We still think margins can be in the 10% range, which is shocking 10 years into a cycle. Even if they slip to 9%, they’re still 50% above their long-term averages.- John Lynch – LPL Chief Investment Strategist
In this week’s Market Signals podcast, the discussion centers on moving equity allocation to market weight, the bond market, and some positive economic news.
Stocks are up 12% for the year — and more than 20% from December, as of March 22, 2019. Combined with weakening economic data and corporate profit outlooks, the LPL strategists have readjusted domestic equity allocations back to market weight. They note this doesn’t mean they expect a retest of the December lows. Nor are they calling for an end to the bull market or the economic cycle of growth. However, they believe the risk-reward trade-off for stocks has become a bit less attractive.
Last week’s global equity weakness generated lower yields. The German 10-year Bund yielded sub-0% for the first time since 2016. There were also new all-time lows in 10-year yields in Australia and New Zealand. In addition, part of the yield curve in the US moved to inverted.
It’s important to pay attention to these worries. But even as the global economy struggles with intensifying trade and political risks, US fundamentals remain quite strong.
There are more positives out there. The LPL strategists note that 12-month S&P 500 earnings per share have started to increase. Coincident data for retail sales, jobs, and industrial production have all been weak. However, more leading economic data, such as housing and consumer confidence, have significantly improved over the past few months.
The 3-month/10-year yield curve inverted last week, meaning yields on the shorter-term 3-month T-bills were greater than the 10-year Treasury notes. Historically, since 1955, this yield curve inverted ahead of all nine recessions. We would rather focus on the 2-10 year yield curve though, as it hasn’t yet inverted. Additionally, even after it inverts, that doesn’t mean a recession is imminent. In fact, the S&P 500 has usually peaked 19 months later and had gained more than 22% on average.
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John Lynch: Hello everyone. This is John Lynch, chief investment strategist for LPL Financial. Welcome to this edition of LPL Market Signals Podcast. Delighted to have you listening today. I am on the call with my good friend and colleague Ryan Detrick. Ryan, hello.
Ryan Detrick: Hey John, good morning. How is it going today?
John Lynch: I'm well, thanks. How are you?
Ryan Detrick: I mean you look at the calendar John, it is the last week of March.
John Lynch: Madness.
Ryan Detrick: I mean 2019 is flying through, and that's obviously good segue for some little bit of basketball talk I guess. How is Villanova doing?
John Lynch: Not well unfortunately. Took it on the chin to a very solid big 10 team, and the round to 32. Having won two of the past three, I can take solace in that, but yeah they did struggle.
Ryan Detrick: Exactly. As most people know if you listen to this, I'm a Xavier guy. Xavier did actually last a little bit longer than Villanova, but they lost the NIT yesterday a few hours after Villanova. Nonetheless, we are done.
John Lynch: You know what NIT stands for don't you?
Ryan Detrick: Just no, let me know.
John Lynch: Not in the tournament.
Ryan Detrick: Yeah I figured it was going there, I know. Four starters back next year. We'll try it again next year.
John Lynch: That's right, that's right. It's just a great, great time of year. You see these kids hitting last minutes, last second shots. The UCF Duke game was-
Ryan Detrick: Oh my goodness.
John Lynch: ... unbelievable.
Ryan Detrick: To think that was 70 miles away from us. I can't believe my boys, saying, “Boys, I can't believe we're not there. I can't believe we're not there.” [cross talk 00:01:26] and everybody, that was awesome.
Ryan Detrick: Depending on how you look at it, it was awesome. All around good game if you didn't have a horse in that race, so it was something.
John Lynch: Once again, you did not listen in to hear sports talk radio, we always digress.
Ryan Detrick: That's right.
John Lynch: What we'd like to cover in today's podcast aptly named Market Signals is that the market has been sending us some signals the past couple of weeks, and we wanted to highlight what we see going on in the equity market, and the bond market. The Market Signals has cleared the item to discuss today, first on the equity, then on the bond market. First off on equities, we want to reiterate what we announced earlier this week that LPL Financial is moving its equity allocation from overweight to market weight. I want to emphasize that. We're talking about a handful of percentage points out of equities, and we'll redistribute those really between emerging market equities, and find a balance between high yield and investment grade bonds. We just really feel that Ryan and I have talked about this quite a bit, Ryan what are we up 20, 25% from the December 24th low, correct?
Ryan Detrick: Exactly. Yeah we were up over 20, 22% maybe approximately?
John Lynch: Yeah.
