on Monday, 31 July 2017. Posted in 2017, July


More for Less in a 2% Economy

“Technology makes the world a new place.”

                                    Shoshanan Zuboff


The 2% economy chugs along; earnings moved double digits, major averages set new highs, tech with some bumps continues to dominate, and the Wall of Worry gets higher.  The recently released 2Q2017 GDP report shows real growth at 2.6%, and when averaged with 1.2% for 1Q2017, gives 1.9% for 1H2017.  Estimates for the second-half 2017 remain in the 2%-2.5% range.  The inflation rate remains below the desired 2% and interest rates remain lower than had been expected.  The Fed FOMC meeting left interest rates unchanged, but gave indications of a balance sheet unwinds in the not-to-distant future.  Another sharp selloff in the tech-heavy NASDAQ brought the technicians to claim an “Outside Reversal,” signaling an intermediate top with a possible reversion to the 200-Day moving average.   
As intelligent investors know, stocks do not go up in a straight line forever.  Although looking at the charts of the major averages since the lows in February 2016, it certainly did over 17 months.  From those 2016 lows until its record highs last week, the S&P is up 37.2%, while the NASDAQ Composite rose 53.5%.  Over the same period, the S&P 500 Information Technology Sector rose a staggering 74%, followed by Financials at 60% and Industrials up 45.3%.  Prior to the early-2016 correction, Healthcare was the undisputed sector leader.  But, since early-2016 it rose a paltry 23%.  Over this time the economy, measured by real GDP, grew at 1.9%.  Earnings and revenues flatlined in 2016 as energy prices fell and then rose modestly and the dollar strengthened.  Throughout this period, Volatility, as measured by the CBOE Volatility Index (VIX), remained in a 10-12 range before falling to a record low 8.8 last week.   
The combination of new record highs and a period of low volatility is taken by many as a prescription for a pullback, particularly for sectors in “extreme overbought” territory.  This seems to be the reasoning for the recent sharp sporadic downturns in tech.  The selloff in late-June/early-July for tech reversed and set new record highs.  But once again, last week into today the NASDAQ again is selling off.  One of the reasons cited by investors negative on equities is the lack of buying power in the form of potential inflow.  As evidence, bears mention that cash holdings at Charles Schwab are at a historically low 11.5%, compared with a historical average of 15.6%, concluding that the market is near a peak.  However this conclusion does not address the possibility of rotation out of fixed income into equities, a strong likelihood as rates begin to rise.  According to Morgan Stanley, net exposure to equities of their Prime Broker Content (Hedge Funds) is at 46%, reflecting a lack of commitment.  Additionally, Mutual Funds are 54% equities, below the 59% in 1999 and 56% in 2008.  Moreover, a combined outflow of equity Mutual Funds and stock ETF’s was $29 billion in the past month.   
Over the last few years, our Reports have discussed the back-loaded consumer.  The financial condition of households is in the best shape since the 1980’s.  But this consumer has become accustomed to convenience and productivity at a lower price.  This preference shift has created shocks to retailing and many aspects of everyday life.  How many people could go more than a day without a smart phone?  Getting more for less is not only redefining consumer spending, it is pervasive and affects all sectors of
the economy.  This is one reason for our long-term outlook for low inflation in a full-employment environment.     
Technology advances are the reasons for excess capacity utilization, particularly in manufacturing.  With levels below 80% there is less pressure to raise wages and build additional plant and equipment.  This is more evident in retailing with a rapid growth of the Internet, it is directly responsible for the closings of malls and big box stores.  These Internet retailers are expanding into urban areas, utilizing less space and catering to the lifestyles of the tech-centric millennials.  Free standing ATMS and Uber and other ride sharing services, have increased convenience and lessened demand for bank branches and car ownership.   
What appears to be a secular bear market for commodities limits the potential for inflationary pressures.  Technology affects all commodities, with sophisticated location equipment or highly technical extraction machinery.  This reduces costs and has created over supply for most minerals and industrial materials.  Advances in agriculture have increased output and limited the effects of droughts and floods, but nowhere are the changes more evident than in energy.  Advances in solar have lowered costs to an acceptable level and along with other renewable sources, approach 10% of energy consumption.  Fossil fuels best illustrate the effects of technology.  From a world of rapidly depleting oil and gas reserves, the introducing of fracking and other geological and related technologies has created a global supply glut never imagined only 20 years ago.  Oil and gas fracking continue to provide a disruptive force as supply is available at manageable costs.  Inflation in the energy sector is limited by technology and consumers and corporations benefit from more for less.   
As mentioned earlier, 2Q2017 earnings are better than even the more optimistic forecasts.  While traders focus on short term valuation, this earnings season shows the potential for rising corporate earnings going out through 2018.  Despite disappointment with Amazon and Google, Technology is leading the trend in continued earnings growth.  Combined with Financials, these two sectors are about 38% of the S&P 500 and are forecast to lead earnings growth through 2018.  FactSet reports that with 57% of the S&P 500 companies reporting, 73% of both earnings and revenues have beaten the mean estimates.  Overall, 10 of the 11 sectors are above forecasts.  Looking out into 2018, these two leading sectors are expected to grow earnings in double digits, along with Consumer Discretionary, Industrials, Energy and Materials.  Earnings are in the early quarters of elevated growth.  More important than the 2% real growth economy will be the balance among various sectors.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies.  To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.

David Minor
Rebecca Goyette

William Hutchens