Earnings Growth Ahead Despite Shutdown │ LPL Market Signals Podcast

John Lynch:         Over the last 20 shutdowns, 12 months following the shut down the S&P 500 was up 13%. The average return is approximately 8%. We've got about a 500 basis point bid. I don't know if we can assign attribution of causation to that. What the historical data is telling us, that it's not crippling for the financial markets. From LPL Financial, welcome to Market Signals. I'm John Lynch.

Ryan Detrick:     I'm Ryan Detrick.

John Lynch:         Hello Ryan.

Ryan Detrick:     Hey John. Good morning. How you doing today?

John Lynch:         I'm pretty well. Thanks. How are you?

Ryan Detrick:     I'm doing well. I mean ... What else did you do this weekend John?

John Lynch:         This weekend, kind of recovered, kind of relaxed. It was kind of fun. Had been in DC the week before. We had some good meetings with many of our investors and advisors. That went over very well. DC wasn't very crowded. Could get around DC pretty easily with 800,000 less cars on the road, unfortunately for those people. Hopefully, we'll get to some clarity on that soon. In fact, one of the main topics we're gonna be discussing is the government shutdown. Tell me a little, bit about your week. I was in DC. You were a little farther north.

Ryan Detrick:     That's right John, I was. Obviously, we're down here in Fort Mills, South Carolina, a little warmer. I got to up to Green Bay, Wisconsin, the Appleton, Wisconsin area for an advisory event. It was some of, advisors would present. It was a lot of fun. I just talked with you before we started recording. I hopped in the rental car and drove up and saw Lambeau Field. I've never seen it. I just wanted to check it out. It almost gives you chills. You turn off the highway, you turn right and boom, there it is. It was really neat to see Lambeau Field. It was cold. I walked around, got a few pictures like, "Man. I'm glad to be leaving," cause [crosstalk] it was a little chillier what I'm used to.

John Lynch:         They didn't call security on you?

Ryan Detrick:     Well, no. Not this time.

John Lynch:         No incidents that I need to know about?

Ryan Detrick:     Nothing. Please the fifth. Everything was pretty good.

John Lynch:         Convicted never, right?

Ryan Detrick:     Exactly. It was icy. I was like, "Wouldn't it be something if I walk around and I slip and fall on and break a wrist in Lambeau Field's parking lot." I thought that's be almost kind of funny, in a, weird way, but I fortunately did not fall. It was definitely icy. Some black ice in that parking lot. No doubt.

John Lynch:         You might have had to wait till September for someone to find you right? They're already done with their season.

Ryan Detrick:     There were actually a lot of cars in the parking lot. I was wondering the same thing. They just hired a new coach. Maybe he was there. Who knows.

John Lynch:         All right, well good deal. I'm glad you're home safe and warm as I'm sure your family is. Well, on this week's edition of Market Signals Podcast, we wanna talk about the government shut down. Also wanna talk about the very impressive market recovery we've had from the Christmas even lows, but also recognize that some of, the challenges that remain and then finally a fundamental or two that could really help the market push through even higher will be corporate profits, which will start to be released this week. Let's get started with the government shut down Ryan. What's some of, the work you've done on that?

Ryan Detrick:     Well John, first things first. As the time of this recording, it's official the longest government shut down ever at 24 days. 21 was I believe was the previous record. What we've kind of ... You and I discussed this before over the previous couple months, talking about potential government shut downs and just that usually stocks take it in stride. I know you've got some numbers that we just wrote in one of our weekly economic commentaries, but the one thing I pointed out, the last five times we had a shutdown stocks, were actually higher. Now, the average government shut down is about eight days. Most of them are two to three days. This is longer.

John Lynch:         Right.

Ryan Detrick:     John, potentially stocks ... Again, let's be honest, stocks are taking this one astride too, right? We've had a big bounce. There's other reasons Markets [inaudible] I think than a government shutdown, but once again it's another good reminder that government shutdowns are important. We're not minimizing the impact it could have to specifically the people that obviously are not getting their paychecks. Stocks seem to be taking this one astride as well. What about longer term though? Could it impact the economy?

John Lynch:         Well yes. There's always concerns about consumption. We don't wanna be dismissive of the pain 800,000 families are feeling, without getting a paycheck.

Ryan Detrick:     Right.

