The themes moving the market today remain the prevailing themes for the quarter. » Read More
Industrials: there is a change in tone. I've been talking this week about watching what the big industrials have to say about the global economy.
The markets have recovered. We are a long way from the worries about a global recession that dominated markets in February.
But is there really any signs of improvement, even modest improvement? Last quarter, conference calls were dominated by phrases like "cautious."
Has the message changed? Yes, modestly.
It started this week with Illinois Tool Works, which reported Wednesday. Management repeatedly stated that conditions were " firm" and "stable" in most end markets, but were "not accelerating."
OK, that's better than "cautious."
General Electric reported today, and reaffirmed full year guidance with respectable organic growth of 2-4 percent. On the conference call, GE CEO Jeff Immelt was blunt in calling the oil & gas business "challenging," but he also said the aviation business was seeing "sustained strength," that healthcare was "rebounding" and that he was seeing "improvements in our business" in China. Overall, Immelt concluded "there's plenty of business out there to achieve our goals."
That is marginally more positive than last quarter.
Even companies that have had a tough time are modestly more optimistic. Take Caterpillar. No one is trying to gild this lily: there were sales declines in all the key businesses, including construction, oil and gas, mining and rail.
But CEO Douglas Oberhelman came on our air and said, "Overall I think we are close to the bottom." He talked about a bounce in China,
good orders in Europe, while acknowledging that Brazil was still bad and mining was flat.
For a company that has seen declining revenues since 2012, saying we are close to a bottom is a definite change in tone.
For Honeywell, each of the segments exceeded the sales guidance they provided earlier in the year. Earnings were up 9 percent year-over-year; HON has been a consistent earnings grower. The two biggest sectors by revenue showed respectable gains: Aerospace had 3 percent organic growth, while automation and control solutions saw organic growth of 4 percent.
On the conference call, Honeywell officials noted that growth "accelerated" in key categories like aerospace. They raised the low end of their 2016 earnings guidance, expecting earnings to grow 7-10 percent. Core organic sales guidance is 2 percent in the second half of the year, better than the 1 percent growth in the first quarter.
In energy, Schlumberger CEO Paul Kibsgaard, on the conference call last night, said that the oversupply in the oil market will narrow to zero by the end of 2016. "So yes, we believe and I think we agree with you that the oil market is in the process of balancing," he said in response to a question.
So what's this mean for the markets? There's a change in tone, however modest, and that's a good sign for earnings in the second half of the year and increases the chances that we can end this earnings recession (four consecutive quarters of earnings decline in the S&P 500).
There's two problems. First, many investors have anticipated a modest uptick in the global economy and started buying these names when they were beaten-up at the end of February at what now looks like a bargain-basement price. As a result, the stocks are not cheap anymore.
(forward P/E ratios)
Illinois Tool Works 18.9
The second problem is that the whole world has become a momentum investor, and will dump stocks with perfectly good earnings reports that have run up in anticipation of a decent report.
This was the problem with Google , Microsoft , Visa and Starbucks all of which are trading down today as growth was just not quite as strong as the most bullish holders of the stocks anticipated. Not surprisingly, none of these are cheap either.
But have you noticed something? Despite big declines from these huge names, the S&P 500 is trading on either side of up or down a half
percent through the morning. There almost two stocks advancing for every one declining on the NYSE.
Surprised? Everyone is looking for some kind of correction due to weakness in those stocks, but it's not happening. Investors want to own stock! The pain trade still appears to be higher.
Utilities and defensive names: is the party over? Utilities are again melting down as Treasury yields rise. The Dow Jones utilities index is down another 2 percent midday after dropping 2.5 percent Wednesday.
What's up? A sudden rise in the 10-year yield yesterday, which is continuing today, is the likely culprit. We went from 1.73 percent to Thursday's 1.87 percent on the 10-year note in 24 hours.
The opposite happened, though over a longer period, in February. As Treasury bond yields dropped in February on recession fears, investors dumped massive amounts of money into Utility ETFs and other defensive sectors like consumer staples.
The prices also rose. The Dow utilities index rose almost 10 percent in February and March, as did select consumer staples like Colgate, which rose in January and February as the broader market declined.
The result: valuations rose rapidly. Many of the big utility names are trading at 17 to 18 times forward earnings, well above their traditional range of 15 to 16 times. Colgate is at almost 25 times forward earnings!
