The S&P 500 gained 1.49% for the week ended July 15, its third consecutive week of gains following the modest post-Brexit sell-off. In total, the index has gained 6.1%, its best three-week showing since October 2015. Gainers last week were led by the traditional “risk-on” sectors, including materials, financials, industrials, technology and energy. Risk-off sectors, like utilities and telecoms, took a breather after leading the market higher for most of the first half of 2016.
As with most market moves, interpretations of performance depend upon whether you see the glass as half empty or half full. Bulls will take heart that the risk-on sectors are finally outperforming. The market could not be led higher indefinitely by the risk-off sectors. Valuations in “safe” stocks have become stretched. Continuation of the recovery requires that economically-sensitive sectors participate.
Improved relative performance of the risk-on sectors follows some modestly better economic data. Job growth snapped back sharply in June after a dismal showing in May. Gains in personal consumption expenditures and retail sales have picked up in recent months. These reports lend some support to the stock market’s optimism, so maybe we will see better news on the economy in the weeks ahead.
However, the bears can still claim that all of this is wishful thinking. The consumer cannot carry the economy and stock market indefinitely. The industrial sector, which typically leads the way, has been struggling. Since 2014, industrial production has been hampered by the rise in the dollar (which crimps exports) and the drop in the price of oil and natural gas (which has shut down much of the country’s exploration and production activity).
According to the Federal Reserve, industrial production declined 1.0% in the third quarter, its third consecutive quarterly decline. On a year-over-year basis, industrial production has declined for 10 consecutive months. Manufacturing output was noticeably stronger in June, but most of the strength was due to an increase in motor vehicle assemblies.
Without a rebound in industrial activity, it will be increasingly difficult for the U.S. economy to sustain its gains in employment, personal income and consumer spending. June could conceivably mark the beginning of an uptrend. The month-to-month gain in industrial production coincided with a modest pick-up in the ISM purchasing manager’s index. With the rebound in oil and more recently natural gas prices since February, drilling activity has begun to pick up, but the rebound so far has been only modest. Yet it is still too early to make that call. The June rebound could prove to be a blip.
The upward momentum in the housing market, a key sector of the economy, has also been slipping in recent months. Single-family housing starts, measured on a seasonally-adjusted three-month moving average basis, have been losing ground since peaking in February. Single-family permits have essentially been flat all year. There are some signs that house prices in frothy markets, like New York, San Francisco and Denver, have peaked. Construction spending, in both the residential and non-residential sectors, has been slipping since March.
Concerns about the pace of the recovery in housing have been reflected in the stocks of homebuilders, which have underperformed the market slightly this year. According to my equal-weighted index, homebuilding stocks are up 2.8% year-to-date through July 15, less than half the gains of 5.8% in the S&P 500 and 6.1% in the Russell 2000. Most of the underperformance is due to Beazer Homes and Toll Brothers, but eight of the twelve builders in the index have underperformed the broader market.
It is perhaps noteworthy that the index lagged the market last week, with outright declines in five of the twelve builders, including NVR, which is considered a bellwether. Of course, all is not lost yet. The index has bounced back from its mid-February low, but it is well below its May 2013 peak. As a group, the homebuilders are cheap, with forward P/Es of 12 for 2016 and 10 for 2017, well below market averages. The Commerce Dept. reports June housing starts and permits on Tuesday. Without a clear turnaround in the industrial sector, however, it will be difficult to sustain the employment gains that are necessary to uphold the recovery in housing sales and production.
The S&P 500 stock chart, courtesy of Stockcharts.com, highlights the bounce back from the mid-February lows. Up until the Brexit vote, the market had been range bound with a negative bias since the middle of 2014. With its gains over the past three weeks, the S&P 500 has pushed ahead to a new all-time high. It is still too early for the bulls to declare victory, but from a technical perspective, the bulls now enjoy the benefit of the doubt and the burden of proof has shifted back to the bears.
Before this year began, I had remained guardedly optimistic that the global economy could “thread the needle” and achieve sufficient growth to allow central banks to begin withdrawing their extraordinary monetary stimulus and restoring their balance sheet strength to be better prepared for the next financial crisis, should one arise. Given the events of this year – the slow progress in the economic recoveries of the Eurozone and emerging markets, the continued strength of the dollar, the uncertainty that arises from Britain’s decision to leave the EU, the slowing in the pace of economic recovery in the U.S., the recent rise in terrorist attacks and the inability of the Federal Reserve (and other central banks) to begin the process of normalizing interest rates – I am today more willing to argue the bear case. I believe that with deteriorating fundamentals, most investors should adopt a more cautious stance vs. the market.
July 17, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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