John Lynch:         That's not something to be dismissed from an economic impact. What is it, 1/10th of one percent potential over a three or a four week period. We see limited economic damage from that standpoint. As you pointed out, the last five government shutdowns, market was essentially flat or rose positively, right?

Ryan Detrick:     Right.

John Lynch:         We did some work late last week. That's announced in this week's weekly economic commentary from LPL research, and found that over the last 20 shutdowns, 12 months following the shutdown, the S&P 500 was up 13%, and the average return is approximately eight percent. We've got about a 500 basis point bid. I don't know if we can assign attribution of causation to that.

Ryan Detrick:     Right.

John Lynch:         What the historical data is telling us, that it's not crippling for the financial markets. I think that's something to keep in mind. Obviously, sentiment has been fractured over the past month or two, given market performance. While government shutdown can add to the headlines, add to the duress, emotionally that many investors are feeling, fundamentally we've not found it to be justified to really disrupt things longer term.

Ryan Detrick:     No, that's right John. You know, you talk about kind of what some of, the economists out there are saying with the fourth quarter GDP. I mean, [Jeff Buchbinder], our senior market strategist on staff has pointed out, fourth quarter GDP is really about the same, right? It's not like economists are saying this is gonna have a big impact on necessarily the economy going forward.

                It looks like, according to the data we did John, 12 of the past 20 shutdowns actually had a higher S&P 500. We'll see if we can get some type of resolution regarding the shutdown here. Consumption obviously drives such a big part of the overall economy. We still see consumption. It's not like this is really impacting the average consumer quite yet. Should this reach a whole month, you know, five weeks, could it potentially start to impact, you think some spending habits?

John Lynch:         Absolutely, to the degree that sentiment is fractured and we've talked about the possibly for self-fulfilling recessions, when we talked in our last podcast about bear market without recession. We addressed the possibility that, that could be the case if consumers stop spending, businesses stop investing. We still maintain that the more important driver for the economy, not only in 2019, but for the economy to extend the length of the expansion is whether, or not businesses are gonna start investing again. Capital investment was up. Business expenditures were up 10% in the first half of the year. Essentially ground to a halt, maybe 80 base points or up one percent in the third quarter.

                We're waiting on the fourth quarter data now. The industrial production was up, which kind of was a nice offset to the weak manufacturing data. To the degree that we get clarity on trade, that businesses therefore will be more apt to take advantage of immediate expensing and some of, the tax incentives for investment as well as utilizing some of these repatriated assets. It takes a while to put it to use. We don't think all of it's going to CapX by any stretch. If a third of it goes to CapX, at all, so should bode very well for economic activity. Business investment really is the key.

Ryan Detrick:     Right. Now, you know one other potential negative from a government shutdown is some of, the economic data is on hold, right? We've got the fourth quarter GDP number that comes up, I think it's January 30th. If the government's still shut down, we probably don't get that number.

John Lynch:         That's right.

Ryan Detrick:     Fun little stat. Usually, Jobs Friday, right? That's comes out the first Friday of the month, when the jobs numbers come out. You look back in history, there are some times it wasn't the first Friday. Sure enough, that was during some government shutdown. There is the potential that some of this government data will be a little, obviously a little, bit delayed. I guess the good news is, it sounds like obviously tax returns [inaudible] W2's soon. It sounds like our tax returns are not going to be delayed. I'll tell you what, if that were the case, then I think people would be a little more up in arms real fast, but doesn't sound like that's the case here.

John Lynch:         That's true. That's true. When you think about GDP and you think about some of, the data that's already come out, we'll get retail sales middle of this week. We saw high profile retailer's struggle, but others did very well. Clearly we saw north of five percent on holiday sales. We saw a very good, or encouraging inflation number in the consumer price index recently. Inflation's clearly not a threat for the Federal reserve. That bodes well for increased expectations for a pause. We saw a great jobs number. We see good income numbers. Those all suggest we should print a two percent-ish type number for the fourth quarter in GDP.

Ryan Detrick:     Right. You talk about good news John. Maybe let's go to the next subject. Markets. Markets have bounced. We've-

John Lynch:         It's why we do this.

Ryan Detrick:     That's right. We've had three consecutive weeks of the S&P up at least one and a half percent. Been a while since we've seen something like that. Now, let's not forget. As we laid out, worst fourth quarter since financial crisis, worst December, pretty much in history, the first time since 1950. December was the worst month of the year for equities, looking at the S&P 500. We were historically oversold by a lot of different measures. At the same time, like you said, there's some positive new.

