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One Inch Punch

The Days Ahead: Bonds likely to stay firm.

April has two things going for it. Rebalancing at quarter end and tax rebates. We think that mostly explains the rally in bonds and easing back of stocks. But there’s also little news around. We read the Fed Minutes where three things caught our eye:

1) The Fed is now thinking about the great unwind of the balance sheet following the massive QE bond buying of 2008 and 2014 (we knew that).

2) Some Fed members said stocks, emerging markets, high-yield bonds and commercial real estate had all risen “significantly” and (there was no “and”, they just said it)

3) Yet, oh so casually, swept aside the weak economic numbers (you know, little things like auto sales and mortgage applications) saying they all may come back because confidence is up and there might be some fiscal stimulus ahead.

This all kind of reminds us of Bruce’s One-Inch-Punch but without the desired effect or excitement. As we have said before, there’s a growing gap between “soft” data (things you say you're going to do) and “hard” data (things you actually do). The Fed is putting up a good front of knowing what it’s doing but this is a group who are 75% confident that the Fed Funds two years from now will be between 0.75% and 5.5%! In what they say will be a slower economy. Yes, really. Not making this stuff up.

The Fed is way ahead of itself in thinking the economy needs tightening and the bond market tends to agree. The 10-Year Treasury has held up well in the 2.3% to 2.4% range and inflation expectations are down.

1. Jobs: As if to hammer this all home, we had a terrible NFP number on Friday. New jobs came in at 98,000. Consensus and the ADP numbers were around 200,000. It was the seventh worst number since mid-2011. Here’s the chart:

That's hourly earnings at the bottom, up 2.6% YOY. But industries like retail and health care services, which are 25% of the labor force, saw wage increases of 1%. So, you know, jobs that pay less than half the national average. The unemployment rate fell to 4.5%. You can take this as the Fed hitting its target. Or that labor force participation, low quit rates, past month downward revisions, all still point to a precarious job market. Treasuries rallied so the market probably thinks more like us.

2. Emerging Markets LatAm version: We've liked the asset class for the last year based on relative valuations, reforms, dollar retracement and a general reflation catch-up. Peering under the Emerging Market hood, Mexico is around 3.6% of the index. Sentiment has improved markedly in the last few weeks.

The peso is up 15% from January’s low and stocks are up 13% (or 27% for a U.S. investor) from their post-election lows. This is a remarkable story and is down to i) trade talk histrionics abating ii) consumer confidence rising and iii) the protests at the privatization of the gasoline industry fading. We think there is more catch-up likely given Mexican stocks have underperformed the broad Emerging Markets index by 13% over the last year.

And here we would insert a warning. Emerging Markets have posted a 10% correction in almost every year since 1990 (h/t Caesar Maasry at Goldman Sachs). That's about twice what it is for U.S. stocks. What can trip a correction? Political risk, local and global, trade wars, China credit, 59 Tomahawks, bricks in walls or just a few missed economic numbers. On balance, we like Emerging Markets but just wanted to get the “we told you so” out of the way. Final note: even for our All-Equity portfolios, we don't own more than a 8% weight.

3. Is Tech Expensive? Yes. But then it often is. We took the PE on the S&P 500 and divided it by the PE on the S&P tech sector. The result is the dark red line below, which shows the tech sector selling at a 20% premium to the market. So on that measure, it’s rich. And it rose from about 5% to 20% richer in the last year. But wait. These numbers i) exclude companies with negative earnings (around 15% of the total) ii) include companies that prefer to think of themselves as retailers (so Amazon, Expedia, Netflix, Tesla) and iii) companies that want the tech aura but are, well not really, tech (so Corning, Visa, MasterCard etc).

Back in the true ‘90s bubble, tech stocks traded at eye-watering premiums of 2.5x. So, it’s cheaper now. But another way to look at it is, what’s the tech weight in the S&P 500? We ran the numbers. It was 35% back in the peak years. The average is 15% and it’s now 22%, or its highest since 2001. We'd argue that it’s even higher because of the loss makers. Put all those together and we’d say, yep, it’s expensive.

We've been saying for a while that there are no bargains in U.S. equities right now. The high PEs are somewhat justified by low rates. But still, worth keeping an eye on.

Bottom Line:
Stocks have no immediate catalyst and may drift. Dollar weakness continues. Meanwhile, Alcoa, as always, kicks off the earnings season on April 24th.


What was he thinking? Fed Governor leaks.

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.