Perspectives

With unemployment below 5%, the stock market near record highs, inflation contained, and the possibility of pro-business policy changes, what could go wrong in the U.S. economy? Realistically, quite a few things. Besides the more obvious issues of war with North Korea, tensions with Russia, terrorist attacks from ISIS, the ongoing probe of President Trump and the potential that Trump may not be successful with his agenda for economic growth, there are other less reported on issues in the background.

Investment as a percentage of GDP appears to be hitting a plateau approximately 11% below pre-crisis levels. One of the primary arguments in favor of continued economic growth (and therefore stock market growth) has been the optimism of business owners. The question we have to ask is, “If business optimism were truly as robust as surveys indicate, why are investment levels stubbornly low?”

Further, productivity levels seem to be struggling to pass 1%. Historically, productivity levels have been an important input with respect to wage growth. There has been a lot of discussion over when we will see the more meaningful increase in wages that many predicted would follow the drop in unemployment. In past cycles, we would have already begun to see stronger wage growth than is now present. Perhaps the less than desirable productivity levels are indicating we will not see the wage growth so many anticipate will come.

Looking deeper into the details, we observed a drop in U.S. manufacturing, durable goods, non-durable goods and transportation equipment. The ratio of U.S. wholesale inventories to sales is also weakening. Construction spending has been on a stable decline over the last year. Additionally, there has been a slowdown in automobile sales. We also recently saw a drop in consumer confidence and U.S. retail sales. These data points are supported by the fact that we are witnessing both a drop in U.S. personal spending and personal income. In addition to these data points, we have seen the 3-month moving average of U.S. consumer credit slow (meaning people in the U.S. are less inclined to want to access credit), and perhaps signaling consumer confidence is beginning to wane.

When we couple these facts with equity markets being on the high side of fair value (and over-valued according to some metrics), we believe a thoughtful approach to where investors should accept risk is in order. Further, we are witnessing a fall in correlations among equities, indicating a more active approach to stock selection may be expected to outperform passive or index investing. In April, CNBC reported that 52% of stock-based mutual fund managers were beating their benchmarks. We believe the trend of active management beating their benchmarks will increase over the coming year.

In choosing where to allocate risk, we believe it’s important to first understand how most equities are valued. One of the most common valuation methods is known as a Discounted Cash Flow Model (DCF). The basic idea of a DCF model is that a stock is worth the present value of its future cash flows. Without going into too much more detail, these models can be complex. The process of forecasting future cash flows of high growth companies that operate in new areas of the economy is very sensitive to the assumptions used in the model. For example, when computers were in their infancy, it was very difficult to project when growth would level off in that industry and when competition from new entrants to the industry would compress profit margins. In late 1999 and 2000, analysts began to observe a slowdown in the growth of tech companies; growth in the industry began to level off before most expected. Upon observing the slowdown, the prevailing DCF models were re-evaluated, and it was then determined tech stocks were incredibly over-valued, causing the massive selloff in tech stocks that we now call the bursting of the tech bubble.

Fortunately, not all stocks are as difficult to value as high growth new industry stocks. More established companies in more established areas of the economy have already passed through the high growth phase and the leveling off that follow it. These companies tend to produce more consistent and predictable growth patterns with more predictable and consistent profit margins. We can think of a company like Johnson and Johnson. Many of their products have been with us for decades, and while new entrants in any market can always present themselves, it’s less common in well-established niches of the economy. To show an example of the difference in outcomes during the tech crash, Intel (a high growth company in a developing niche of the economy) dropped in value 60.1% from January 1, 2000 to March 31, 2003. During the same time period, Johnson and Johnson gained 29.8% in value. Analysts did not have to completely refresh their assumptions on Johnson and Johnson during the tech bubble like they did with Intel. We see the same evidence in broad terms through comparing the Nasdaq with the Russell 1000 Value Index. The Nasdaq 100 (primarily newer, high growth companies) lost 72.4% of its value between January 1, 2000 and March 31, 2003) while the Russell 1000 Value (primarily older, more well established, lower growth companies) only lost 17.9% of its value.

