Sevens Report

Tuesday, 3 October 2017

Should We Buy Value to Get Growth?, October 3, 2017

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At the start of 2017, I incorrectly expected growth sectors of the market to outperform, as I anticipated inflation and economic data to steadily improve as the Fed continued to hike rates.

The latter expectation (Fed rate hikes) has been met, but the former two, until now, have not, as the dip in inflation and growth caused a drop in bond yields and resulted in the outperformance of defensive sectors (not growth/cyclical sectors) so far in 2017.

But things appear to be changing, and while past performance is no guarantee of future results, if we are on the cusp of a “reflationary” rally, then history suggests buying “value” funds will be the way to outperform into year-end.

On the surface, though, this doesn’t make sense. If we are going to see a reflation, won’t “growth” styles naturally outperform given the acceleration in inflation/economic activity?

The answer is “yes,” but here’s the rub: Growth-oriented sectors like banks and energy have massively underperformed this year and are now heavily owned by most value-styled ETFs. Meanwhile, growth-styled ETFs are heavily overweight tech, and stand to underperform in a reflation, just like they did in 2016.

The key here lies in the fund’s sector allocations.

My favorite “growth sector” ETF is actually the iShares S&P 500 Value ETF (IVE), which is allocated as follows: 28% financials, 12% healthcare, 11% energy. So, 40% of the ETF is weighed to sectors (financials and energy) that will surge in a reflationary rally. Conversely, utilities are just 6%, tech is 7% and consumer staples are weighted at 11%.

Up until September, this weighting has caused IVE to lag the S&P 500, but IVE rallied 2.7% in September, more than doubling the S&P 500. Looking further back, in the pro-growth, post-election rally between Nov. 8 and year-end 2016, IVE surged 17% compared to just 9% for the S&P 500.

Point being, lackluster inflation and economic readings in 2017 have created a scenario where outperforming sectors are predominantly “defensive” sectors. But, this big rally has caused these sectors (utilities, staples, super-cap tech) to be significantly underweighted in some value ETFs and mutual funds—and that creates this weird set up where getting exposure to growth sectors that can outperform in an economic reflation means buying “value” ETFs and mutual funds due to their recent underperformance.

So, as we start the fourth quarter, if you’re reviewing client exposure, don’t forget that “value” funds, if we see a confirmed economic reflation, will provide the exposure to growth sectors we need to outperform.

Food for thought.

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The post Should We Buy Value to Get Growth?, October 3, 2017 appeared first on Sevens Report.

source https://sevensreport.com/buy-value-get-growth-october-3-2017/

Monday, 2 October 2017

Weekly Market Preview, October 2, 2017

Friday, 29 September 2017

Virtuous vs. Non-Virtuous Reflation Trades

Can the economic data support a continued bullish “reflation” trade in the markets? So far, the events of this week (strong Durable Goods, “progress” on pro-growth tax reform) have supported that idea, and that’s why the S&P 500 is sitting at fresh all-time highs.

But, the next seven days will present both risks and opportunities for the reflation trade to accelerate, or falter.

In yesterday’s issue, I referenced a “virtuous” reflation trade—one that is positive for the broad stock market and especially positive for our reflation basket.

In this scenario, 1) Inflation firms and gradually accelerates, 2) Growth accelerates modestly, 3) Central banks gradually raise rates but not at a pace that unnerves the stock market or sends yields too high, to quickly.

That’s what we’ve seen from the data starting almost three weeks ago with the Chinese inflation numbers
(followed by firm British CPI and US CPI). That’s why stocks have rallied, and it’s why our reflation basket has outperformed.

Conversely, there is a “non-virtuous” reflation we need to be aware of. In this scenario, growth and inflation accelerate too quickly, and markets begin to price in a more hawkish Fed, ECB and BOE.

In this scenario, while banks and other ETFs listed in our reflation basket would either outperform on an
absolute basis and/or on a relative basis, the rest of the market might not fare as well (particularly tech).

This is what we saw in June, where the declines in tech weighed so much on the market that it began to “suck in” other, more cyclical sectors. This is the negative side of reflation we need to watch for in the weeks ahead.

Bottom line, the market now again nearing a tipping point, and the data today and next week will go a long way to telling us 1) Whether we’re seeing a legitimate reflation, and 2) Whether it’s virtuous (bullish).

The post Virtuous vs. Non-Virtuous Reflation Trades appeared first on Sevens Report.

source https://sevensreport.com/virtuous-vs-non-virtuous-reflation-trades/

Thursday, 28 September 2017

Reflation On? Why the Durable Goods Number Was Important, September 28, 2017

Durable Goods
• August Durable Goods rose 1.7% vs. (E) 1.5%.

Takeaway
Wednesday’s Durable Goods report was a surprisingly strong number, and if it’s the start of a trend in the data, then we could finally be seeing an economic reflation.

The reason the Durable Goods number was so strong wasn’t because of the headline (it was a mild beat, but revisions largely offset it), but instead because of the key New Orders for Non-Defense Capital Goods ex-Aircraft (NDCGXA). NDCGXA surged 0.9% vs. (E) 0.3%, and the July number was revised sharply higher to 1.1% from 0.4%, signaling that business spending and investment accelerated during the summer.

That’s a legitimately positive surprise, as business spending and investment have been lackluster so far in 2017.