Then there's the final piece of sector-specific news for Utilities: earnings. Electric and gas utilities are beginning to report, and analysts I have spoken with have indicated that the warm winter didn't help any of them.
You can see this in the report today of Unitil Corporation, an electricity distributor that operates in New England. They reported much lower energy usage for heating related purposes due to the unusually warm weather; the stock is trading down over 8 percent Thursday.
Bottom line: with utilities, you have a combination of 1) warm weather hurting earnings, 2) high valuations, and, most importantly, 3) a move up in interest rates, which are causing yield-hungry investors with itchy fingers to pull the trigger and get out early.
Finally, with about one-fifth of the S&P 500 reporting earnings, you can throw in a growing realization that the earnings guidance in general is somewhat more positive than expected. Bingo. Rotation time!
OK, we are not there yet. They are getting out of defensive names without piling into cyclicals. But watch this space for signs of moves into the cyclicals like industrials, materials, and consumer discretionary.
Can earnings from industrials push the markets to historic highs?
Last week, it was bank stocks that moved on earnings. This week, it may be industrials.
Positive commentary from this group may be enough to lift the Dow and the S&P 500 into record territory. We are very close already.
Here's the issues with big global industrials:
1) There's been a huge downturn in their end markets. Spending on energy, mining, power, and infrastructure-related projects got cut all over the world, particularly in emerging markets. Inventories built up dramatically.
2) Earnings for the entire sector got slashed big-time last year, and the stocks fall apart. Analysts predictably overreacted and cut estimates too much. When traders realized this in mid-February, they bought the stocks back, big time. ITW, for example, went to $105 from $80.
3) Investors typically overshoot the mark on the upside, hoping that growth will resume. The recovery in growth tends to last longer and go deeper than anyone expects. Investors fret and have to decide if they want to hold, or buy even more.
The central problem is figuring out much growth there will be.
Take Illinois Tool Works, one of the great industrials of the world. They are in everything: construction, automotive, commercial food equipment, adhesives, sealants, lubricants, welding equipment. They are everywhere: half their revenues are in the U.S., a quarter in Europe/Africa/MiddleEast and a quarter come from Asia.
If there is a sign of a global slowdown, or a global recovery, they will see it.
Oddly, the stock is at an historic high Tuesday. Why?
The key point helping markets is the expectation that rates will indeed remain lower for longer. This means that investors will pay higher multiples for low risk assets that offer any kind of growth — even modest growth. Earlier in the year, ITW's management guided to 1 percent to 3 percent organic growth in 2016. But its 2017 projection of 5 percent growth — along with some margin expansion — is key to investor attention.
And that's it: modest organic growth, some margin expansion. Caution on capital spending.
Not very exciting, but in a world of 2 percent to 2.5 percent GDP growth for the U.S. and flat growth elsewhere, that's what an investment looks like.
The downside is that valuations are pretty full for those that offer any kind of growth. Many of these Industrials are trading at 20 times 2016 earnings. ITW is at more than 19 times 2016 earnings.
Why buy at these inflated prices? One veteran analyst said to me that the only thing worse than buying ITW (or other industrials) at or near its all-time high in this environment is NOT buying it. There are not a lot of alternatives for idle cash, so, you stick with better quality names with modest growth expectations.
Remember: there is a big penalty for underperformance. You are not going to beat your bogey if you carry too much cash.
I know it sounds like pretty thin gruel, but those kinds of modest growth expectations may indeed be enough to get us another leg higher, into record territory.
Remember, this is exactly what happened with banks last week. Very modest commentary on loan growth and the economy was enough to lift bank stocks 4 percent to 6 percent.
And if someone like GE CEO Jeff Immelt on Friday implies the global economy is in better shape than, say, three months ago, that may be enough to get a few percentage points gain in GE and propel the Dow to new highs.
It's a well-worn piece of Wall Street mythology by now: We are in a profits recession.
The S&P 500 has seen four consecutive declines in quarterly earnings. First quarter 2016 earnings are expected to be down roughly 8 percent, following a 3.8 percent decline in the fourth quarter of 2015.
There's a reasonable shot that might be about to change, however, and that may be a motivating factor in the markets march toward historic highs.
That's right — historic highs, because we are very close. The Dow passed 18,000 yesterday, a mere 300 points from the closing high of 18,312 on May 19 of last year. The S&P 500 is less than 40 points from its historic high of 2,131, as well.