Knowing what you own and how its market price is determined can go a long way in helping investors avoid getting blind-sided by something like the tech bubble. Our process focuses on the valuation of what we own with a deep understanding of the variables being used to derive a stock’s price in a DCF model. As in past cycles, growth will slow, models will be readjusted, and the price of over-valued stocks will fall. Because it is difficult to identify when the music will stop until it does, we believe the best course of action is to avoid following the herd and to choose sound investments with more predictable valuations. We actively monitor your investments to ensure we understand what is driving their price.

Fortem Financial 2017. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

While last Thursday marked one of the first notable drawdowns in a several months, the S&P is barely off -2% from recent highs. With 45% of issues above their 50-day moving average, it’s also too soon to say market momentum is washed out, particularly given the overhang of the weaker seasonal period and the recent pick-up in the new low data. August 2017 doesn’t share much in common with August 2015 when the market was struggling to get back to breakeven for the year. Looking forward, it’s the character of the next advance that will likely be revealing as to the market’s strategic standing. We’re watching credit conditions and the relative performance of the Industrials sector for clues. The Transports are also at a key juncture here, near 200-day moving average support.

Source: Strategas

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Market Week

The VIX is up roughly 50% over the last few days and likely speaks to what is still a fragile sentiment environment, as does the meaningful spike in put volume for the South Korean ETF – both conditions are bullish from a contrarian perspective, but likely too early to play just yet. Curiously, lower yields have not translated into any relative advantage for the REITs, which remain underperformers because of headwinds from Retail brick and mortar holdings.

Markets declined last week on escalating tensions between the U.S. and North Korea. Small cap stocks and sectors which respond well to economic growth were particularly hard hit; prices for Treasuries and gold rose as investors adopted a “risk off” sentiment. The prospect of a military conflict, while seemingly remote, unnerved investors who had enjoyed a relatively benign investing environment so far this year. Indeed, the CBOE Volatility Index (VIX), which had been trading near historical lows, spiked 55% this week to close near its highest level since the November 2016 elections. And yet, geopolitical and other “macro” risks are a staple of investing. The North Korean episode is the latest in a surprisingly regular series of events that have shaken markets over the past several years: the Brexit vote in 2016; the Greek bailout negotiations in 2015; the Russia-Ukraine conflict and oil market selloff in 2014; the “Taper Tantrum” in 2013; and the European debt crises and “fiscal cliff” showdown in 2012. In the midst of these events, though, the major equity indexes have more than doubled over this five and a half year period. These episodes often have limited economic impact for individual companies and industries; the flare-ups, though, can create opportunities for long-term investors to selectively acquire stocks that others may have discarded in a move to avoid risk.

Politics have largely overshadowed the second quarter earnings season; nevertheless, results have been impressive. Over 90% of companies in the S&P 500® Index have reported earnings; of these, 70% have met or exceeded analysts’ sales estimates and 82% have met or exceeded analysts’ earnings per share estimates. Sales for the quarter are now expected to rise 5.2%, while earnings are expected to rise 10.2%. These results, which are significantly above initial expectations, reaffirm a positive outlook for corporate profits. Department store retailers Macy’s and Nordstrom were in focus this week. The companies pointed to a strong start to the popular back-to-school shopping period. Yet, weak overall traffic patterns and concerns over online competition persist; the stocks were down 11% and 4%, respectively. Other companies perceived to be “Amazon proof,” such as Home Depot, have outperformed thus far this year. Next week, specialty retailers, including Home Depot, TJX Companies (owner of T.J. Maxx and Marshalls), and L Brands (owner of Victoria’s Secret and Bath & Body Works) will report earnings. The updated results and management commentaries will provide important insights into the state of retail with regard to the rapidly evolving nature of their businesses, particularly as it relates to online competition, as well as broader consumer sentiment.

