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The FOMC Expects a Rate Hike “Fairly Soon” – Here’s What We Think That Means. February 27, 2017.

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This is an excerpt from today’s Sevens Report. You can get a free 2-week trial and see for yourself how the Sevens Report can give you fresh talking points for your client conversations, and help you outperform your peers. Read on to see our predictions for when the FOMC will announce the next rate hike.

There were only two notable economic events last week and neither were particularly positive for stocks (although they weren’t outright negatives). For weeks, the economic data has been supporting markets through consistent policy disappointment from Washington, so it’s notable that last week the data wasn’t particularly supportive, and incremental disappointment finally weighed slightly on stocks. Going forward, with policy outlook continuing to dim, data will need to be consistently good to further support this rally.

Last Week

Looking at last week’s data, the February flash PMIs (both manufacturing and service sector) were surprisingly disappointing. The flash manufacturing PMI declined to 54.3 vs. (E) 55.5, which was a surprise miss given the very strong Empire and Philly surveys from two weeks ago. The flash services PMI also missed estimates at 53.9 vs. (E) 55.9, again posting a surprise decline. Additionally, most of the details in these reports, including New Orders in the manufacturing PMI (which is a leading indicator), also fell. Meanwhile, the manufacturing input price index rose slightly while the selling price index declined slightly, implying margin compression in the manufacturing sector.

Now, to be fair, the absolute levels of these two PMIs remain high and by no means does the mild pullback imply a loss of economic momentum. However, the market needs consistently better data to offset the noise from Washington, and that didn’t happen last week.

The FOMC expects another rate hike "fairly soon," but it is unlikely to be in March 2017.

The FOMC expects another rate hike “fairly soon,” but it is unlikely to be next month.

The FOMC minutes were the other notable economic event last week, and while the minutes were taken as slightly dovish by the currency and bond markets, in reality they only confirmed that May is now (in our opinion) the next likely date for a rate hike.

The key phrase in the minutes was the FOMC expected another rate hike “fairly soon.” The reason that was taken as slightly dovish is because fairly soon isn’t the “next meeting” (that’s what has appeared in the FOMC minutes before the previous two rate hikes). The takeaway is that a March hike is unlikely, though that’s not incrementally dovish because the market wasn’t expecting a March rate hike anyway. If we get a strong inflation number this week and a strong jobs report Friday, odds of a March rate hike could creep closer to 50% from the current 22% (and that could be a headwind on stocks).

This Week

This will be a busy and important week for the economy as we get some critical data on growth and inflation, and if stocks can maintain this rally, the former needs to be strong and the latter doesn’t. The most important number this week is the PCE Price Index contained in Wednesday’s Personal Income and Outlays report. February CPI and PPI were both much stronger than expected, and if the Core PCE Price Index (which is the Fed’s preferred measure of inflation) moves close to 2% (currently at 1.6%) then we will see expectations for a March rate hike increase, and that will send Treasury yields higher and send the dollar higher—and that will put a headwind on stocks.

The next most important number this week is the ISM Manufacturing PMI, out Wednesday. Normally, this would be the most important number of the week, but even if this confirms last week’s flash PMI and pulls back a bit from January, it’s still a very high absolute level and it will take several months of declines before anyone would get worried about activity in the manufacturing sector. Nonetheless, it is still a critical number and if it’s soft we could see a bit of stock weakness.

There are other notable reports this week including Durable Goods (today) and the services PMI (Friday). Finally, revised Q4 GDP comes Tuesday, and analysts are still looking for around 2% growth (Q4 GDP was 1.9% in the advanced look last month). As we said, all the data is important given strong data has helped offset growing policy worries, so these number meeting or beating estimates will be generally supportive. Bottom line, data needs to stay good and inflation needs to stay tame in order to support this market, because Washington policy expectations are a growing headwind.

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Oil Market Internals Confirm Our View of “Lower-for-Longer” Price Environment, February 24, 2017

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We have recently been monitoring the calendar spreads and term structure of WTI crude oil futures with a little more attention, as there have been notable developments.