But if we see that activity pick up (and importantly close the gap between actual data and survey data), then that will help push broad economic growth higher. And if inflation keeps accelerating, then we’ve got a legitimate reflation.

Stocks reacted accordingly to this surprisingly good data, as the market rallied (growth is good) and was led higher by our “reflation basket” of banks (KRE), industrials, smalls caps, and inverse bond ETFs. That carried through to other assets, as bond yields surged on the news to new multi-week highs while the dollar also broke above 93.00.

Bottom line, this was a legitimately positive surprise for markets, and stocks and the dollar/bonds reacted accordingly. However, one number does not make a trend, so we’ll need to see continued acceleration in other data (industrial production) before we can confidently say the gap between very strong, “soft” survey data and actual, hard economic numbers is closing in a bullish way. Still, yesterday’s number was definitely a good start.

The post Reflation On? Why the Durable Goods Number Was Important, September 28, 2017 appeared first on Sevens Report.

source https://sevensreport.com/reflation-durable-goods-number-important-september-28-2017/

Wednesday, 27 September 2017

Tax Cut Preview, September 27, 2017

Today we should see the next step in the tax cut drama, as Republicans unveil a more detailed tax cut plan. But while some of the headlines around this are sure to seem “pro-growth” and positive, it’s important to realize that almost nothing announced today will actually make it into any legislation (and it doesn’t remove the chances nothing gets done at all).

Still, tax cuts are the most credible and legitimate “bullish” or “bearish” wildcard remaining for the markers in 2017.

From a bullish standpoint, real tax cuts could easily push the S&P 500 up another 4% (to 2610) because that will increase expected 2018 EPS to (conservatively) $145/share.

From a bearish standpoint, while tax cuts aren’t fully priced into stocks, there is the expectation something does get done, especially regarding foreign profit repatriation. If tax cuts, like healthcare, fail, then we’re now sitting with a market at 18X next year’s earnings—and no identifiable future growth catalyst (and a Fed raising rates). That will cause investors to reduce exposure.

Regarding today’s announcement, here’s what’s (generally) expected:
1. Corporate rate cut to 20% from the current 35%.
2. 10% tax on foreign profits (this is the foreign profit repatriation piece).
3. Individual top rates cut to 35% from 39.5%.
4. “Pass through” rate cut to 25% from 39.5%.

Again, little (if any) of this will make into final legislation.

But, it’s the starting point for negotiations to a potential deal.

Bigger picture, the expectations for tax cuts (what makes them bullish of bearish) won’t change regardless of today’s details.

To review, from a corporate rate standpoint…

What’s Expected: Corporate rate cut to around 28%.

Likely market reaction: Mildly positive.

Bullish If: Corporate rate cut below 25%. Likely market reaction: Reflation basket outperforms.

Bearish If: Corporate rate doesn’t change. Likely market reaction: Modest Decline, but not a bearish game changer.

Foreign Profit Repatriation Holiday: Expected to pass.

Likely market reaction: (Withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

Wildcard to Watch: I was actually surprised and encouraged to see that a “pass through” rate cut is in this proposal. This is very important to small businesses (like mine). Approximately 95% of American businesses are “pass through” (LLCs, S Corps, etc.) where the business owner is taxed at the individual rate. So, in many ways that makes corporate tax cuts just important for large corporations and shareholders.

A cut to the pass through rate lowers taxes for small business, and that could be a potentially significant (and unexpected) positive for the economy, if any of this actually gets passed into law (and that remains very much in doubt).

Bottom line, don’t let positive (or negative) headlines fool you today. The tax cut fight has only just begun, but how it works out will have potentially significant consequences for the economy. We will remain on top of it for you throughout the process.

The post Tax Cut Preview, September 27, 2017 appeared first on Sevens Report.

source https://sevensreport.com/tax-cut-preview-september-27-2017/

Tuesday, 26 September 2017

North Korea Update, September 26, 2017

Starting at last week’s UN General Assembly, the war of words between US and North Korean leaders has been steadily escalating, but things got even more serious yesterday for two reasons.

First, the North Korean foreign minister said Trump had “declared war” on North Korea with his tweets.

Second, the same foreign minister said North Korea reserves the right to shoot down US bombers, even if they are not in North Korean airspace.

This is no doubt in retaliation to the US flying bombers very close to North Korea in a recent show of
force.

Of the two statements, the later is much more important than the former for this simple reason: The
war of words can escalate, but the event that makes North Korea a bearish game changer for stocks would be the firing (but not necessarily striking) of a missile or rocket at anything US, including planes or Guam.

The North Korean threat to fire a missile at US war planes operating outside of North Korean airspace ups
the ante and creates another opportunity for a potential incident.

From a market standpoint, despite the uptick in tension, and despite yesterday’s mid-day dip, I don’t think the North Korean threat is going to cause a pullback, at least not in its current situation. Taxes (will we get cuts?), rates (will they rise?), inflation (will it gain momentum?), the dollar (will it appreciate?) all are much more important in the near term for stocks than North Korea.

But, that said, clearly this is something that can still move markets and dominate the headlines, so we’ll continue to watch it for you and look for signs of it legitimately becoming a bearish game changer for stocks.

For now, and until North Korea shoots at something US, the situation remains more bluster than bearish (although it still makes me uncomfortable).

The post North Korea Update, September 26, 2017 appeared first on Sevens Report.

source https://sevensreport.com/north-korea-update-september-26-2017/