Source: Strategas and Pacific Global Investment Management Company

Last Week's Headlines

1. According to the Job Openings and Labor Turnover report for June, the number of job openings increased to 6.2 million (+461,000). Over the month, the number of hires fell from 5.5 million in May to 5.4 million in June. There were 5.2 million total separations in June, little changed from May. Job openings increased in a number of industries, with the largest increases occurring in professional and business services (+179,000), health care and social assistance (+125,000), and construction (+62,000).
2. The monthly federal government budget deficit was $43 billion in July on the heels of a June deficit of $90 billion. Total government receipts were $232 million, while total outlays were $275 million. The total budget deficit for fiscal 2017 sits at $566 billion — 10.6% higher than the $512 billion deficit over the same 10-month period last year.
3. There continues to be little upward movement in consumer prices. The Consumer Price Index rose 0.1% in July following no movement in June and a 0.1% drop in May. The CPI has risen 1.7% over the last 12 months ended in July. Prices less food and energy also increased 0.1% for the month and 1.7% over the last 12 months.
4. Dwindling inflationary pressure has been the theme over much of 2017, and the latest figures from the Producer Price Index continue that trend. The prices producers receive for their goods and services declined 0.1% in July, following a 0.1% increase in June. Over 80% of the decrease is attributable to a 0.2% drop in services, although prices for goods edged down 0.1%. Prices less the volatile components of food, energy, and trade services were unchanged in July, while prices less food and energy fell 0.1%.
5. In the week ended August 5, the advance figure for seasonally adjusted initial claims for unemployment insurance was 244,000, an increase of 3,000 from the previous week's revised level. The previous week's level was revised up by 1,000 from 240,000 to 241,000. The advance seasonally adjusted insured unemployment rate remained 1.4%, unchanged from the previous week's unrevised rate. During the week ended July 29, there were 1,951,000 receiving unemployment insurance benefits, a decrease of 16,000 from the previous week's revised level. The previous week's level was revised down 1,000 from 1,968,000 to 1,967,000.

Eye on the Week Ahead

July's report on housing starts is out this week. The housing market has been up and down so far this year, with low inventory and rising prices discouraging would-be home shoppers. However, housing starts and building permits were up in June — a trend builders and homebuyers would like to see continue in July. Another report released this week, the Treasury's Industrial Production Index, not only shows how much factories are producing, but it also measures how much factory capacity is in use.

Fortem Financial 2017. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

While we are mindful of the seasonal weakness that is typical this time of year and know that low volatility is making investors anxious, I wouldn't want to be on the wrong side of this trade. The trend of the market is still positive and I'd much rather be long. Pullbacks are generally buyable when the credit environment is as well contained as it is today. The leadership reversal we've witnessed over the last few weeks is risk seeking which is another supportive sign.

Source: Pacific Global Investment Management Company

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Market Week

The longevity of this bull market is one of the characteristics that people point to as a source of concern. Although the S&P did not decline 20%, between mid-2014 and mid-2016, most global markets experienced a bear market and nearly 70% of U.S. stocks were down by 20% or more during that period. This should buy us some time.

With interest rates off of their historic lows and emerging signs of global central bank policy beginning to change, lower correlations and greater dispersion from equity and debt securities are likely ahead. The correlations among equities have been in steady decline for the better part of the last 12 months. Negative/zero rates have kept a lot of weak players on the field and the normalization of rates should help to separate the winners from the losers, creating opportunities for outperformance to stock pickers. Ultimately, we believe that inflation will be the catalyst that starts the trend away from passive to active management.

Markets continued to fluctuate last week as mixed economic data offset positive earnings results. The Dow Jones Industrial Average, once again, outperformed the major indices; Apple (+4.6%) and 3M (+4.0%), which together account for more than 11% of the Dow, led the gains. Large caps outpaced mid-cap and small cap stocks as market sentiment remained cautious. Financials were the strongest performing sector, with investors responding to comments from Federal Reserve officials that “balance sheet normalization” would likely commence in the second half of the year; the reduction of the Fed’s bond holdings should produce upward pressure on interest rates. Oil prices remained near $50 per barrel; even so, Energy lagged as investors assess the rapidly shifting dynamic between OPEC, shale oil producers, and large offshore projects (more on this below). Economic data indicated a slight downshift in domestic activity: July’s auto sales decreased 7.1% year-over-year; and, the ISM manufacturing and services data indicated slower rates of expansion. Job growth, though, remains ahead of the six-month average; all of the major world economies are growing; and corporate earnings are improving. The decline in the dollar (which has lost roughly 10% against a basket of currencies since early January) could help mitigate softening domestic demand. The more favorable exchange rate effectively lowers the price of exports, aids tourism-related spending in the U.S., and benefits the earnings results of companies with foreign subsidiaries.

