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Weekly Review - August 24, 2015

Weekly Review - August 24, 2015

Guest Post - Monday, August 24, 2015


  • Economic data in the U.S. was again mixed, with regional manufacturing surveys offering conflicting results, while housing metrics turned out well and showing some moderate improvement. However, the story abroad was the problem, as Chinese manufacturing survey figures showed continued contraction.
  • Equity markets globally reacted with the strong negative returns, in response to global growth concerns. Consequently, bonds fared well in the risk-off environment as interest rates fell sharply. Crude oil fell to new multi-year lows in the $40 range, while gold rebounded somewhat as a safe haven.

Economic Notes

(-) The Empire Manufacturing index for August fell by almost -20 points into contractionary territory at -14.9, in a negative surprise, as market consensus pointed to a small gain to +4.5. Underlying components were generally weak as well, as shipments and new orders both fell in similar magnitude to the broader report, while employment didn’t deteriorate quite as much and remained in positive territory. No factors were included that helped explain the deterioration.

(+) The Philly Fed index rose +2.6 points to +8.3 for August, surpassing the expected +6.5. In the details of the release, shipments and employment both rose from moderate to highly positive levels, while new orders declined a bit, while remaining positive. Overall, this was a strong report, and the complete opposite of the weaker Empire version a few days prior./p>

(0/+) The NAHB housing market index for August rose a point to a new recovery high of 61, in keeping with consensus expectations. Current sales and prospective buyer traffic both rose, while future expectations were unchanged. The Northeast was the sole weak spot for the month, while other regions generally performed better.

(+) Existing home sales for July rose +2.0% to a recovery high point of 5.59 mil. annualized units, outperforming the expected -1.1% decline. Single-family sales led by gaining +3%, while condo/co-op activity dropped by -3%. In recent months, this metric has continued to show improvement.

(0/+) Housing starts in July rose +0.2% to a seasonally-adjusted 1,206k, which lagged an expected +0.5% increase, but included some upward revisions for prior months which improved the net result. The 12-month moving average of this data (which smooths out the rough edges) of 1,064k is the highest since mid-2008, but remains at half of peak levels and a quarter-million starts below the 20-year longer-term average. By contrast, building permits fell -16.3%, which was about twice as bad as the -8.0% expected, but these can be volatile. The backward adjustment appeared to be related to an earlier spike in the Northeast (specifically, resulting from property tax abatement changes in NYC), as the other regions deteriorated by a far lesser amount, and single-family permits only declined by about -2%. While these data is choppy on a monthly basis and can be difficult to gauge in that context, longer-term trends are beginning to show some improvement.

(0) The consumer price index for July rose +0.1% on both a core and headline level per a seasonally-adjusted basis—both of which were about half the increases expected. (Headline CPI barely budged on an actual, non-seasonally adjusted measure.) As implied by the results, food and energy weren’t big determining factors, rising in line with broader indexes, while shelter gained +0.4%, followed by similar gains for apparel. The only bigger surprise was a -6% decline in airline ticket prices, some of which can be explained by changes in calculation methodology a year or so ago, so this has less direct effect than at first glance (lest we run out and buy vacation tickets immediately). Year-over-year, core and headline inflation are +0.2% and +1.8% higher, respectively, so remain in tempered territory. Energy price declines will weigh on the year-over-year number for at least a few more months unless something dramatic happens in the meantime.

(-/0) The Conference Board’s index of leading economic indicators for July fell by -0.2%, bucking recent trend, as the two prior months had showed gains of +0.6% each. Positive contributors continued to be more numerous than detractors, and included interest rate spread, low levels of weekly jobless claims, credit and new orders. Negative factors building permits and stock prices. The coincident and lagging indicators both increased by +0.2% and +0.3%, respectively for July, in contrast to the leading report.

(0) Initial jobless claims for the Aug. 15 ending week moved upward slightly by +4k to 277k, in contrast to an expected decline to 271k. Continuing claims for the Aug. 8 week fell to 2,254k, below the expected 2,265k. No special factors were reported by the government and stats were well within recent (low) ranges.