As a refresher, a calendar spread is simply the difference in price between two contracts with different expirations. For example, contracts with a December ’17 expiration are currently trading at a roughly $1.00/bbl premium to contracts expiring in December ’18 (this is called an inverted market, or backwardation, and is not typical in energy markets). Normally, back-month con-tracts are more expensive than front-month contracts to reflect the price of storage and other variables. Such a structure is called normal contango.

The trend is long-term bearish oil.

The trend is long-term bearish oil.

Over the last week or two, calendar spreads have surged, which would be considered very bullish in normal market conditions like we had late last year when OPEC announced their agreement to cut production with several large NOPEC producers. After that announcement, the entire WTI expiration curve rallied on the speculation of that bullish development in the supply-demand fundamentals with front-month contracts out-performing back months (calendar spreads rallied, con-firming the move in active-month futures).

In the current case, the strength in the calendar spreads has been the result of weakness in back-month contracts like December ’18. Think about the simple equation a – b = c (calendar spread). If “a” (Dec ’17) and “b” (Dec ’18) are both increasing, but the pace of a’s increase is faster, “c” will be positive (so the calendar spreads would be rallying, which is bullish). Right now, “c” is rising because of a faster decline in “b” than in “a” and that is far less of a reason to be optimistic on this current, sluggish trend higher in oil prices.

Stepping back, this development in the calendar spreads confirms what we have been saying, and that is we remain in a lower-for-longer price environment in the energy market.

The logical reason for a faster decline in back-month contracts such as December ’18 expiration suggests that US producers are hedging out future production for wells they have either just brought online or are in the process of bringing online. And this concept supports our idea that US production has not only bottomed, but has begun a cyclical move higher.

Bottom line, that trend is long-term bearish oil for two reasons. First, the obvious fact that rising US output will offset the efforts of the production cut agreement overseas is supply side bearish. Second, OPEC producers are not likely going to be comfortable with the idea of losing market share to the US again (after all, that is the reason they switched to “full-throttle” policy back in summer 2014, which led to the near-80% plunge in oil prices over the subsequent 18 months). The more market share OPEC loses to the US the more likely their compliance to individual quotas will begin to fall, which is very bearish for prices as that is what this current recovery into the $50s is fundamentally based on.

Looking ahead, we could very well see a continued run higher towards our initial target of $57.50, or to our secondary target of $60/bbl, as optimism surrounding OPEC compliance remains elevated. The longer-term outlook is not so bright, and the low $50s will likely remain a “magnetic” level for WTI futures.

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“Is the Stock Market Too Expensive?” February 23, 2017

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“Is the Stock Market Too Expensive?” 

That’s a question I’m getting asked a lot lately by subscribers and colleagues.

With stocks at record highs, there is a lot of worry that the market is unsustainably expensive. But, that’s simply not the case.

Yesterday, in the full edition of The Sevens Report, we broke it down.

  • Provided a three-part analysis of what makes the market 1) Expensive, 2) Fairly Valued (with some room for upside) and 3) Cheap
  • Named each catalyst that would decide that valuation level
  • Listed specific sector and style ETFs that we believe can outperform in this valuation environment.

Excerpt from that research below:

Valuation Update: How Overvalued Are Stocks?

It’s no secret that stocks are richly valued, but while those high valuations make me generally uncomfortable (I’m a value investor at heart) I do feel the need to push back a bit on the idea that valuations, alone, are a reason to lighten up on equity exposure.

Yes, in some scenarios the stock market is simply “too expensive.” Still, there are other, more plausible scenarios where I can show the market as reasonably valued or even cheap. Here are a few of those scenarios.

The Market is Too Expensive If: You’re Looking at Current Year Earnings. Looking at current year earnings, the S&P 500 is historically very expensive. With consensus $128 2017 S&P 500 EPS, the S&P 500 is trading at a whopping 18.44X current year earnings. Anything above 18X has proven (longer term) historically unsustainable.

The Market Is Not Too Expensive (Yet) If: You Look At Next Year’s (2018) Earnings (And This is Without Any Tax Cuts). Consensus 2018 (so next year) EPS are around $135, which does not include any benefit from a corporate tax cut. At $135, the S&P 500 is trading at 17.4X next year’s earnings. Yes, that is expensive (the 20-year average is 17.2X per FactSet) but it’s not unsustainable, not in an environment with historically low interest rates and an apparent macro-economic acceleration.

