Via ConvergEx's Nicholas Colas,
With yesterday’s impressive equity rally, every trader is asking the same question: “Can U.S. equities go green on the year?” The S&P 500 is now down “just” 3.2% in 2016 and there’s nothing like a +2% one-day rally to hold out hope of actual gains before March 31.
To think through this question, we outline the scenarios that DO push equities higher (a good jobs number, a quiescent Fed, and good economic data) and compare them to those that DON’T (presidential politics, oil prices, and corporate fundamentals). To our thinking, it’s a coin toss either way. For the bullish camp, we recommend Financials – laggards YTD, but set for a rally based on the catalysts that might move markets higher. And for the bears: the biggest winners YTD (Utilities, Staples and Telecomm) along with gold and Treasuries.
Nothing is working the way it’s supposed to, at least lately. Just consider a few of yesterday’s headlines:
On Valentine’s day, a Google autonomous car had an accident because its algorithms assumed an oncoming bus would let it into the flow of traffic. Apparently the software engineers who wrote the code were unaware that California bus drivers follow the same rules of the road as NYC cabs and the Pirates of the Caribbean – give no quarter, and expect none in return. A Financial Times article on the mishap led with this distinctly downbeat assessment: “Experts warned that a lack of social awareness meant that it would be a long time before autonomous vehicles can navigate the streets completely safely alongside humans”.
Donald Trump, as reviled among the elites as he is adored by his followers, seems set to be the Republican Party’s choice for President. What happened to Citizens United making U.S. politics a simple exercise in billionaire and corporate crowdfunding of the election process? If that were really the case, it would be Jeb Bush set to win big tonight, not the Donald.
Don’t tell Detroit that the U.S. economy is on the verge of a recession or even that a choppy stock market will ding sales. New car and truck sales for February came in at an annualized selling rate of 17.9 million, up 11% from last year.
The biggest surprise of the day, however, was a 2.4% rally in the S&P 500. Moreover, the CBOE VIX Index closed at 17.7, its lowest level of the year. The news flow behind this move was relatively light. A more cautious outlook from NY Fed President Dudley, a less-bad ISM number, and stable crude prices all helped. And then there’s the market lore about the first day of every month being a time when managers put new money to work.
With 21 days left in the first quarter of 2016, it is time to ask an even more unexpected question: can U.S. stocks turn positive on the year? Yes, I’ve been skeptical of the recent move but the tape trumps opinions, no matter how heartfelt they may be. So we’ll break this down into 2 scenarios: one where the S&P does go green on the year and one where it doesn’t.
The playbook for beating the market in a continued rally anchors on three basic assumptions. They are:
The Federal Reserve comes out of their March 15-16 meeting with a clearer message about their plans for Fed Fund rate increases in 2016. Fed Funds futures – and by extension, equities – have made up their mind: there is only a 59% chance of any rate increase by the end of the year. Now, we just need the Fed to agree. That seems like a long shot in a “Data dependent” world, so the best we can hope for is a statement that recognizes downside and upside risks.
The U.S. economy ends the quarter on a strong note. We’re big fans of the Atlanta Fed’s GDPNow model, which has been surprisingly sanguine about Q1 economic growth through much of this quarter. Even after a few hits to the estimate from weaker ISM data today, GDPNow still expects 1.9% growth this quarter. There are only 6 more data points that matter to this model between now and the end of the month: International Trade (March 4), Wholesale Trade (March 9), Retail Trade (March 15), Housing Starts (March 16), Advanced Durable Goods (March 24) and Personal Income/Outlays (March 28). After that, whatever the model predicts is the number, for good or for bad.
A decent Jobs Number on Friday. I can’t help but think that NY Fed President Dudley’s cautious comments today do not come in isolation from the Friday Jobs Report, where economists expect 190,000 jobs added and an unemployment rate of 4.9%. Employment is a notoriously lagging indicator, so one month’s weakness isn’t the end of the world. Still, with U.S. equity markets on a tear from the lows last month they will likely want to have their cake and eat it too: a good jobs number AND an accommodative Fed.
What to buy in this scenario? Financials seem the most obvious pick. First, they are the worst performing group in the S&P 500 year to date. Also, a more restrained Federal Reserve that seems willing to accept slightly higher inflation to preserve global financial stability should allow the yield curve to steepen. That helps investor sentiment on the sector. Layer on a rising equity tide for European financials, and you have a trifecta of reasonable catalysts.
The other side of the macro coin isn’t the simple reverse of the optimistic case:
The oddball political environment surrounding the U.S. presidential election has thus far been more water cooler fodder than investment consideration; that seems set to change between tonight’s “Super Tuesday” results and March 15 Republican primaries. To read the political commentary, a Donald Trump nomination is something akin to all 10 Plagues of Egypt descending on America simultaneously. Yes, offshore oddsmakers put the chances of a Trump win at less than 30%, but where would those have been a year ago?
Oil prices are still the “Dog” in this market, and equities are the “tail”. And both have been on an e-ticket ride from the lows. Has the fundamental story for oil changed dramatically over that time? Maybe – chatter from oil producing countries about curtailing oversupply has helped. But if oil prices pull back, it is hard to see equities rallying. This, by the way, is where China fits into our bull-bear tug of war. It will be hard to interpret a sudden pullback in oil as anything other than fresh concerns over that oil-consuming economy.
U.S. corporate fundamentals are still sloppy. Revenue growth for companies with international operations will be negative in Q1, for example. Earnings estimates still seem too high: S&P has a $26.43 number for the S&P 500 for Q1, up from last year’s $25.81. That compares to the recently reported Q4 numbers, where EPS went from $26.75 in 2014 to $23.50 for 2015. Analysts typically wait until the last minute to reduce their estimates, so we aren’t out of the woods when it comes to earnings revision.
In this scenario, it is the market leaders YTD that should shine: Utilities (+6.5%), Telecomm (+3.9%) and Consumer Staples (+1.8%). Other assets that have done well – Gold (up 16.1%) and long dated Treasuries (+6.5%) – should also be winners.
In short, I see the chances of each scenario as roughly balanced. And there’s no saying that a straight shot higher for U.S. equities is even sustainable. After all, we’re just in the first innings of this game. There’s a long way to go in 2016. Better to let equities digest both stories – pro and con – for the remainder of Q1. There’s still a long way to go.