Sunday, October 22, 2017

An Increasing Dividend Payout Ratio Is A Positive Indicator For The Market

Admittedly, in an equity market run investors are currently experiencing, i.e., the second longest run without a 20% pullback, a common theme that continues to seep into ones thinking, including mine, is when is the market going to experience a bear market correction of 20% or more. Even a double digit pullback is a scarcity as the below chart of the S&P 500 Index shows. The last double digit pullback occurred in February of 2016.


Without including all the charts in this post, I could reference a number of valuation charts that would indicate the market, at a minimum, is stretched. One could look at the CAPE ratio, price to book ratio, price to earnings ratio, and I could go on. One thing to remember about valuation though is markets tend not to correct simply because of extended valuations.

Are there fundamental underpinnings to the current market that would suggest investors could experience higher prices ahead. Yes. An important variable we evaluate at HORAN Capital Advisors is company action around the dividend payment. In a paper written by Robert D. Arnott and Clifford S. Asness and published in the Financial Analyst Journal in 2003, Surprise! Higher Dividends = Higher Earnings Growth, they highlighted in the paper's conclusion,
"We found that the empirical facts conform to a world in which managers possess private information that causes them to pay out a large share of earnings when they are optimistic that dividend cuts will not be necessary and to pay out a small share when they are pessimistic, perhaps so that they can be confident of maintaining the dividend payouts."
Since the end of the financial crisis, the dividend payout ratio has been on the rise and now exceeds the pre-financial crisis level. Companies are broadly optimistic about the future.


In a recent report released by S&P Dow Jones Indices they highlight the increased growth in dividend activity,
  • "within the S&P 500, the average dividend increase for Q3 2017 was 14.4%, up from 10.5% for Q2 2017 and 10.1% for Q3 2016. The median increase was 9.8%, up from 8.2% for Q2 2017 and 8.1% for Q3 2016."
  • “Q3 2017 dividend payments for the S&P 500 were a record $105.4 billion, but it may be short lived as initial Q4 numbers are trending higher,” said Silverblatt. “For full-year 2017 dividends are on track to post a 7% gain, compared to a 5.6% gain for 2016, and income tax reductions could increase payments. At this point, Street estimates call for continued gains in earnings and cash flow, as well as the potential for repatriation, all of which traditionally stimulate dividend growth."
The positive outlook around dividend growth and dividend payout ratios is an indication companies are optimistic about earnings growth in the coming couple of years. Analyst are on board with this thinking as well as Thomson Reuters I/B/E/S is reporting double digit earnings growth expectations for 2017 and 2018. There is truth in the fact that stock prices follow earnings.


Certainly valuations seem to be elevated and the market is overdue for a pullback. A Fed intent on pushing rates higher and draining liquidity from the economy is also a factor we are evaluating. However, pullbacks are normal and current data is not suggestive of a recession around the corner. A pullback would not be unexpected. Also, it is appearing tax reform might, I stress might, get done before year end. If Congress can pass a tax reform bill, this too is likely to be a positive for the market. And maybe some of the market's recent advance is pricing in some of this potential good news. Absent tax reform and healthcare reform though, company actions around their dividends are suggesting a postive earnings environment in the coming years.


Sunday, October 15, 2017

Citgroup Economic Surprise Indices Have Little Bearing On Equity Market Performance

One set of indices that seems to cycle from positive to negative over a relatively short period of time are the Citigroup Economic Surprise Indices (CESI). This aspect of these indices means they gain prominence from a commentary standpoint when they reach high and low points. What is important for investors to know is the CESI is a mean reverting index, that by design, cycles between highs and lows over relatively short periods of time. In June of this year, the Citigroup U.S. Economic Surprise Index (CESI-US) was a minus 78 after falling from plus 57 in March. At the June low some commentary began noting the U.S. economy might be headed for a recession. However, the correlation of the S&P 500 Index to the CESI-US is a small negative .04, so actually a slight negative correlation between the two variables.



