Why I Like Bank of America and Goldman Sachs as Inflation Hedges: Market Recon

 | Feb 12, 2018 | 9:20 AM EST
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"There is only one sort of discipline -- perfect discipline."

-- George S. Patton, Jr.

Are you ready for this? My gut tells me that you probably better have your "A" game squared away from the get-go this week. Morning equity index futures are trading well above fair value as I write this, but then again, Treasuries are yielding more Monday morning than they were at any point last week. Can this pairing co-exist?

Actually, equity markets can do well in higher-interest-rate environments, particularly if contained within an ecosystem of economic growth and rising inflation. Inflation without growth is what we saw back in the 1970s, and that was awful. But rising interest rates without inflation? Well, that's a horse of a different color -- and probably the one thing that could grind the U.S. consumer to a halt.

Recession? Oh, its ugly face is only seen through clouded memory at this point. It's normal for the human brain to screen out the echoes of pain in order to allow one to move on.

However, any missteps in policy (be they monetary or fiscal in nature) are the only ingredients we need to put together the next economic disaster. I'm not telling you that today's the day, but I am telling not to pretend that nothing evil is lurking out there. Stay disciplined, stay diversified and listen to the voice in your head that tells you when you've hung onto a position too long or pulled the trigger early in a dangerous spot.

What to Watch For

Apple (AAPL) will hold a shareholder conference Monday, while Credit Suisse kicks off its Financial Services Forum as well. Interestingly, Wells Fargo (WFC) will present there, and don't be surprised to see that stock behave erratically (or differently from the group) at some point on Monday.

And on Tuesday, expect a high-profile technology conference in San Francisco hosted by Goldman Sachs (GS) to make noise. Both Nvidia (NVDA) and Alphabet (GOOGL) will present there.

But you know what? All of these will amount to a hill of beans compared to the macroeconomic data scheduled to be released this week, as well as to the president's infrastructure plan that we expect to get later Monday. Among the numbers that traders will react to later this week will be consumer inflation, retail sales, industrial production, manufacturing numbers and housing starts.

In other words, if you spent last week playing "whack-a-mole" from the perspective of the mole, you'd better tape on the foil this week, gang. Button down that jersey. Opportunity doesn't always ring your doorbell and announce itself.

All the President's Infrastructure Plans

We expect President Trump to unveil plans to spend $200 billion over the next 10 years on infrastructure projects. The funding for this would likely come from grants that would in turn compel local governments and private investors to expand upon this spending to improve railroads, airports, roadways and waterworks.

The plan will lay out the possibility of total final investment that approached $1.5 trillion, but I don't know if I'm willing to bet the farm on this plan. In fact, while I'm still long in the infrastructure space for exposure, my picks represent a smaller slice of my overall book than they had only a month or so ago. When I went to higher levels of cash in mid-January, these were among my early casualties.

After all, the president's plan will very likely be obsolete after last week's two-year spending deal from Congress. When it comes to infrastructure, I would love to see it, but let's pretend that I'm from Missouri -- the "Show Me" state.

Inflation Risk

Treasury yields are higher again Monday morning. Obviously, markets are trying to price in a fairly dramatic change in the overall environment.

Macroeconomic data are seemingly healthy, both home and abroad. At home, the S&P 500 now trades at just 16.6 times forward earnings and there's strong evidence that capital investment is on the upswing (as sentiment remains strong).

As we grind through earnings season, 77.3% of all U.S. firms that have reported have beaten analysts' expectations, while earnings growth is running at 15.4%. Revenue growth is also very strong, rising at 8.6% year over year versus expectations in the low 7s.

So, the U.S. economy is fundamentally sound and corporate America is humming. What could possibly go wrong?

For me, while I'll try to excel in any market environment, fiscal discipline will at some point become a necessity. Deficit-hawk Sen. Rand Paul (R-Tenn.) might be eccentric, but he's not crazy in complaining about excess government spending.

This economic growth spurt that we've enjoyed in recent years has been supported through perverse monetary policy -- you know it and I know it. We've delayed the pain of extreme calamity, but for how long? A year? Ten years? A lifetime? Where the wheel stops, nobody knows.

But while the Federal Reserve tries to quietly withdraw liquidity from the U.S. banking system, the U.S. economy's leadership going forward is expected to come from the fiscal side. The Congressional Budget Office is forecasting an extra $1 trillion or so increase to the budget deficit in each of the next three years (give or take a little).

That same office also expects the US budget deficit to triple over the next 30 years. Love your children? Your grandchildren? I bet you do. Yet we all seem just fine with forcing our descendants into poverty as long as we feel less pain now.