Earnings, and more importantly second-quarter guidance, are the key to pushing the markets to new highs. Financials rallied last week as the biggest banks reported modest gains in loan growth, despite flat net interest margins. A little better than expected was enough to move this unloved group up.
Well, this wasn't supposed to happen. Oil was supposed to be down big if there was no Doha agreement, right?
Except it's not. Oil is closing in the regular session down only 1.5% And instead of a selloff in energy stocks, they are leading a modest market rally.
What happened? Blame it on the so-called "smart money," which appears to be wrong again. The smart money bet — correctly — that there would not be any agreement in Doha.
But then a funny thing happened. Oil dropped in early trading but quickly started turning around.
The low print in oil was at the 9:30 a.m. market open, but if you look at oil-related ETFs like USO you can see volume really picked up immediately after that and then again after 11 a.m., when oil started climbing above its earlier lows.
In other words, it looked an awful lot like the smart money was short oil into the Doha meeting. When there was no real selloff, the shorts covered quickly.
And you can see this in energy stocks, which are leading the market to the upside.
What happened? Everyone keeps talking about the strike in Kuwait, and there may be something to this, depending on how long the strike lasts. Kuwait produces about 2.8 million barrels a day, and if half of that could go offline, that's significant.
Also, the market doesn't seem to believe that oil will degenerate into "everyone for themselves" or that this threat is a paper tiger. Maybe countries like Saudi Arabia and Russia are already at peak production, so they can't really bring more crude on line?
But there seems to be something else going on: there's a broad market uptrend still unfolding. The advance/decline line is still in an uptrend. We have not had significant breakouts in indices, nor in the New High list, but the trend seems to be up.
Much of this bullish talk is based on the hope that earnings for the broader market — particularly global Industrials — will be a little better than expected, just as they were for big banks last week.
There's early talk that the Q1 2016 earnings season — four consecutive quarters of declines — may be the bottom of the profits recession. Is there much to support that claim? No. But that's the whisper trade.
There's a problem with earnings this season: stocks are trading at the high end of their trading range and are also expensive.
The failure of the Doha meeting to produce a production freeze is causing a predictable drop in Energy stocks worldwide, though perhaps not as much as market participants were talking about last week. High-beta names like Chesapeake Energy and Devon are down about 4 percent, but large oil like Chevron started down only fractionally and some have turned positive.
The big issue is, what happens to Energy stocks from here? A few thoughts:
1) The stocks have generally outperformed this year—The Exploration & Production ETF is up nearly 8 percent year-to-date, handily outperforming the S&P 500. Valuations are way ahead of themselves. Chevron, just as an example, is trading at a crazy 68 times 2016 earnings because everyone is assuming oil will recover toward the second half of 2016 and so big oil is being priced on 2017 earnings (Chevron is a more reasonable 20 times 2017 earnings). In other words—many of these stocks are already discounting a significant rise in oil.
2) How much more dilution? Several dozen Energy companies have issued more stock, the most recent of which was driller Ensco (ESV), which floated a secondary at $9.25 at the end of last week and was deemed a success. But remember: Ensco was $19 a year ago. It's pretty hard to argue that issuing stock at half the price a year ago is a victory.
3) More M&A? Maybe, but just look at what's happened to Halliburton-Baker Hughes. There's big political risk. Big oil is under a lot of scrutiny. Certainly with President Obama in the White House no big deal will get through without a fight. After November, maybe.
There's a similar problem with Industrials, which will begin reporting this week, including big names like Honeywell , Caterpillar, Illinois Tool Works and General Electric. With the exception of GE, which is flat this year after a spectacular 20% rally in 2015, these big names are up double digits:
Honeywell up 10.7%
Caterpillar up 15.2%
Illinois Tool Works up 12.8%
These stocks are rallying on two issues: 1) the lower dollar, and 2) less worry about a U.S./global recession.
But they seem to have overshot the target: most of the big names are trading at 19 or 20 times forward earnings. The problem is that the growth outlook still remains relatively weak, so we are expecting very modest top & bottom-line growth (low single digits at the very best). Throw in the fact that we are entering a seasonally weak period for the group, and we are left with the one hope that the commentary will be marginally above expectations.