What is important to note about the CESI is Citigroup designed the index for uses as a model in its FX unit. Specifically, Citigroup noted in May of this year and discussed in a Financial Times article,
"The Citi Economic Surprise Index is a perfect example of unique proprietary design which has almost no bearing on those who discuss it. The models were built by quantitative analysts in Citi’s FX unit and were structured for currency trading. Thus, if the CESI wiggles one way or another, investors get signals to buy the yen or the euro or the loonie, etc. It was not meant to be used for stock prices or for Treasuries, but coincident rather than causal relationships are relied on even if they have no consistency whatsoever."
Bloomberg defines the CESI as follows, and note the FX reference,
"The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance [been] beating consensus. The indices are calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets."
Lastly, I have seen variations of the below chart circulating recently noting the positive reading on the various Citigroup Economic Surprise Indices.


Certainly, the indices readings are a positive from an economic data perspective, however, the construction of the CESI means equity market or economic conclusions should not be drawn from this data point in isolation. In fact, it is critical to understand the construction of the various economic and market models in order that proper conclusions are drawn from them.



Saturday, October 14, 2017

Synchronized Global Growth

Much of the sentiment and global market data continues to come in on the positive side of the ledger. Friday's University of Michigan Consumer Sentiment jumped six points to 101.1 for October and is the highest reading in thirteen years. As reported by Econoday, "The expectations component is up nearly 7 points to 91.3 with the component for current conditions posting a nearly 5 point gain to 116.4."


In reviewing the Global PMI's for Manufacturing, as of the end of September, the below table shows all of the PMIs are in excess of 50 which suggests improvement versus deterioration in the manufacturing sector. PMI's are leading indicators with health in the manufacturing sector providing insight into sales, employment, etc. The common surveyed questions center on new orders, manufacturing output, employment, suppliers' delivery times and inventory.


The positive sentiment and economic data has translated into positive equity market returns around the world. All of the 45 country Exchange Traded Funds (ETFs) at the following link are showing positive returns year to date through October 13, 2017.

The economy is not the market and vice versa; however, the positive sentiment and positive economic data currently being reported is translating into higher equity market prices. The lack of market volatility is certainly something that will not persist forever. Maybe the Fed's desire to reduce its balance sheet will result in higher equity market volatility. A correction or pullback near term would be healthy, noting the average intra-year pullback is just over 14%.


Tuesday, October 10, 2017

A Decline In Small Business Optimism

Today, NFIB reported the September Small Business Optimism Index results and they showed the Index fell 2.3 points to 103, which was below the lowest consensus forecast. In spite of the decline, the index remains at a high level as can be seen in the below chart.


A larger percentage of the index components declined in September as the report noted,
"Six of the 10 Index components dropped in September. Three improved, and one remained unchanged. The bright spot last month was inventory plans, which gained five points as more business owners anticipate a strong 4th quarter."
Below is  a table showing the component changes from August.


One concern in the report is the difficulty firms are having finding qualified workers. Nineteen percent of owners indicated this was their single most important business problem behind taxes. For construction and manufacturing, it is the top problem in these two industries.

And finally, small business optimism is tracked as small businesses are the job creators in the economy. The December 2016 report that was released in January of this year pushed the NFIB Index to one of its highest historical levels. The S&P 500 Index's one year subsequent return from these high NFIB readings is displayed below. The market's performance since the December 2016 reading is tracking ahead of the market performance following the other four high readings.



Monday, October 02, 2017

Fall 2017 Investor Letter: The Hated Rally Continues

Our Fall 2017 Investor Letter has a music lyrics theme to it and since we have an age-diverse team as it relates to the employees of HORAN Capital Advisors so goes the taste in music for our colleagues as readers of the newsletter will find out.  As Chuck Prince, former chairman and CEO of Citigroup, said almost a decade ago,  "As long as the music is playing, you got to dance." This seems to be one of those markets where the music just doesn't seem to stop and just maybe has resulted in one of the most hated equity market rallies in some time.


The Fall 2017 Investor Letter touches on a number of topics, including the unwinding of the Fed's balance sheet, low interest rates and the negative impact on income generation for investors and the benefit achieved by investors that have pursued diversification outside of the U.S. equity market.

