This commentary is an excerpt from the Growth Seeker Weekly Roundup. Click here to learn more about this dynamic portfolio and market information service.
There is a saying that goes "March comes in like a lion, and goes out like a lamb." This week was quite the opposite as we entered the shortened trading week with Wall Street and Main Street getting back to work on a calm note, but it ended with one of the sharpest moves lower in some time. Since mid-summer, the S&P 500 has experienced a level of sideways trading that we've never seen before. Looking back to when the S&P 500 index began in 1928, it had never experienced a 42-day trading period with a smaller hi/lo spread. Who would have guessed during the Brexit panic that we would be heading into the flattest trading range in history! Then again, in an environment in which investors buy stocks for yield and bonds for capital appreciation, nothing is quite what one would expect.
As we mentioned last week, September tends to be one of the worst months for the stock market, and after trending sideways for a prolonged period, it was hit in the last few days by several items that, combined, raised "caution" flags. Spooking the market on Friday, Federal Reserve Bank of Boston President Eric Rosengren said that "a reasonable case can be made" for tightening interest rates to avoid overheating the economy." Given the August data received thus far, we're inclined to think Rosengren has either not recovered from his recent trip to China where he made similar comments or he hasn't had time to digest the latest data. Now let's layout why we think that a Fed rate hike is likely to be off the table...
Last week we learned that the manufacturing sector had slid back into contraction mode in August, with the ISM Purchasing Managers' Index once again dropping below 50, the demarcation line between expansion and contraction. This week we learned that it isn't just manufacturing that is suffering, with the ISM non-manufacturing (better known as the service sector) falling to 51.4 in August from 55.5 in July, the lowest level since early February 2010 and the biggest monthly drop since November 2008. Potentially even more depressing than the headline number was breadth in the report, with only two out of the 10 categories increasing as New Orders and Business Activity experienced the largest declines.
The combined ISM report for August fell from 55.1 in July to 51.2, which is also the lowest reading since January 2010 and the largest monthly drop since November 2008. Our thinking is that after the disappointing August Employment Report, these ISM reports have pretty much ruled out any Fed rate hike on Sept. 21.
On Wednesday, Europe's largest economy, Germany, reported that its industrial production fell 1.5% from the prior month and vs. an expected increase. Even worse, it was down 1.2% on a year-over-year basis. We also learned this week that in July, U.K. manufacturing output dropped at the fastest pace in a year. Given what we've seen from container shipping companies over the past few years, we aren't terribly shocked by this news. In fact, we are on the lookout for the fallout from shipping-giant Hanjin Shipping's recent filing for receivership, leaving some 61 of its ships, loaded with a half-million containers full of consumer goods stuck at sea. To paraphrase a sailor, global growth headwinds are honking.
Wednesday's JOLTS (Job Openings and Labor Turnover Survey and a favorite of Hawkins) report revealed that listed job openings in the U.S. hit an all-time high in July despite the weak August payroll report. Digging into the data we can see that the mismatch continues between what kind of skills businesses are looking for and what's available in the labor pool. This mismatch speaks to the heart of our Tooling & Re-tooling investment theme. Total separations have fallen, which means that businesses aren't having a tough time keeping their employees on board.
Thursday's weekly jobless claims came in slightly below expectations at 259,000 versus 265,000, further painting a picture of the job market that is solid in terms of employment, but without the wage gains that would normally accompany such levels.
Thursday morning we learned that the European Central Bank will leave all its key rates unchanged, despite inflation in the 19-nation block remaining at historical lows. It will continue its asset-purchase program of $90 billion through the end of March 2017. While there will be no new monetary stimulus there, what it's got going has been pretty substantial, without clear success from such efforts. This pretty much validates what we've seen here in the U.S.
Outstanding consumer credit balances increased in July by a seasonally adjusted $17.7 billion vs. expectations for a $16 billion increase, for a 5.83% adjusted annual growth rate in July compared to 4.8% in June. Rising credit balances can either reflect increased confidence or rising financial stress. Given that we've seen hours worked falling, we aren't inclined to assume increased confidence levels just yet. Paired with the continued rise in auto loan delinquencies, we suspect it means consumers are once again on the verge of being overextended -- not good for retailers as we head into the heaviest shopping season of the year.
The Fed's Beige Book release, using data compiled on or before Aug. 29, revealed that most of the 12 districts reported "fairly modest" wage pressures that are expected to remain as such over the coming months. Overall price increases were subdued and consumer spending was little changed. The presidential election appears to be increasing caution around expansion plans, with only modest expectations for sales and construction activity in the coming months. We found it telling that the word "flat" was used 56 times in the report, vs. 36 times in the last.
Our key takeaway was the report gave little indication that we are likely to see that widely predicted surge in growth during the second half of 2016, something we've been quite skeptical of given the lack of identifiable catalysts for such a move. The follow-through on that thought is that earnings from S&P 500 companies in the December quarter are likely to underwhelm, relative to current expectations.
Taking a look at various sectors for signs of economic strength or weakness, auto sales, which are typically a leading indicator, are telling us that consumer spending may be heading toward a slowdown.
Meanwhile, grocer stocks were hit hard this week after Sprouts Farmers Market (SFM) revised its guidance downward for the third quarter and for the full fiscal 2016, pushing its stock nearly 14% lower in the aftermath, while Whole Foods Market (WFM) , Kroger (KR) and Supervalu (SVU) dropped 5.3%, 4.1% and 3.9%, respectively, in sympathy on Wednesday. By Thursday, Kroger had hit a 52-week low following Supervalu's lowered guidance for its fiscal year. That guidance cut pushed SVU's shares down another 9.5% and cause RBC Capital Markets to lower its price target. We are hearing that there is a lot of pricing pressure in this sector along with highly price-conscious consumers.
On the other end of the spectrum, Restoration Hardware (RH:NYSE) knocked it out of the ballpark with better-than-expected second quarter results: revenue up 7% and EPS of $0.44 that was better than consensus expectations. That being said, overall net income was down almost 80% from the year-ago quarter and the company reported that early shipping helped pull revenue forward from the third quarter. We aren't seeing this as a reason to start celebrating the return of strong consumer spending just yet.
Friday morning we learned that wholesale inventories were unchanged in July, vs. expectations for a 0.1% increase, while sales fell 0.4% vs. a 1.7% advance in June. This was the biggest drop in sales since January. Just more of the ho-hum data that has dominated lately.
Putting it all together, we see little reason for the Fed to hike rates based on the incoming data. The much anticipated economic acceleration in the back half of 2016 is not materializing, as we here at Growth Seeker expected. Stock prices are still richly valued and more vulnerable as the hope for that back-half hockey-stick growth fades away. We will be selectively adding to the portfolio as we see pricing opportunities in what is likely to be a period of increased volatility.
The bottom line is that we have:
-- A recession in capital spending
-- A recession in good-producing employment
-- A recession in productivity
-- A recession in the cyclically-sensitive areas of the economy, (which includes durables, housing, non-residential construction and all forms of business capital expenditures and inventory investment).
-- A recession in corporate profits
In fact, if you look at the following chart from the Federal Reserve, corporate profits have never contracted this much before without a bear market. The bear market may start after profits begin to improve, but we've never managed to see this sort of pain in earnings without experiencing a bear market.
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-- Lenore Hawkins and Chris Versace are co-portfolio managers of Growth Seeker.