Ryan Detrick: Pulled back after Friday's big pull back, but year to date up over double digits as we saw one of the best starts of the year since even 91 or 87, depending on how you want to look at it. History does say when you have a big move off of loads, you can get some continuation. The near term John, we sure are stretched, historically stretched.
John Lynch: Yeah so we rallied North 20%, up about I guess last Thursday, the S&P eclipsed 2850, 2-8-5-0 and 2815, 2-8-1-5 was the big hurdle everyone was worried about, and then got through that. Thursday's trading was just kind of weird. The research team had been talking about this for a little bit over a week, and then with the Fed announcement, it was more buy the room or sell the news, right? Thursday's trading I just thought I was so uncomfortable. I mean there was a giddiness to trading, just a “Money's free again, let's buy equities.” That's when the team finally made the decision, when we closed Thursday above 2850.
Ryan Detrick: Right, and just to do a quick recap I guess of the Fed decision, really nothing us by surprise there. They said there was going to be no rate hike rest of this year. It's interesting John, there's 17 voting members for the Fed Dot Plot. I know, my stomach's growling, and hopefully I think it picked up. I'm really hungry.
John Lynch: Really working up an appetite for this podcast.
Ryan Detrick: It's almost lunchtime here. Talking about the FED makes me hungry. There's 17 people that get the vote for the Fed Dot Plot. Out of those 17 members, not one is looking for a rate cut this year as of the recent Dot Plots. If you look at the Fed funds futures, what the market thinks is a 40% chance for a rate cut this year, so yeah who is right, who is not? It's just kind of interesting right there. Bottom line, the Fed said they're on pause, and market's definitely bounced back big time on Thursday. Then, we had Friday.
John Lynch: Right, right, so big sell off on Friday. When talking about equities, we always at LPL Research, we always like to talk about technicals, fundamentals, and valuations. From a technical standpoint as we mentioned, north of a 20% rally off the market loads in December. We're up 14% year to date or so through last Thursday's close at 2850. We didn't see everything technically that gave us comfort. For example, semiconductors were doing really well, transports were not. While the S&P500 was able to eclipse its 200 day moving average, an index of small cap stocks whether you look at the S&P600 or the Russell 2000, they failed to eclipse their early February lows. They also failed to eclipse their 200 day moving average. It was really a double doink for those two indices right, not being able to move faster. Then you see [inaudible] support it. As I said earlier, transports didn't.
John Lynch: Advance-decline line still looks pretty good though.
Ryan Detrick: It sure does John. The NYSE advanced-decline line recently is still flirting with new all-time highs, which is a definitely more positive bigger picture longer term opinion. I kind of said this year looks a little bit like 2016 where in April 2016, we had the breakout of the NYSE advanced-decline line, the new highs, and stocks eventually followed suit in July. What happened in the middle of that? You had the Brexit sell off, and you had some volatility. Just because advanced-decline lines are breaking out, doesn't mean stocks are going to follow right away. It can be a second half of the year we can get the new highs. For the meantime like you said, the risks are definitely adding up in the near term here.
John Lynch: Absolutely. We do want to emphasize also that we are talking about a potential for consolidation. We are not looking for a test of the December lows consolidation unit. December lows was really a unique combination in our estimation of miscommunication, misunderstanding of the Fed's message in December, but also it was the worst month for hedge fund redemptions, or the highest month of hedge fund redemptions in the past 10 or 12 years. Those lever trades kind of magnified losses. We just think looking at the S&P fifty day moving average as well as the 200 moving day average, we see pretty good support 2725, to 2750 range. They're after call it that former support which had been resistance right?
Ryan Detrick: Yes.
John Lynch: The 2600s to 2625 range.
Ryan Detrick: That was the big thing John we talked about earlier this year. Will there be a retest? Will it be the W formation? We go back down and form a W formation, and test the December 24th loads? We were in the camp, we didn't really think so. We saw some extremely strong breath off those lows that suggested maybe we won't go all the way back down and retest. Unfortunately, that's exactly been the case. Still, near term, things are at. Now John, this week's weekly market commentary like we said which we'll release by the time people will listen to this podcast, we've got three big themes that we've mentioned that are concerning, economic soft patch, stalling capital investment, and then slower earnings growth. Those three things by themselves are kind of the big umbrella under why we made this change. Out of those three, you want to maybe kind of pick on one?