For additional insight into our views for the market and economy, see our Investor Letter accessible at the below link.


Thursday, September 28, 2017

Shifting Investor Sentiment

It seems the market's consistent bid to move higher this year might be confusing the individual investor. That is, the fact the market has escaped any material pullback this year may be weighing on consumers in that they are prepared for or expect a pullback. As the below chart shows, the market has avoided such a pullback of more than 3% so far this year.


This lack of volatility has not translated into a bullish individual investors though if the American Association of Individual Investors Sentiment Survey is a guide. This week's sentiment report shows bullish sentiment declined almost seven percentage points to 33.3%. Most of this decline showed up in an increase in the neutral reading with a 5.3 percentage point increase to 37.9%.



With the strength of this year's market return that actually began in February of last year, one would expect the individual investor to be bullish on equities. Remembering the sentiment reading is a contrarian one, high bullishness readings can be a negative for future equity prices. Excessive individual investor bullish is certainly not the case at the moment if the survey readings are to be believed.


Wednesday, September 27, 2017

A Recession And Equity Market Bubble Five Years Ago Did Not Materialize, Now What

I was communicating with a client today who reminded me of a conversation we had five years ago almost to the day about whether or not the U.S. equity market was in a bubble. The discussion was prompted by the USA Today article, Consumer Sentiment Stat Hints that Bull Market May be Stalling Out, that highlighted a data point from the recent University of Michigan Sentiment Survey. In the survey it was noted that 65% of individuals surveyed believe stock prices rise over the next twelve months. This is a high level for the survey and a contrarian data point for stocks. The conclusion from that 2012 conversation was equities were attractive and our firm wrote as much in our third quarter 2012 newsletter. Additionally, I shared a Fidelity white paper, U.S. Equities: Light At The End Of The Tunnel. An interesting read in retrospect.

Much was occurring in 2012 with the 10-year Treasury yield below 2% and the Federal Reserve providing massive monetary support (QE) to the economy, i.e., buying $40 billion of mortgage bonds each month. This was occurring on the back of an equity market that was up 100% from the March 2009 low to June 2012. Both print and television financial commentary at the time was intimating concern for the markets.



A CNN Money article from September 2012 was titled, Stocks End Week At Multi Year Highs. In the article a link was provide to, Are Investors Getting Too Greedy which referenced CNN Money's Fear & Greed Index that was flashing an extreme Greed level of 93. Several weeks later and into the first week of October 2012, Sam Zell, Chairman of Equity Group Investments, stated in an interview on CNBC, "We're heading for a recession and that's exactly what you're looking at now."

Five years after 2012 to today and following all the consternation about bubbles, corrections and recessions, the U.S. equity market (S&P 500 Index) is up an additional 87% and the economy has avoided a recession. Certainly the period from 2015 through the third quarter of 2016 was a choppy one with the S&P 500 Index trading mostly sideways for almost two years. But so far in 2017, U.S. stocks seem to know only one direction and that is up, with the S&P 500 Index returning just under 13% on a price only basis with very little downside volatility


Raising the bubble question now is even more appropriate today then it was five years ago given how far the equity markets have risen over the last five years. Also, market data is decidedly different and is summarized below. Some of the data was taken from the earlier cited Fidelity white paper. If any variable in the below table jumps out at readers, it should be the higher valuation of the S&P 500 Index based on the price earnings ratio or P/E, 56.5% higher, while earnings are higher by only 17.5% during the same time period. In other words, the market advance over the last five years has largely been supported by multiple or P/E expansion. Sentiment data is also more bullish at the moment, but not at a level that has historically been associated with a bear market type downturn.


Certainly given current market valuation levels, earnings growth will be important for strong S&P 500 Index returns as we look ahead. Twelve month trailing earnings as of June 2017 does capture the energy weakness in 2012; however, when evaluating the year over year June 2017 to June 2018 estimated operating earnings growth rate for the S&P 500 Index, earnings growth is expected to equal about 18% and in line with the forward P/E. On a calendar year basis, comparing 2018 to 2017, earnings growth is expected at a respectable low double digit growth rate.