Oil prices may remain in the range of $40 to $60 per barrel for some time. At these prices, major oil producers will likely include both shale oil and deepwater wells in their long-term strategies; shale oil projects respond quickly to changes in demand while deepwater wells often produce over several decades. Technological improvements and operational efficiencies have reduced deepwater drilling costs; several of offshore projects can generate attractive returns as low as $40 per barrel. Indeed, this week, multiple offshore oil drilling contractors reported that bidding activity is starting to improve, albeit slowly. Looking ahead, we expect that Energy companies, which have materially underperformed, should provide significant returns as projects are announced and investor sentiment improves.

Earnings season is largely over. Revenues and earnings continue to outperform; many companies expect the positive momentum to continue through the second half of the year. The House is already on summer recess; the Senate will adjourn next week so legislative activity will pause until September. Trading activity will slow over the next few weeks as many investors enjoy their annual summer vacations. So, absent unexpected events or significant economic reports, market activity may be muted during this seasonally slow, end-of-summer period.

Source: Strategas and Pacific Global Investment Management Company

Last Week's Headlines

1. Another strong month of growth in the employment sector as there were 209,000 new jobs added in July. This follows the 231,000 new jobs added in June. Employment growth has averaged 184,000 per month thus far this year. Job gains occurred in food services and drinking places, professional and business services, and health care. The unemployment rate for the month was 4.3%, down from 4.4% in June. The average workweek was unchanged at 34.5 hours in July. Average hourly earnings rose by $0.09 to $26.36 in July. Over the year, average hourly earnings have risen by $0.65, or 2.5%.
2. Not unexpectedly, growth in consumer income and spending was essentially nonexistent in June. Pre-tax personal income and after-tax personal income were unchanged in June from May. Consumer spending, as measured by personal consumption expenditures (PCE), increased 0.1% in June. Core personal consumption expenditures (excluding food and energy) also increased 0.1% for the month. For the 12 months ended in June, the PCE was up 1.4%, while the core PCE has gained 1.5%. This report confirms that, entering the summer months, inflation is relatively flat and consumers are not seeing an increase in their income. Consumer spending, which accounts for roughly two-thirds of overall economic activity, has also stagnated.
3. The final report on the international trade in goods and services deficit for June showed the total trade deficit to be $43.6 billion, down $2.7 billion from May. June exports were $194.4 billion, $2.4 billion more than May exports. June imports were $238.0 billion, $0.4 billion less than May imports. Year-to-date, the goods and services deficit increased $26.7 billion, or 10.7%, from the same period in 2016.
4. The purchasing managers' index is a survey of selected companies relative to manufacturing output, new orders, inventory, employment, and prices. IHS Markit and the Institute for Supply Management (ISM) each put out a monthly index. The results of each survey are not always similar, as is the case for July. Markit's U.S. Manufacturing Purchasing Managers' Index™ (PMI™) registered 53.3 in July, up from 52.0 in June, indicating an increase in production. On the other hand, the ISM purchasing managers' index was 56.3%, down 1.5 percentage points from the June reading of 57.8%. It should be noted that a reading over 50% indicates growth, which means manufacturing expanded in July according to the ISM report, but at a slower pace than June.
5. According to the Institute for Supply Management's Non-Manufacturing ISM® Report On Business®, the non-manufacturing index slipped 3.5 percentage points in July to 53.9%. This represents continued growth in the non-manufacturing sector, but at a slower rate than in June. Survey respondents thought business activity, new orders, and employment decelerated while prices increased in July from June. The report covers industries such as accommodation and food services; utilities; wholesale and retail trade; real estate, rental, and leasing; health care and social assistance; and finance and insurance.
6. In the week ended July 29, the advance figure for seasonally adjusted initial claims for unemployment insurance was 240,000, a decrease of 5,000 from the previous week's revised level. The previous week's level was revised up by 1,000 from 244,000 to 245,000. The advance seasonally adjusted insured unemployment rate remained 1.4%, unchanged from the previous week's unrevised rate. During the week ended July 22, there were 1,968,000 receiving unemployment insurance benefits, an increase of 3,000 from the previous week's revised level. The previous week's level was revised up 1,000 from 1,964,000 to 1,965,000.

Eye on the Week Ahead

Trading should continue to be light as the summer rolls on. Both producer prices and consumer prices showed little upward movement in June. July's figures are not expected to change that much as reports on the Producer Price Index and the Consumer Price Index are out this week.

Fortem Financial 2017. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.