John Lynch: We covered the technicals already, so from a fundamental standpoint, I think we could really break it down. Economic soft patch, there's concern about slow and global growth, right? We're not being dismissive of that, but we have never seen a period in history where the globe led the US into recession. The US always leads the globe into recession. We do see some slowdown, but we also see massive policy intervention and support in Japan and in Europe. Looking at fundamentals, we're looking for a mild first quarter right? Maybe one percent GDP growth. That's going to be a significant downturn from what you experienced at a call it a three percent pace last year. I do want to emphasize though that this will be the tenth disappointing first quarter of the 10 year cycle right? For whatever reason, seasonality, now this time could be magnified by the government shutdown.
John Lynch: We always see poor GDP in the first quarter.
Ryan Detrick: Yeah, it's almost like we didn't realize the weather was going to be really poor early in the year, and every year it surprises people. Again, pick a reason why, the bottom line is the first quarter has definitely been the weakest out of the four. Then the second half of the year, you do see a little bit more of an acceleration in the economy. Hey, I think there's a good chance that happens one more time here.
John Lynch: A lot of that is also our forecast for the past nine months or so has been contingent on economic baton if you will being passed from the US consumer to business investment. In the first half of last year, we saw business investment grow at about a 10 percent pace, and then it ground to a halt in the second half of the year as the trade dispute with China dragged on. To the degree we get some clarity on a path toward progress with the trade dispute with China, that gets businesses re-energized 'cause they already have immediate expensing, they have reduced regulation, they have lowered taxes, they have repatriated 750 billion or so over the past 12 months in overseas profits. Even if it's a third a third a third for dividends, buy backs and then capital investment, we think that the economy can gain traction again in the second and third quarter.
John Lynch: When you just factor in the fundamentals in the near term, we think those fundamentals again looking at technicals, fundamentals, and valuation, we just think some of these fundamentals would support that what we expect to be the big consolidation in the next handful of weeks.
Ryan Detrick: Exactly. John, to kind of summarize it all, this week's weekly market commentary again just describes exactly what we've just discussed with the overall equity allocation, bring it down just a hair here. You want to move over to bonds now?
John Lynch: Let's cover up the valuation aspect also because I think that's really important before we move to the economic and bond commentary. From a valuation standpoint, when we issued our year end fair value estimate for the S&P500, say maybe we came up with that, that was probably November first or so when we first wrote the-
Ryan Detrick: We started thinking about it around Halloween yes.
John Lynch: Right, so thinking about I guess the S&P was about 2750. Operating earnings for the S&P500, the consensus forecast was $177.50. We thought about that number, we thought that was too much of a reach. When we did our analysis with the different analysts on our team, we came up with a number five dollars less than consensus. Our number was 172.50 in operating earnings for the index in 2019. Looking at a low inflation environment, there are a lot of ways to value the market. We think that on a trailing 12 month basis, a 17 to a 17 and a half PE on that $172.50 was a good number that could get us on and around the 3000 level. Over the past two months though, Wall Street analysts have slashed estimates by about $10. Now, we are a premium to the consensus estimate, and that's something we're mindful of. We are not cutting estimates yet.
John Lynch: We think that it's too soon to do so, and wouldn't be prudent, want to hear what happens with first quarter earnings, want to see what second quarter visibility is. If we have to tweak, maybe in the mid-year outlook, we go to $170. Still, a 17 PE on 170 is what 2950? It's still 3000 ish. Directionally, we still from a valuation standpoint want our investors, and our listeners to understand and appreciate that directionally we still see the fundamental supporting it, near term we see consolidation.
Ryan Detrick: Exactly. I love looking at market cinema John. One thing that caught my eye was when you look at those analyst cuts that we saw in the first half of this year or early this year, it was the largest cuts analysts had made S&P 500 earnings since the first quarter 2016, the last time we really had a big correction, a big scare similar to what we just saw. The economy definitely picked up, and the earnings estimates were once again too low. You talk about earnings estimates, 172.50 is six percent. Again, we still feel that's the case. Most analysts now are at around three percent earnings growth, many are up over double digits. I think around early this year when everyone else was cutting their estimates as we laid out in this podcast, we simply didn't see a recession on the horizon.
Ryan Detrick: We did hang tough with our earnings estimates. As of this second, we're not cutting them still. We didn't kind of panic in that midst. We said this is not a recession and stocks could bounce back and could be led by earnings. As people once again panicked, we avoid the asteroid once again.
John Lynch: Absolutely. You want to make the math work as an analyst. Again, 17 multiple on 170, close enough for government work, close enough certainly for our investors, not to be dismissive with a comment like that, but really think about whether you're calculating on cash flow, sales per share, adding sales per share back into the sales per share calculation. You multiple that by the margin estimate, come up with a top down approach to earnings. We still think margins cam be in the 10% range, which is shocking to say 10 years into a cycle. I mean even if they slip to nine percent, they're still 50% above their long term averages. It's quite an experience. From a valuation standpoint, we want the math to work. We are pulling back from overweight where we've been from my two years at LPL-
Ryan Detrick: Yes, my three.