                Now we've had a pretty good rally. We don't like to always say ... Well, we say it like this. History doesn't always repeat, but it does rhyme. There have been sometimes, when you have a good start to a year. That can lead to continued strength. I was playing with some numbers, when the first five days of the year in the S&P are up over two and a half percent or more. The previous 12 times, the full year was higher.

                Last year ... This was back in 1950. Last year was the first time that didn't work. A lot of first times didn't work last year. Still, a good start to a year. It's a very small sample size. A good start to a year sometimes can be a good thing. We've had a good start to a year. Can this continue you think?

John Lynch:         Good start to the year, you can look at the election cycle as well. Third year tends to be strong. We've talked [inaudible] about the November, to November post-election rally, the market typically sees. We've also talked about average draw down in midterm election years, 16%. We were down 19.8% ...

Ryan Detrick:     Right.

John Lynch:         at the end of 2018.

Ryan Detrick:     That's the largest pull back out of the four year cycle is the midterm year.

John Lynch:         That's right. That's right.

Ryan Detrick:     Specified.

John Lynch:         12 months later, that average draw down is 16%, but 12 months later, you're up by a third almost, right? 32, 33%.

Ryan Detrick:     Right.

John Lynch:         You make that and more back. I think that's something to keep in mind. With this recent example, S&P 500 hit a low of approximately 2350 on Christmas Eve, intra-day low was maybe 2344, I believe was the number. That would have been the number that would have gotten us to an official bear market on the S&P 500. Now, we're not splitting hairs. The Russell, the NASDAQ and a handful of sectors did hit a bear market, but the DOW and S&P escaped the classic definition of a bear market.

                Nonetheless, we're up about 10% off those lows. The real key that caused us to pummel or to fall so severely, and to sell at such a ferocious pace, was when the S&P failed to hold, what we were terming the triple bottom, 2600 to 2620 on the S&P 500. We dropped through that like a rock, once we failed to hold it.

                As we recovered over these past handful of weeks, we've gained that 10% back. There was literally no resistance, because we dropped so fast and so far, that there were no base camps set up. Now, that we're in the 2600-ish range, Monday morning, January 14th, as we're taping this, it'll be interesting to see what is going to be required to push us through this technical resistance.

Ryan Detrick:     Right. You know, you talk about technical resistance. I mean, old technical saying is, previous resistance can be support or previous support can be resistance, like you said. We have a triple bottom. We'll call it the Halloween bottom, the Thanksgiving bottom, and the early December bottom. In the middle of December, that 2600-ish level gave way to the very significant sell off. And then, had a 10 rally in 10 days coming off of December 26 lows. Last time John, we had a 10% rally in 10 days, was July 2009. Obviously a very long time.

                At the same time, very small sample size. I get it, but not the worst time to be long. Just because you're overbought, doesn't mean you can't become more overbought. As we saw in the fourth quarter, when oversold can become more oversold. One thing ... I don't wanna get too technical in this podcast, but there's something called the McClellan Oscillator, and over bought, over sold indicator.

John Lynch:         You're getting too technical.

Ryan Detrick:     I'll keep it real simple. It was historically oversold, and then it became historically overbought within two weeks. That's really rare. That's something that you tend to see, at significant market bottoms, when the markets very oversold and becomes very overbought in the near term. I think we're in the process of trying to carve out those lows. Here's the question John, do we go back and test the Christmas eve lows you think? Is that something that's necessary for markets to form a real good bottom here?

John Lynch:         Retests of [crosstalk] ...

Ryan Detrick:     Not to put you on the spot here.

John Lynch:         Yeah. Retests of lows, are not the exception, they're the norm, right? Investors need to be prepared for that. We wrote that in our client letter, we wrote that in some things that we're trying to get out to our investors. Retests are the norm. We have to be mindful of that particularly with the rapid pace with which we've rebounded.

                Now, what could cause a retest? Well, failure on trade, a more aggressive terrible earning season, which we don't project. The random unpredictable that happens on a Tuesday afternoon, that nobody saw coming. That would be a geopolitical source. Hopefully, that won't be the case certainly. Nonetheless, that is a possibility. We're trying to look at ... We call this market signals for a reason. Some of, the good things we've seen, that would suggest we could power through some of this upcoming technical resistance, whether you look at the performance of small caps, whether you look at consumer cyclicals, relative to consumer staples.