In fact, if the macro set up doesn’t change (and we don’t get any definitively bad news from Washington), I could see investors pushing that multiple to 18X, or 2,430 in the S&P 500 (about 3% higher from here).

Above that, I think the market would get somewhat prohibitively expensive, but that would depend on what’s happening with the economy, inflation and rates.

The Market Is Cheap If: Real, Material Corporate Tax Cuts Get Implemented. If we do get material corporate tax cuts in 2017, most analysts think that would add at least $10/share to S&P 500 EPS, bringing the 2018 number from $135 to $145.

At $145 EPS, the S&P 500 would be trading at just 16.3X next year’s earnings, which in this environment could easily be considered reasonable if not outright cheap.

“Is the stock market too expensive?”

Six Value ETFs That Can (and Have) Outperformed

From a practical standpoint, the fact that the stock market is on the expensive side historically does reinforce my preference for value-oriented ETFs. Since late 2016, we’ve focused our tactical strategies on sectors we considered a “value” and they have handily outperformed the S&P 500:

  • In September of 2016, we strongly advocated getting long banks due to 1) Compelling valuation and 2) The start of the uptrend in bond yields. Since that call on September 26, our preferred bank ETF has risen 41%!
  • In late 2016, while many analysts were chasing cyclical sectors in the wake of the election, we instead advocated buying value in super-cap internet stocks. Our preferred internet ETF has risen 9.8% in 2017, handily outperforming the S&P 500.
  • At the start of 2017, we cited the maligned healthcare sector as our preferred contrarian play for 2017, based on the idea that overly negative political fears had created a value opportunity. Our two preferred healthcare ETFs have risen 7.3% and 7.5% so far in 2017, and we think that trend of outperformance will continue. 
  • More broadly, we have identified two “Value” style ETFs that we believe will outperform the markets in this current macro-environment, and these two broad ETFs remain our preferred vehicle to be generically “long” the market.

The Sevens Report doesn’t just help you cut through the noise and focus on what’s truly driving markets – we also provide tactical idea generation and technical analysis to help our subscribers outperform. You can sign up for your free trial today: www.7sReport.com.

“This is a huge value add. If I can avoid even a modest portion of significant market pullbacks, and be well-invested during bull markets based on your Dow Theory calls, my clients will be extremely happy with me. I already look like a genius to them!” – Financial Advisor with a National Brokerage Firm, New York, NY. 

Did One Fund Cause The Rally?

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Make sense of the rumors FAST. Below is an excerpt from today’s Sevens Report: www.7sReport.com.

Easily the biggest story that circulated trading desks Thursday morning was an article that a $4 billion options fund was blowing up. In doing so, the implication was that is what has caused the relentless really we’ve seen in stocks since last Thursday.

The fund in question is the Catalyst Hedged Futures Strategy, and in a broad sense this fund sells volatility using option strategies.

Did one fund cause this rally?

The story/rumor going around is that this fund sold a massive amount of call spreads, making them effectively short $17 billion worth of S&P 500 Index futures. Well, you can imagine how that’s worked out over the past week, and the takeaway is that this fund has been relentless buying S&P 500 futures over the past week to cover their shorts… and that’s why stocks have surged.

Normally, these stories about funds blowing up and causing a market disruption are little more than rumors created to explain a market that is defying fundamentals. But, markets defy fundamentals in the short term quite frequently without fund blowups.

This, however, is a bit of a unique case, because we can actually see the return data for this fund (it’s an open-ended futures fund). Over the past week, the fund has lost -14%. That has brought its year-to-date return to -13.5%, meaning prior to the last week, the fund was flat year to date. Taking a quick look at historical returns, a 14% weekly move in this fund is not normal, so it’s fair to say that something has gone very wrong there.

Looking more broadly, does the story of this fund explain why the market simply hasn’t been able to go down for a week (and why it suddenly exploded higher last Thursday despite the lack of anything good happening)? Yes, partially.

Even though I can’t directly validate the story, it reinforces my skepticism on this latest move higher from 2,300 in the S&P 500, and that is that this is a rally built on chasing and a squeeze.

 

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