John Lynch: ... within the equity market. It's growth with income or our balanced accounts will still have 60% equity. I want to make sure people still feel good about that. Yes, let's go to be bond market 'cause the bond market is also sending signals in addition to the equity market.
Ryan Detrick: Oh true it is John. Obviously we kind of hinted at Friday's big sell off, S&P down almost two percent. Kind of what caught everyone's attention was the three month versus the 10 year yield curve inverted. We also had the German bund go to beneath zero, zero percent. Global yields, and this is across the whole globe they continue to drop, big drop on Friday. Our yield curve again we can probably talk a half and hour on yield curves, there's various yield curves, but the three month tenure did invert on Friday, I believe the one year tenure did as well. That caught investors and the media's attention John, the bond market. The smartest guys in the room, “What's the bond market know that the stocks don't know?” Oh my, I don't even want to tackle the yield curve.
John Lynch: First off, you said the media, I think the media was looking for any curve to invert so they could report on it right?
Ryan Detrick: Good point.
John Lynch: 90 days in 10 years is one to pay attention to. The one we pay most attention to is twos and 10s. Not to split hairs, but we're about 10 days two points now. 10s 30s have actually widened over the past week right?
Ryan Detrick: Exactly.
John Lynch: I think that's something to keep in mind about longer term growth prospects for the economy. Also recognize what is the message from the curve? This is a real debate right now not only what we're having on our research team at LPL Financial, but also I think every investment policy committee out there, every investment team out there is trying to define is the yield curve flattening pointing toward recession, or is the yield curve flattening pointing toward extreme valuation dynamic between the US 10 year for example, and the bund and the JGB, the Japanese Government Bond? I always like to think about bonds as stocks. If you want to look at, to make the math easier, just say the bund and the JGB are one basis point, and the 10 years are 250. 2.5% is a percentage point, right? What is percent? It's division. Take the inverse of that and pretend there's a PE on that bond.
John Lynch: If you're yielding two and a half percent, you're willing to pay 40 times to earn that 2.5% assuming [inaudible] right?
Ryan Detrick: Right.
John Lynch: If you're using that same analogy, global investors have the opportunity to buy the bund or the JGB at a PE of 1000 if it's yielding only one basis point. It's a screaming buy when you think about the US Treasury 10 year can be considered a screaming buy relative to for global investors relative to what other leading sovereigns are offering. It's not that simple. You have to factor in currency hedging costs. Now, when you look at currency hedging costs, it's a bad trade for global investors. Nonetheless, global investors are piling into the biggest, baddest bond market in the world, the most liquid, the highest rated, and that's altering the dynamic.
Ryan Detrick: No, that's a great point John. I might swipe that in the presentation. I like that, the way you described that using PEs. Yeah so there's yield curves in the US. Nine of the last nine recessions we did see an inverted yield curve approximately 14 months or so if you look at the one year 10 year spread. Now the two 10 is different. We've looked at that a little bit before. It's a little bit longer. I think it's 19 months after that inverts. Nonetheless, there are other yield curves out there. You look at Japan, they've had inverted yield curves for a long time, and it didn't do anything, they did not have recession. You look at the inverted yield curves of the UK and Germany historically, once again, very poor predictors for recessions there. It's really unique, I don't want to say this time is different, because believe me, this show is related to cycle, and we absolutely are concerned with it.
Ryan Detrick: Again, to just blindly sell because one of the lower end or the belly of the curve in essence has inverted, like you said the long end of the curve the 10 year 30 year continues to steepen. You look at the mid-90s John, and I'll hand it over to you for a second, the mid 90s we saw the belly of the curve invert almost invert in 94, invert in 98. What happened with the longer end of the curve? It didn't invert. Those were times when we kind of had false signals if you will. Then in the mid-60s, we had some false signals on yield curves. It's not a perfect indicator. You can have different curves invert. As long as the longer end doesn't, I'm not quite as concerned here.
John Lynch: Yeah and we want to emphasize excuse me, get so choked up talking about-
Ryan Detrick: You do, you love yield curves.