(0) The minutes from the late July FOMC meeting ended up being a bit more dovish than some expected, and there appeared to be no clear signaling in regard to when a rate decision would be made. ‘Almost all’ members needed to see additional evidence of improvement in the inflation outlook in order to be more confident in a return to longer-term trends. An improvement in labor conditions was acknowledged, yet the lack of wage growth was seen as an ongoing concern. The Fed’s annual retreat/symposium in Jackson Hole is scheduled for later this week, with a theme of ‘Inflation Dynamics and Monetary Policy,’ so no doubt there will be a sound bite or two from the usually-impressive cast of speakers and other characters. The weakness in China, further elaborated on below, also threatens sooner action and raises the chances of a December rather than a September rate change.

Read the "Question for the Week" for August 24, 2015:

What happened with China’s currency devaluation?

Market Notes

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U.S. Treasury Yields

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U.S. stocks struggled during the week, with additional volatility from Asia carrying over to our shores. Particularly, losses on Thursday and Friday wrapped up the worst market week in four years. Technically, the Dow hit -10% correction territory based on highs in May, while the S&P fell just short of that result. From a sector vantage point, utilities led with minimal losses of a percent, while energy and technology were hardest hit—the former losing -8% in line with much weaker oil pricing.

The catalyst for all this was an advance PMI report from China showing further economic weakness—in the measure for July falling by more than half a point to 47.1 (under 50 is considered contraction territory), as well as the revelation that the near-term Chinese GDP target could be lowered from 7.0% to 6.5%. (It’s probably already fallen to that; they’re just hesitant to admit it.) This led to renewed sell-offs in the Chinese Shanghai stock markets that carried over elsewhere. Of course, as the primary global growth engine of the past decade, slowing here lowers overall world GDP growth targets, which has intensified the broader concerns about already-lackluster global growth. At the same time, the U.S. economy is less dependent on China than the headlines would have you believe. So, it’s important to put this in context (more on this below).

These selloffs can feed on themselves for a time, as we all know. From a charting perspective, selling pressures were exacerbated in normal fashion, as S&P prices hit and fell below the newsworthy round 2000 level (which shouldn’t matter, until it ends up on the evening news), and dropped below the 200-day moving average, which is a key technical marker utilized by many momentum managers. How quickly or not quickly markets respond back will demonstrate the key differences/risks between momentum and other investment strategies, such as valuation-based or buy-and-hold.

Foreign stocks generally performed in line with domestic equities, with developed market areas ending up a bit better than emerging markets. The dollar weakened by about a percent on average, so USD-denominated indexes tended to outperform the local variety. Losses here were just a matter of severity, so additional detail isn’t worth much. In keeping with expectations, China A shares and export competing nations in the Asia-Pacific region fared worst, while oil exporters such as Russia weren’t far behind. Despite the hugely negative sentiment, valuations for several emerging market areas have turned quite low, prompting additional interest from a variety of asset allocators who look at such opportunities from a 5-10+ year perspective.
U.S. bonds gained on the equity risk-off trade for the week—just when everyone is primed for sharply higher bond yields, they surprise once again on the lower side with a 0.10-0.15% point drop in yields across the curve. Naturally, the longer the duration of the bond involved, the stronger the effect, so long treasuries performed especially well, while high yield lagged, as a smaller energy sector component has been sold off due to oil price fears.

Developed market foreign bonds generally gained on a weaker dollar, in relative terms due to stronger exports in Europe and higher inflation and tightening pressures in the U.K. Emerging markets generally widened, while several other emerging nations have taken China’s lead to weaken their currencies—notably last week, Kazakhstan announced a policy change away from a peg towards traditional inflation targeting instead, causing their currency to fall by -20%. Vietnam has weakened its currency for the second time in a week.

Real estate also declined, but held up relatively well compared to equities, helped by lower interest rates (better than the converse of being penalized by higher rates, which can affect REITs near term). European and Japanese REITs came in better than the U.S. variety, where healthcare barely budged while industrials suffered.