In a couple of recent posts I have noted the Fed's desire to actually begin withdrawing liquidity from the market and they announced as much in last week's Fed statement with a start date beginning next month. An old adage that gets repeated around Fed accommodation changes is, 'don't fight the Fed'. Just as the Fed has been supply liquidity since the onset of the financial crisis, and this has likely had some positive impact on asset prices, withdrawing liquidity can be disrupting on the way out. We will be on guard for potential asset price volatility, but will note, historically, stocks have been positively correlated to the rate moves when they occur below 5%.

In summary, we were strongly bullish in 2012 given equity valuations and a high equity risk premium. We do not expect a recession near term, but believe today that more pressure falls on companies to generate earnings growth, which we do think is likely, but probably not a market where a rising tide raises all boats.


In client accounts we have reduced some equity investments where we believe earnings growth is more challenged  and taken profits in some stocks that have moved higher and gotten ahead of valuations. At the same time, we have allocated equity investments to developed and emerging international markets over the last 18-months or so. This allocation adjustment has been a positive for clients and we continue to find valuations outside the U.S attractive.


Sunday, September 24, 2017

Higher Bond Yields A Headwind For Technology Stocks

In a recent note from the John Murphy of the stockcharts.com website ($$) he notes technology stocks tend to have an inverse relationship to bond yields. In his commentary he noted,
  • "One of the lesser known intermarket principles is the inverse link between bond yields and technology stocks' relative performance...Growth stocks like technology...do better in a slower economy which is usually associated with low interest rates."
  • "Value stocks (like banks) do better in a stronger economy with rising bond yields...Rising global bond yields could make the going tougher for technology stocks."
The below chart was included with his comment and shows the inverse relationship between the 10-Year Treasury yield (red line) to a ratio of the Technology SPDR (XLK) divided by the S&P 500 Index. Jon Murphy notes, "Rising rates this past month may again be contributing to tech selling, especially with a more hawkish sounding Fed. The inflationary impact of rising energy prices may also give the Fed more cover for a December rate hike."


Weakness is beginning to show in some of the large cap technology stocks. Below is a chart of the average return of Apple, Alphabet and Amazon for month to date in September. This time period is a short three weeks, but the performance of large cap technology stocks is something investors will want to follow as the last three months of the year unfold.


Disclosure: Firm/family long AAPL, GOOGL


Sunday, September 17, 2017

Market Is In An Uptrend And Trends Tend To Persist

One strategist I read regularly and who prepares weekly technical commentary, Charles Kirk at The Kirk Report, had a reference in this week's report relative to the strength of the current market. Kirk highlighted the below quote from James DePorre,

"If you simply focus on what the pricing action is saying, then your job of profitably navigating the market becomes a lot less complex. The simple fact is that we are in a very long-term uptrend, and trends tend to persist. The media might have all sorts of headlines to create their narrative, but all we really need to know is that the odds favor the bulls in an uptrend and vice versa. At some point, that pattern (and trend) will change, but trying to predict it ahead of time is a hard way to make a living."
The quote is certainly applicable in the equity market environment investors are currently experiencing as corrections and pullbacks seem to be nearly few and far between. I noted this lack of volatility in a post late last week, The Risk Of De-Risking The Equity Portfolio. And as it relates to trends, over the long term, the market trend is one that moves higher as can be seen in the below chart. An important observation from the below chart is the fact the line mapping the current market advance falls between long term support (green line) and resistance (red line.) So one might say the market is neither oversold or overbought from a technical perspective when only evaluating the below chart.


Saturday, September 16, 2017

Stocks Need Some Healthy Competition

It seems a day does not go by where various strategists lament the market's valuation and lack of any significant pullback in over a year and a half. Not only are the valuations of a number of equity indices above their long term average, some might say the valuations are indicative of the speculative froth in the market. One data point highlighted is the margin debt level. Certainly margin debt has increased as can be seen in the first chart below. However, the second chart shows that margin debt as a percentage of total equity market capitalization has remained fairly stable since 2010. A good article on evaluating margin debt can be found in a MarketWatch article from a few years back, Cash vs. margin debt is the real problem for this market.