                Some of, the things that we'd like to see to help give the market more upward mojo, would be the percentage of companies trading at 20 day highs and to the degree we get half of those companies in the S&P 500 at 20 days highs, forward returns tend to be very positive. It seems to be more of a sustainable rally. A few concerns, copper is underperforming gold in the rally. The 10 year, two year spread isn't steepening to the degree you would think it would be, with the 10% rally in the markets. Not all the stars are aligned just yet. It's conceivable we could test the low again.

Ryan Detrick:     Yeah. You talk about the two/10 spread. Obviously that's more known as the yield [inaudible]. What we're getting at is the yield curve was flattening most of last year. That was concerning. Now, all of a sudden, we're not really getting a steepening yield curve. Also, you know, credit markets ... You think the bond guys are the smartest guys in the room. Bond markets were definitely flashing some worrisome signs back in the fourth quarter. What are the credit markets looking like now John? They've improved a little bit, but are they kind of that place where we feel a little more comfortable about stocks here?

John Lynch:         Yeah. [inaudible] are still a bump in the yield curve, a slight inversion of two or three basis points. I guess Fed funds in two's, two years treasuries are now hovering at that level as well. When I say credit, we don't see credit to fall swap spreads blowing out right? I think that's an important development. While we've seen investment grade and high yield spreads, increase over the past couple of months, they're really only increasing to historical averages.

Ryan Detrick:     Exactly.

John Lynch:         If either of those areas got out of whack, it was high yield. They kind of came back. Those spreads probably got as high as 525, 525 base points. Interest rate differential from the average high yield, to the 10 years treasury. That's come in to about 475 base points over the last week or two.

Ryan Detrick:     Right. Let's not forget high yield has a large energy component to it.

John Lynch:         That's exactly right.

Ryan Detrick:     Clearly in the fourth quarter, we had a really big sell off in crude oil. Crude oil's bounced back up above 50 dollars a barrel. If crude oil, that's one of the concerns in the fourth quarter. We had the Fed, we had China, we had crude oil. Well crude oil [inaudible] kind of flying some type of, a low here which it looks like it is. That probably will help the high yield markets and those credit spreads and be one more positive. John ...

John Lynch:         That's also a big thing if I may.

Ryan Detrick:     Sure.

John Lynch:         The whole idea with energy ... You never, wanna say it's different this time, but it is different this time. Now that the US is the world's ...

Ryan Detrick:     Thought you said you don't wanna over say that.

John Lynch:         The world's largest producer of oil. We're the largest swing producer, meaning we can take fields on and off more quickly than many of our global competitors. To the degree that lower oil prices were always good for the economy. The consumer had more money, cause they weren't spending as much on gasoline, it's critical that oil be north of 50 dollars a barrel, because that's if you will the demarcation line for capital investment. Energy related CapX, is such a large portion of our call for increased investment from businesses in the next year or two. Consequently, now that oil is back above 50, the big producers are less apt to cut capital expenditures for energy related investment.

Ryan Detrick:     Right. It's obviously a big level. We'll keep watching that. John, we've got a few more minutes left. Let's go to the next thing here. We hinted that, the next big driver for markets very well could be earning season. Earning season kicks off later this week with most of the financials coming out on earnings. I'll set the stage. I'll hand it off to you.

                The last three quarters, we've had about 25% year over year earnings growth, really solid earnings growth. Now, the fourth quarters coming up. We're looking for more mid-teens-ish area. Do you think we can top earning? 39 straight quarters now, earnings have come in better than the expectations. Could this happen once again? How is this earning season looking, shaping up here?

John Lynch:         Well, it's conceivable that earnings do come in better than expectations, because expectations have been low balled so much over the past three or four weeks, right? Everyone completely caved in, in December with the worst December in 87, 88 years for the S&P 500. Forecast did come down. Expectations did come down. Beating lowered expectations is a bit of a [inaudible] victory.

                Nonetheless, you have this opportunity for investors to just reassess and recognize that while the fundamentals supporting the economy and profits might be slowing they are still very much growing. I think that's a primary message we've got to get across to investors. We've typically seen this cycle earnings surpass expectations by about three or 400 basis points. If people are looking at 10 to 12% this quarter, it's conceivable we could see a 15% type number for the fourth quarter. It really comes down to guidance for 2019 ...