The Consumer

The U.S. consumer doesn't show much sign of forcing inflation right now. Yes, inflation is likely coming some day -- just not from the U.S. consumer.

We all saw that misleading 2.9% year-over-year wage-growth number in the January U.S. jobs report. But if you actually read the data, you saw that laborers worked fewer hours and netted less in their weekly paychecks in January than in December. So, all of our super-smart talking heads are either intentionally disingenuous or don't do their own homework.

When we see inflation, it'll come from a ghastly increase in U.S. government spending at a time when China and Japan (the Treasury market's best customers) take a hike. Add to that the obvious efforts by both China and Japan to draw back from such reliance upon the U.S. dollar and if long-term inflation arises, it'll come in the form of dollar weakness.

The Federal Reserve is preparing for this by forcing the yield curve's short end higher. Those concerned about the prospects for this inflation will watch the long end of the curve for broad market expectations.

As I write this, the 10-year Treasury is yielding approximately 2.89%, while the 30-year Treasury is paying 3.18%. In other words, even though yields are up from Friday, this is still a tactical skirmish and not yet a battle of strategic scale.

How to Defend Yourself from Inflation

The most obvious way to defend yourself against the prospects of any future significant dollar weakness is to devote a portion of your portfolio toward this well ahead of time.

This implies to me a need to include physical gold as a store of family wealth. And from an equity perspective, look to areas that might grow as fast as inflation itself (or at least benefit from inelastic demand).

That would include health care -- if it weren't for the fact that Big Pharma has drawn both major political parties' ire. Bond proxies will be of little help in this environment either, and you could head for the consumer-discretionary sector if you believed that coming inflation were to be consumer driven. (At least the companies in that group would be better able to pass costs on to their customers.)

But for me, I like banks as a place to hide out. Not only have they benefited from a deregulatory environment, but we're also starting to see life in the yield curve. The all-important 2-year/10-year U.S. Treasury spread is banging around at 76-77 basis points as I write this, up from 50-ish very recently.

Meanwhile, the market's recent volatility should benefit the more aggressive names among the banking group. Amid last week's madness, I initiated longs in both Bank of America (BAC) and Goldman Sachs, with small nibbles close enough to the week's lows. I bought Bank of America for the prospect of improving conditions for traditional banking and Goldman for its known aggression when markets allow traders to trade.

As the week starts, I'm up small in BAC and down small in GS. Let's take a look at these two names and see what I see:

Chart 1: Bank of America

What stands out on this daily chart of BAC? First, the Chaikin Money Flow (CMF) remains positive despite a weakening Relative Strength Index (RSI):

There's also a very sloppy Moving Average Convergence Divergence oscillator (MACD) that sports a nine-day exponential moving average (EMA) deep in negative territory. What I see is support that did indeed show up at almost a precise 38.2% retracement off of the recent top. This stock also closed Friday at its 50-day simple moving average, which will only be significant in hindsight if this works.

Now I know that I'm going out on a limb here, but if that Fibonacci level holds and forms the crook of the Pitchfork's elbow, I see support for BAC rising to levels around $32 within a month.

Am I crazy? My wife thinks so, but I'm not a daredevil. I'm only long about an eighth of my targeted position size. Should BAC take off, this becomes a trade rather than an investment. But should we head toward last week's lows and beyond, I have plenty of dry powder set aside for this one.

Chart 2: Goldman Sachs

Charting GS over the same time frame reveals a different story, but not without some similarity:

Like Bank of America's chart, Goldman's also shows a softening Relative Strength Index, accompanied by an MACD gone bad -- but with positive money flow.

We've also seen some obedience to our favored 900-year old Italian mathematician Fibonacci, but the support seems to have arrived at a 61.8% retracement. We've already seen a significant move off of the stock's lows.

But Goldman is far more dangerous than BAC in terms of volatility, so I've been less aggressive in this name. I only wear about a sixteenth of my target position.

I expect the recent environment to shine favorably on this firm, yet I'm dragging my feet a bit here. Again, direction will decide for me if this is a trade or an investment, although I don't see myself flipping out of this position until we see a retest of the $275 level at this early stage of position-building. Then, again, if I'm forced to buy more at a discount, that will also drag down my target price.

Sarge's Trading Levels

These are my levels to watch today for where I think that the S&P 500, and the Russell 2000 might either pause or turn:

SPX: 2670, 2648, 2620, 2605, 2570, 2540
RUT: 1515, 1495, 1488, 1474, 1463, 1446

Today's Earnings Highlights

Consensus EPS expectations are in parentheses:

ACGL ($1.12), DNB ($3.04), FMC ($1.05), VIPS ($1.33)

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