Commodities continued to struggle on the back of lower oil prices, which tumbled another -4% to right above the $40 level—the lowest price since the recessionary lows of 2009. This capped an 8-week losing streak, which hasn’t happened in 30 years. For the technicians out there, relative strength in crude is adequately poor enough to perhaps even signify an ‘overshoot’ to some degree. While weakening demand in China and related regions is one headline reason no doubt, high supplies remain, which appear to have kept possible recoveries at bay. On the other hand, precious metals experienced gains of +4% as investors sought out gold as a traditional safe haven asset (a weaker dollar over the past week helped its cause). Agriculture and industrial metals were much more tempered, by comparison. Interestingly, a recent survey put out by a large bank/brokerage noted a record underweight position in the commodity sector and energy in particular.

On a market structure note, the SEC fined Investment Technology Group (ITG) a record $20 mil. for admitted wrongdoing involving high-frequency trading in dark pools. Essentially, it appeared the firm used client information to its own advantage by trading ahead of them for its own benefit, even if by milliseconds. The effect is really no different from the client ‘front-running’ activities that have been banned for some time, yet the traditional form is more obvious to spot with the human eye than the high-frequency variety. So, while the tools are different, the issues are the same. The question becomes a key one for the high-frequency trading world: how to define that gray area between competitive information advantage and illegal anti-competitive activity.

One final market note. After an extended run, markets generally need to take a breather and there is a contingent who’ll sell just because they want a reason to sell (which is why some news that already seems obvious is acted on dramatically, when in other weeks it can be surprisingly brushed off). Flattish markets of the summer up until now with low volatility haven’t shown a pattern towards bullishness or bearishness, as noted by the high levels of self-proclaimed ‘neutral’ investors from the weekly AAII survey.

For perspective’s sake, from the lows reached in March of 2009 through this week, the S&P has gained +230% (20.4% annualized). We’ve moved from overly cheap valuations (remember the companies with price/book less than 1, that were ‘worth more dead than alive’ temporarily back then?) to ranges that are more typical of long-term averages. It probably isn’t surprising that we’re seeing higher levels of market volatility, given the backdrop of these more ‘normal’ conditions and that ‘easy’ growth getting harder to come by. But it doesn’t necessarily mean that the trend upward is over. Again, in normal conditions, stock prices tend to follow predictable patterns—movement can originate from dividends, earnings growth and price ratio expansion/contraction. While the ratio expansion part doesn’t leave us much (unless things get bubbly), earnings growth is slated to recover in coming years to more typical 5-10% levels, based on current economic estimates. If even the lower end of that scale, add a dividend yield to that (call it 2%), as well as implied dividend growth, and longer-term returns begin to look acceptable. All that aside, classic valuation metrics peg the S&P at close to fair value, or even a bit below after this week, based on current earnings, payout ratios, interest rate levels and conservative risk premium estimates.

Compared to bonds, where a good estimate for forward-looking total returns is your starting yield, stocks continue to offer attractiveness in relative terms as well. While -10% corrections occur roughly once a year, we haven’t had one since Oct. 2011, so about four years of a bull market. In fact, even -15% corrections happen once every few years, and shouldn’t be entirely unexpected. From the base of a large multi-year gain, these are merely a blip on the chart and remain the unavoidable and yet unpredictable byproducts of normal market participant behavior. In fact, this several steps forward-one step back pattern can provide a ‘pause that refreshes,’ allowing markets to enter a new phase by washing out any marginal speculative excess. Up until now, despite the recovery, this hasn’t been a very well-embraced bull market. Considering the upheaval in the recent decade, this stands to reason as recessions that deep can have generationally-pervasive effects. It’s important to look at anecdotal information as well as quantitative when looking at such things—if everyone were quitting their jobs to day-trade again, it would be a lot more concerning. The classic ‘topping’ characteristics from a behavioral and economic standpoint just don’t appear to be present quite yet.

Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger's, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder's, Standard & Poor's, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.

Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.

Additional Reading

Read the previous Weekly Review for August 17, 2015.

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