But hey—that worked for banks, right? The SPDR Bank ETF, a basket of big bank stocks, rallied 7 percent last week because the news on bank earnings was less bad than feared. That could work for industrials—except they have already rallied as the banks were rallying. The SPDR Industrials ETF was up 2.5 percent last week while the S&P 500 was down fractionally.
See the problem? Stocks are trading at the high end of their trading range (near historic highs) and are also expensive (or at least "not cheap") by historic standards. It's hard to argue for stocks to break out convincingly without clearer signs of an economic breakout, which remains stubbornly elusive.
That's why so many strategists see a trading range for the remainder of the year. Hey, it could be worse. We were talking recession in February. A "solid hold" is a lot better than two months ago.
The IPO market is finally thawing out.
Exchange operator Bats Global Markets on Thursday priced its long-awaited initial public offering at $19, at the high end of the price range of $17 to $19. The company earlier in the day increased the size of the offering from 11.2 million shares to 13.3 million.
Bats faces a lot of pressure two reasons. First, it tried to go public four years ago on its own exchange but failed due to a technology glitch. Second, it is the first significant IPO in four months, one of the worst IPO droughts in modern memory. So the entire market, and the IPO community, is watching how the offer will price and how it will trade.
If all goes well, the following week will see at least three more IPOs — MGM Growth Properties, a REIT that owns some of the biggest casinos in Las Vegas, American Renal, which runs kidney dialysis facilities and SecureWorks, the Dell security spinoff.
Is there a breakout developing?
It's early yet, but the news out of China — on top of modestly better earnings from JPMorgan — has traders talking about a potential for a breakout in the markets in the next several weeks.
Why? Because China has been a major source of market volatility, and if the positive China trade data is supported by additional data that will greatly change the tenor of the China discussion, which has been relentlessly bearish for over a year.
With other sources of volatility — the Fed, the dollar and oil — also less, well, volatile — there's now greater potential for a breakout than there has been in a long time.
You can see this in the collapse in volatility — the CBOE Volatility Index dipped below 14 this morning and is near a multi-year low. Volatility ETFs like the S&P 500 VIX Short-Term Futures Index have seen heavy volume in the last few months as traders have bought volatility to bet that oil, China, the Fed, the dollar or some combination would blow up the markets (VXX offers exposure to a daily rolling long position in the first and second month VIX futures contracts).
But those bets seem to be unwinding today.
To be sure, we are not there yet. New highs have been modest on both the NYSE and Nasdaq. There are no big breakouts yet in the global markets, though the FTSE All-World Index — a basket of stocks representing the global markets — is close to its highest level of the year.
Before everyone gets too excited, there are other risks sitting on the horizon. I highlighted two this morning:
1) political risk around the U.S. election and around the Brexit debate in the UK/Europe;
2) central banks ineffectiveness. Markets were EXTREMELY nervous last week when everyone saw the yen strengthening, despite efforts by officials to jawbone it down. Kuroda's credible is clearly at stake. This is not yet an issue for the ECB's Draghi or the Fed's Yellen, but it is a blip on the horizon.
Still, we are a lot closer to breakouts than many may be aware. The big breakout — a close above the May 21, 2015, historic high of 2,130.82 on the S&P 500 — is only 50 points away. That's only a few days of aggressive trading!
The two market-moving stories this morning are banks and China.
Chinese exports were much better than expected, and imports dropped less than expected.
China trade (YOY, in dollars)
Exports: up 11.5 percent
Imports: down 7.6 percent
But this is quoted in dollars. In Asia and especially in China, everyone looks at the data in renminbi terms, and the numbers are quite a bit better.
China trade (YOY, in CNY)
Exports up 18.7 percent
Imports down 1.7 percent
On this, China markets were up strongly. There was a short squeeze in Hong Kong, with markets up there 3.2 percent. The Shanghai Composite rose 1.42 percent, and the Shenzhen was up 1.35 percent.
Oil spiked on Tuesday as Russia's Interfax news agency said that Russia and Saudi Arabia had agreed on a production freeze ahead of the upcoming OPEC meeting in Doha, regardless of whether other OPEC members participate or not.
Oil immediately spiked to its highest level since December. More importantly, it moved over the 200-day moving average for the first time since October 2014.
In a range-bound market, a breakout to new highs is a big story.
Never mind that neither the Russian nor the Saudi oil minister confirmed this story. Traders seemed to have convinced themselves that there will be a deal out of Doha.