How High Is Up? June 5, 2017 Gregory M. Drahuschak

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1 How High Is Up? June 5, 2017 Gregory M. Drahuschak All-time highs for the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite index highlighted May trading, but achieving these new heights required overcoming a mid-month slide induced by political disarray in Washington D.C. that threated to delay healthcare and tax reform. The market s recovery was aided significantly by the highest year-over-year earnings growth for the S&P 500 since the third quarter of With earnings season largely complete, the S&P 500 was on track to produce 14.0% year-over-year earnings growth. After the very strong first quarter results, however, it continued to be surprising that that the full-year consensus estimate for the S&P 500 was no higher than it was 22 weeks ago. The equity market also was supported by most measures of U.S. economic activity that remained solid. For example, the May Consumer Confidence Index slipped modestly from April, but the Index remained near a 17-year high. The small cap Russell 2000 index did not share the latemonth enthusiasm as the Russell ended May with its worst monthly result this year, down 2.16%. The underperformance of the Russell was particularly unusual considering that the Semiconductor Index posted its best monthly result this year (up 8.54%) and dramatically eclipsed gains for the Dow (up 0.33%), S&P 500 (up 1.16%) and the Nasdaq Composite (up 2.50%). 1

2 Entering May, the equity market perennially faces the press onslaught of the old cliché, sell in May and go away. More often than not, however, during the spring-summer months, June is more problematic. June is second to September in terms of the lowest percentage of times the S&P 500 ends the month with a gain. June also is one of the three months of the year that on average has produced a loss in the S&P 500. Seasonal biases are interesting, but in recent years their influence has had far less relevance than had been true for many decades. The equity market s fate this month hinges on several factors. Attempting to handicap how the numerous politically charged White House initiatives will go is a foolhardy exercise. However, we see nothing in pending economic data that should rile the market. The possibility that the Federal Reserve Open Market Committee could raise the Fed fund target range at the June meeting already is widely accepted and as such should have no major equity market influence. Rising interest rates in fact could help to reverse the 1.41% slide in the financial sector last month. We, however, would be sensitive to any language in the policy statement that alludes to the consequences of still lackluster wage growth and its implications. Various internal factors are somewhat concerning. While new highs were being set in various market indices, the Russell 2000 vastly underperformed last month and is barely up for the year. Beneficiaries of movement in Semiconductor Index as well as the tech sector have enjoyed significant outperformance, but we are concerned that valuations have become stretched to worrisome levels. 2

3 The Dow Jones Transportation Average year-to-date result likewise is well below performance of the Industrial Average, S&P 500 and Nasdaq. A market destined for higher levels typically would not have the performance disparity present at the end of May. Concentration is another concern. Within the S&P 500, twelve stocks accounted for more than 50% of the index s gain this is year. In the Dow Jones Industrial Average five issues - Apple (AAPL), Boeing (BA), McDonald's (MCD), 3M (MMM) and Home Depot (HD) - accounted for 77.57% of the Average s entire 2017 point gain. Surprisingly good corporate results along with still solid economic data have allowed the market to work higher, but at the same time a major component of the market s advance has been the hope that tax reform and repatriation of foreign held profits would be achieved this year. Accomplishing both of this initiatives could provide the basis for another upswing in stock prices, but, the fate of both initiatives is uncertain. The relevance of a reduction in the corporate tax rate is dramatically underscored when you consider that it potentially could add $10 to total S&P 500 earnings, which if capitalized at the present price-earnings ratio could add 180 points (7.5%) to the S&P 500. At the current level, the equity market needs a catalyst to justify making major new equity commitments, but we do not see the market as vulnerable to a significant pullback. ****************************** This week has a substantially diminished earnings and economic report calendar. However, the following week s meeting of the Federal Reserve Open Market Committee is likely to be on traders minds all week. Following last week s major shortfall in new jobs as reported Friday morning, among the economic reports, the Job Openings and Labor Turnover Survey (JOLTS) report will get attention. The ISM Services Index reported this morning at 56.9 was 0.6 below the month before, but still solidly in an expansion mode. The New Orders Index at 57.7 was 5.5 percentage points lower than the reading of 63.2 percent in April, but the Employment Index increased 6.4 percentage points to The slide in the price of crude oil will focus attention on the energy inventory data from the Department of Energy and the American Petroleum Institute. The drop in bond yields lately has helped to propel prices of all types of bonds higher. The search for yield probably has provided an additional boost to high yield paper, which is beginning to be a concern. A Bloomberg article last week highlighted the potential risk in high yield paper, but prices continued to move higher. The risk, however, is liquidity. We would suggest keeping a close eye on high yield paper price as well as the Exchange Traded Funds that own lower rated paper. The drop in bond yields is odd in the face of the prospects that the June FOMC meeting is likely to produce an increase in the Fed fund target range. This movement has given rise to whether the bond market is foretelling a weaker economy than the equity market is expecting. We see no solid indications that major economic measures are rolling over. Some of these economic yardsticks have not shown major improvement lately, but most measures show that the U.S. economy continues to expand. 3

4 At least partly, improvement in Europe is helping the U.S economy. It also is worth noting that European markets look cheap relative to the U.S. market as economic data coming out of the region remain strong. The euro area labor market is improving and various PMIs are surging, which is an indication of a strong manufacturing sector. The German Ifo, which measures the business climate and outlook, rose to the highest level recorded since its inception in European companies are reporting strong earnings as well, with 54% of companies in the region reporting positive earnings surprises, which is the highest level since This suggests that some exposure to European equity markets continues to be advisable. The latest terrorist attack in London, however, did pressure European markets early today. Investors look at the U.S equity market with some amazement as it seems to be willing to cast aside almost any news that might suggest caution. In a sense, stocks are commodities. Their value is based on supply and demand. Finding what creates these two key elements is essentially, but whatever the cause, if there are more buyers than sellers, stocks go higher. The post-recession QE programs and other factors generated enormous amounts of cash, much of which became available for investment. Over the years the number of stocks has declined. This shrinking supply has a larger pool of cash to buy what is left. With competing vehicles not offering good alternatives, the demand for stocks exceeds supply, even if the underlying economic data do not support higher levels. Effectively the lack of alternatives leaves money managers with little choice but to buy stocks. While this is not the soundest reason to justify higher equity prices, it does partly explain why stocks could move higher even if economic and earnings numbers temporarily are not robust. The stock market s technical posture is mixed. As the chart on the left (courtesy of Stockcharts.com) illustrates, the S&P 500 surpassed a level of resistance (the blue horizontal line), which allowed it to move higher. However, the move last week pushed the index to a short-term overbought condition. We continue to suggest maintaining a sector allocation positively biased toward financials, health care and energy but a less than benchmark position in telecom, utilities and materials. In addition to the normal economic issues that could sway trading this week, former FBI Director James Comey s testimony to a Senate committee on Thursday could have political consequences, which in turn might impact the administration s ability to move its economic agenda forward. Also, be aware of the British election on Thursday that could influence trading in European as well as domestic markets. By the end of last week, 99% of the companies in the S&P 500 had reported first quarter earnings. Of these firms, 75% of these firms beat the mean earnings estimate and 64% beat the sales estimate. This placed the blended earnings growth rate for the S&P 500 at 14.0% for the quarter, which is the highest year-over-year earnings growth rate since the third quarter of However, despite these solid first quarter earnings results, the full-year estimate of S&P 500 earnings has not shown significant improvement from the recent low. Have a great week. 4

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