John Lynch: ... yield curves, but be mindful, you talked about the yield curve and the signal, Ryan and I are paid to worry. We don't want to come across as overly dismissive of the risks out there, but I'm even willing to admit no one ever wants to say it's different this time. I've shared it with audiences, it is different when the global central banks quintuple the size of their balance sheets, and all companies are subject to a low and unbearable cost capital. There's a different dynamic out there right now. That's why Fed messaging is so important. Recognize that it's our belief that it's a valuation metric as opposed to a recession metric with that flattening and some of the inversions, recognize also that what we're seeing in Japan and Europe, it's conceivable that we don't see a one percent overnight lending rate in Europe or Japan for five more years.
John Lynch: There's going to be a valuation dynamic with the US 10 year for quite a while now. We're going to have to keep that in mind. The point you made I think is most important for investors-
Ryan Detrick: Of course there was.
John Lynch: ... if of course if the twos, 10 inverts, we've found that it takes anywhere from 18 to 24 months, what is it the 19-
Ryan Detrick: Yeah the last five times, I was going to make sure I said 19 months. I was incorrect to compliance advocates. 21 months John, the last five two 10 inversions before a recession started.
John Lynch: In the equity market due.
Ryan Detrick: Exactly. The S&P didn't peak for an average 19 months later, S&P peaked 22% gains after the two 10 inverted. The last two times before the financial crisis, S&P gave 22%, in the late 90s gained 40%, then before the 1990 recession, gained 33%. I don't think we want to be blind and ignore those types of gains, even after the 210 inverted, which it hasn't yet.
John Lynch: We do guarantee that that won't be a straight line, okay?
Ryan Detrick: Are you allowed to say that? I heard that dirty word guarantee. [inaudible]
John Lynch: I can see how your eyebrows lift.
Ryan Detrick: You can say a lot of words, not that one.
John Lynch: It won't be a straight line in our estimation. Again, looking at the last five cycles, average return over that period is north of 20%. If you look at the time, it's conceivable our next recession begins at the end of 20 and early 2021. What I suspect now, looking at all the fundamentals, I suspect what's going to cause it, we can't see it in the fundamentals just yet, but it could conceivably be the mother of all election cycles, right, and that could weigh on sentiment from a business investment standpoint, and it could weigh on consumption from a personal spending standpoint. It's conceivable that a late 2020 early 2021 dynamic we pull back one quarter of one percent for two consecutive quarters. I don't see the fundamentals that would necessitate anything approaching what we experienced a decade ago.
Ryan Detrick: Yeah so John I think you wanted to finish it like this, with some potential positives?
John Lynch: We always do.
Ryan Detrick: I'll just give a couple of mine, and you can sign us off. The LEI Leading Economic Index, one of our favorite indicators just made a new all-time high last week, so that's positive. Some of the housing data we've seen, which is more of a leading economic indicator, housing started to turn around. Also, if you look at FactSet data, they look at 12 month, [inaudible] returns on the S&P500, it definitely was lower this year, starting to bottom out. Believe me, there are some real positive signs, and we're going to continue to talk about those in our weekly commentaries on our blog lplresearch.com.
John Lynch: I think that'll be thank you Ryan, that'll be really important because as we get some of these lagging reports that weigh on sentiment, that we suspect will cause this next near term consolidation, we will continue to be emphasizing a lot of the forward looking data, the leading data, like the leading data indicators.
Ryan Detrick: Consumer, confidence and housing, those three have all bounced back nicely.
John Lynch: Small business confidence, business investment, those are all the leading indicators. The best leading indicator is corporate profits. Even though the year over year print is going to be challenged in the first quarter, recognize that we had record profits last year, we still think that those record profits can be discounted at interest rates near historic lows, enhancing the present and future value. If they're growing at what we believe six percent this year, but even if we have to cut it to four percent, you're looking at a two percent yield. You're looking at a six to eight percent total return type opportunity. We want to make sure that while this call is for a near term consolidation, we still think this cycle has more room to run. I think that's a good way to conclude today's call.
Ryan Detrick: I'll sign off John by saying I had a lot of fun this week. Look forward to being back next week with everyone. I want to get it on record, I have UK, University of Kentucky winning it all. I don't even really like them. I just went different than a lot of other people, and that's who I have. Who do you have John?
John Lynch: Calipari can coach-
Ryan Detrick: Yes he can.
John Lynch: ... and he can recruit. They did a good job. Now that Villanova out, my wife went to Carolina, so I'm going to pick the University of North Carolina.
Ryan Detrick: Okay good point, got to go that way.
John Lynch: Although, you have to be respectful of Zion Williamson and RJ Barrett. Those guys can play. It'll be a fun three weeks. Everybody enjoy it. We look forward to talking to you next week. Have a great one everyone.
Ryan Detrick: Thanks everybody.