spurred by things like 7% sales growth, corporate tax cuts, deregulation, elevated operating leverage, a relatively weak dollar, and higher oil prices. Energy stocks, in particular, are providing an outsized contribution to EPS growth as sustained production curbs from OPEC and Russia, strong global demand (especially in Asia), geopolitical developments in producing nations like Venezuela, Libya, and Iran, are all supporting crude prices, despite a surge in US oil production, which is now at all-time highs with infrastructure running at max capacity.