July 31, 2018

In the 1970’s, a psychologist from Stanford and seven mentally healthy people participated in an unusual experiment. They got themselves into 12 different psychiatric hospitals in the U.S. (some had more than one stay). To get admitted, they pretended to hear voices. Once inside, the experiment began. They started acting normally and reported no voices. All 12 hospitals diagnosed each person with various disorders. The patients were all forced to take drugs and had to admit they had a mental disease before they could get released. It was known as the Rosenhan Experiment. If it sounds vaguely like the film, “One Flew Over the Cuckoo’s Nest,” you’re right. The film was released two years after the experiment, but it was based on the Ken Kesey novel of the same name released in 1962. Life imitating art? Or art imitating life?

That’s a terrifying thought – that reality can become what the environment dictates. Despite something actually being true, “crowd-think” can dictate a result which is entirely opposite to what it should be. Similar thinking has been observed in the past with manias like the Tulip Bulb Bubble, or the Salem Witch Trials. The point is that outcomes can be wrong based on crowd behavior, which defies logic.

The market got ugly on Friday. Information Technology dragged the market down and depressed most other sectors too. The real questions are: Is this serious? Is the market turning? Are we headed lower?

The answers lie in thoughtful analysis of the surroundings. As you’ll see, the backdrop says “up,” but emotion and observation may say “down.”  Rest assured, if the market heads lower, I believe it is a normal, temporary symptom of usual summer volatility. More importantly, I think it’s a chance to buy!

Let’s just look at earnings for a moment, as we are in the midst of earnings season. Despite the gloom after disappointing reports from Facebook (FB), which sank the stock as much as 20%, the overall earnings environment is great. According to FactSet’s Earning’s Insight, 53% of the S&P 500 has reported Q2 2018 earnings thus far, and 83% of companies reported a positive surprise and 77% beat sales. If these results hold, they will be the highest on record since FactSet began tracking them in 2008.

(Please note: Jason Bodner does not currently hold a position in Facebook. Navellier & Associates does currently own a position in Facebook for client portfolios).

The blended earnings growth rate is +21.3% over the same quarter last year, which would be the second highest rise on record. Nine of the 11 S&P sectors have higher earnings growth rates, due to positive revisions and beats. Sales growth is the highest since Q3 of 2011. In short, sales and earnings are kicking major butt, and are expected to continue doing the same – so let’s stop worrying about earnings.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Despite Trade War Fears, Industrials Lead the Pack in July

But what about tariffs and the looming trade war, which has engulfed the media’s headline space. Louis Navellier has been a skeptic and he has been right so far. In addition to what he writes in this issue about the EU President caving quickly and China’s chest thumping so they can say “I win” in the end, he told me over breakfast this weekend that his view is that the trade war will ultimately work in the favor of the U.S. because everyone needs us as a trade partner. Interestingly, 61% of companies that cited the word “tariff” on their earnings call said they saw no material impact on tariffs yet, so this risk seems over-rated.

Let’s take a quick look at those sectors that mentioned tariffs on their earnings calls. As you can see (in the chart below), Industrial companies had the most companies mentioning tariffs. This is interesting because as you’ll see, Industrials have been getting bought up. This is likely one reason, as they are not seeing a material impact from the trade war yet, and they’ve seen a month-to-date performance over 6%!

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Next, let’s look at sector strength and weakness and see what we can glean from their behavior. Last week unsurprisingly saw Information Technology as the weakest sector performer with a -1.15% drawdown. That’s not bad, considering how Facebook pulled down the sector. We also saw some continued rotation out of the strongest sectors into weaker ones. Info-Tech and Consumer Discretionary have led the market for nine months. Last week saw an outflow from those sectors into Energy, Industrials, and Financials.

Industrials, Financials, and Health Care all are having greater than +5% moves in July thus far. We’ll have to wait for earnings season to conclude before we can tell if this is the start of a larger rotation, but for now Info-tech and Consumer Discretionary stocks are still performing well for the month.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As we end the month of July today, the bottom line for sectors in July is that we are still seeing strength in growth-oriented sectors. In fact, the only two sectors showing negative performance for July are Telecom and Real Estate. These are rate-sensitive sectors, so let’s stop worrying about the growth sectors.

Lastly, I just completed an in-depth study into the state of share buy-backs. Tax reform allowed a record amount of overseas cash to come home for favorable tax treatment. This caused a boom of companies buying back their own shares. As the number of outstanding shares dwindles, their P/E ratios tend to go up, pushing share prices up. In Q1 2018, companies completed $178 billion of buy-backs, rising more than 42% from Q1 of 2017. In May, U.S. companies announced $201.3 billion in stock buy-backs and cash takeovers, a record amount, with half of that being Apple. Tax reform encouraged the repatriation of cash, much of which went directly into the stock market, raising share prices. As long as interest rates and P/Es remain relatively low, which they should, buy-backs should persist, providing a floor for the market.

(Please note: Jason Bodner does not currently hold a position in Apple. Navellier & Associates does not currently own a position in Apple for client portfolios, however, clients may hold a position).

The numbers don’t lie. Sales and earnings are great. Tariffs and trade-wars are overblown fears, at least for now. Sector strength remains in high-growth areas. Add to all this record corporate buy-backs due to favorable corporate tax rates and I ask you: Where else can money go, and where else can the market go but up? I have harped on expected summer volatility and a usual seasonal swoon. When pressure comes, like Friday, don’t confuse sanity for insanity. Remind yourself: Data is sane, but there’s an art to markets.

Oscar Wilde said: “Life imitates Art far more than Art imitates Life.”

About The Author

Jason Bodner

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. *All content of “Sector Spotlight” represents the opinion of Jason Bodner*


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