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The Fed calls the Shots

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The Days Ahead: Economic data back on line, but may not be reliable for a few months.  

One-Minute Summary: January was a good month. Stocks up 8%, small company stocks up 11%, international and Emerging Markets up 6% to 9% and bonds trading in a narrow and bullish range.

More data confirmed that China trade talks weigh on people’s mind. The Chicago PMI index dropped from 65 to 56 in a month. We don't usually talk about this index much but it’s Chicago and Boeing is headquartered in Chicago and Boeing sells a lot of aircraft to China…2,000 in all and 1,000 in the last five years at $350m each. So when we look at the New Orders component of the Chicago PMI and see it at a two-year low, we know how sensitive things are to the trade, er, talks.

The Fed announcement (see below) did more to drive stocks than earnings. Earnings were generally good and are up 12.4% YOY. But the hard comp numbers are coming up as 2018 had all the tax cut benefits so analysts are looking at low and perhaps negative growth for Q1 2019. We're not concerned. The market has priced in the slowdown and it mostly comes from energy and tech stocks.

We're also seeing a bounce back from bombed-out stocks. There are 38 stocks up more than 20% this year but the same stocks were down 25% in 2018. This seems a good sign as the market leadership is broader and investors are not just bidding up tech names. The best sector this year has been Energy, which peaked in 2015 and fell 38% to its December low. It’s up 13% since then.

We're in an easy money phase right now. That won't last too long because the data is going to start improving. The market overdid it on the downside in 2018. It may be overdoing it on the bounce back in 2019.

1.     Jobs: great numbers or what? What. The headline number was 304,000, way above estimates. But the December and November numbers were revised down by 70,000 and the unemployment and underemployment, or U-6, rates (the black line) ticked up. The government shutdown may well account for the jump in the U-6 rate as it reflects discouraged workers who want, but were unable to find, full-time work. Which describes a furloughed government worker quite well.

Analysts pointed out that hourly earnings growth (white line) was weak (here’s a particularly bad offender at Bloomberg). But they're still running at 3.1% and in line with the employment cost index, which counts benefits and salaries and is a much better guide to wages. Overall, this is a solid report but not building any pressures that the Fed needs to worry about.

2.     Did the Fed blink?  Yes. Last December the Fed completed the fourth rate rise for 2018. Even though the government was in shutdown. Even though parts of the economy were rolling over. Even though the China trade problem was front and center. It seemed as if the economy, the labor market and inflation were all where they wanted them. This time, they said they would “be patient [when determining] future adjustments to [rates].” It was the “patient’ part that the market liked.

So what changed their mind? In our view, it was the stock market. Since the last meeting, we saw the market correct by 8% and then rally by 15%. That put a strain on financial conditions and, along with weaker numbers, was enough for the Fed to not just stay its hand but also hint that rate increases are off the table until June.

They also removed the phrase that risks were “roughly balanced” and referenced “global and economic developments”. We'd be careful not to read too much into this, other than to say that if a trade deal was done, government stayed open and Brexit concluded, the Fed would reverse its position very quickly. But for now, we have a return to easy monetary policy.

As if to confirm the Fed remains the only game in town and can outdo China, the government or any other pretender any time it wants, stocks rallied hard and are now up 15% from the December lows. The 10-Year Treasury also rallied to 2.62%. Remember it reached a high of 3.25% last year and is almost back to where it was two years ago.

And the yield curve? Now looks very odd:

The black line is where it was a year ago. It’s steep, as one would expect with a Fed just getting to grips with tightening and tax cuts. The blue line is where it is now after four rate hikes. The front-end (up to one year) is all up but beyond five years, barely changed. This tells us two things:

  1. The place to invest is between three months and one year. You earn 10% less yield with a 3-month bill over a 10-Year Treasury, but with 96% less risk.

  2. The market expects the economy to slow and sees no inflation risk.

 And that’s why we’re still using the Treasury Floaters and the 7-10 year Treasury bonds.

3.     More Aristocrats.  There are 53 companies in the S&P 500 Dividend Aristocrats index. That’s all the companies that have increased dividends every year for 25 years. S&P just added four more that made the cut: Chubb, People’s United Bank, Caterpillar and United Technologies. This is how the four of them have done since 1994:

It’s a remarkable record. If you bought one stock of each back in 1994, they would have cost $412 and you would have received a $2.12 dividend. They're now worth $5,191 and paying out $41.45 in dividends. And would have outperformed the S&P 500 by around 140%.

Now, we like dividends.  When a company pays a dividend, it’s real cash. There’s an old stock market saying that “dividends are like getting married, share buybacks are like dating”. One is a hard commitment and the other more like “ Yeah, I might when I get around to it”. Share buybacks have three problems:

  1. Management buys stock at market tops

  2. What they announce (wow, great) is more that what they actually do

  3. It’s nearly all tied to management compensation (so some moral hazard, no?)

The Dividend Aristocrats contain few pure growth stocks and almost no tech. They're not all perfect. Franklin Resources, the parent company of Franklin Templeton funds, peaked four years ago and is down 38%. They also tend to be large cap and underperform the wider market in a broad rally. But over time, they've outperformed the S&P 500 by around 2% and we would expect these latest additions to continue the trend.

Bottom Line. Solid earnings but tough if you have any meaningful exposure to China. The Fed changed everything last week. They’ll probably regret sounding quite so accommodative especially if there’s a fix on trade or shutdowns. We'd exercise some caution coming into February. The market is up as much in a month as we expected for the year.

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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.

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