Ryan Detrick:     Right.

John Lynch:         Cause that's really what's been scaring people.

Ryan Detrick:     That's right. You know, we actually wrote in our weekly market commentary, this week, we took a look at earnings. We kind of noted, some of the positives on the earnings front. US economic growth, potential tax cuts are still there. Higher oil prices in share buy backs, all four of those, it's hard to pick a favorite. All four of those together, should show increasing earnings like you said, and probably come in a little, bit better than expected. I mean, out of those four John, what do you think? Which one is really gonna matter for the upcoming earning season?

John Lynch:         Well, I'm gonna add a couple things to that.

Ryan Detrick:     Sure.

John Lynch:         When you think about five or six percent sales growth and you look at margins, still north of 10%.

Ryan Detrick:     Right.

John Lynch:         To the degree, you don't have that margin erosion, that adds to again, you used McClellan Oscillator, so I'll say the elasticity of earnings, from a standpoint of a sustainability in margins that higher wages for example won't eat in, and to the degree that improved productivity which we have seen, in the second half of [crosstalk] 2018, yes. Exactly. To the degree you have improved productivity, the direct result of improved capital investment, that enhances output per worker. Any increase in wages doesn't eat away at margins, because workers are being more productive.

Ryan Detrick:     Right. I think we're kind of reached the end of the road here John. I do wanna say, next week, I won't be ... Unfortunately, I won't be on the podcast. I've got to do some travel. Jeff Bookbinder will come in and Jeff's obviously an earnings expert. I know you guys are dive a lot more in earning season and kind of what's happening. Maybe let's wrap it up like this. We've got earnings coming up. What other big events, so far the second half of January should investors be on the lookout for?

John Lynch:         Well, final thought on earnings.

Ryan Detrick:     Yes.

John Lynch:         There are articles in today's paper. We've been warning our investors about articles such as this, saying about peak and earnings, peak and earnings, [crosstalk] peak and earnings. We wanna make the distinction that's a peak and earnings growth. That may have very well have occurred in the third quarter of 2018, when profits were up, what 25, 26%.

Ryan Detrick:     I think it was 28, 29 [crosstalk].

John Lynch:         Yeah, on a year over year basis. Our emphasis for earnings is that profits in 2018, are at record levels. They may be growing, at or slightly above historically average levels in 2019, but they're still growing. When you do stock calculations, earnings calculations, you wanna take record profits, growing at or above historically average rates, yet you're discounting those at interest rates, which are still below long term averages, enhancing not only the present, but future value of that opportunity.

                I think that's something that investors really need to take to heart, and also recognize that when we looked at the last 10 profit cycles, in our midyear outlook, we found that the time it took from a peak and earnings growth, to recession averaged about four years over the last 10 profit cycles, economic cycles. Over that time period, the S&P was up by about half.

                One thing we can guarantee is that won't be a straight line. That's a cumulative return. That's, I think, something for investors to keep in mind. That's really when asset allocation and portfolio diversification and some tactical moves in portfolios rebalancing portfolios toward targeted longterm allocations. I think that's really what benefits investors over the longer term.

Ryan Detrick:     Right. No, you're right. I mean, that's a great way to sum it up I think, just cause earnings have "peaked" they're still growing. They very well could grow more than a long-term average. That's still a positive backdrop along with a lot of those other things we just discussed. We'll see John how much longer this government shut down goes. Definitely, everyone I appreciated being on the podcast this week. Check out our weekly economic commentary that takes a look at government shutdowns, our weekly market commentary that takes a look at overall earnings. John, I'll sign it over to you, to sign us off.

John Lynch:         Yeah. Thank you Ryan. Hopefully, everyone enjoyed this podcast, talking about the government shutdown, market recovery and what some of, the technical challenges are as we're rising into it. Some of, the fundamental supports, backing it, and then finally corporate profits, the driver of everything for equity. Earnings and interest rates. Thank you everyone. We'll look forward to talking to you next week.

                Well, that's it for this episode. Join us next week, when we'll continue to analyze and discuss market signals. Stay connected by following us on Twitter @LPL or @LPLResearch. Please subscribe wherever you get your podcasts. LPL Market Signals is presented and produced by LPL Financial. I'm John Lynch.

Ryan Detrick:     And I'm Ryan Detrick.

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