Weighing the Week Ahead: What Does the Health Care Decision Mean for Stocks?

The economic calendar is light, but it really would not matter. The defeat (via retreat) of the effort to replace Obamacare will dominate financial market stories this week. The pundits will be asking:

What does the health care decision mean for stocks?

Last Week

Last week the news was mostly positive, but irrelevant. Markets were focused on the Obamacare repeal decision.

Theme Recap

In my last WTWA (three weeks ago since my vacation included two weekends) I predicted a discussion about the expected change in Fed policy and the effect on stocks. That now seems like ancient history, but it was a pretty good theme for that week.

The Story in One Chart

I always start my personal review of the week by looking at this great chart from Doug Short via Jill Mislinski. She notes the overall loss of 1.24%, largest since last October. You can also clearly see the Friday fluctuations around the health care breaking news.

Given the time since our last post, let’s catch up with this longer-term chart.

Doug has a special knack for pulling together all the relevant information. His charts save more than a thousand words! Read his entire post for several more charts providing long-term perspective, including the size and frequency of drawdowns.

The News

Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something very positive. My working definition of “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

This week’s news was slightly negative.

The Good

  • Durable goods rose 1.7%.
  • Earnings growth remains solid. Energy has weighed down earnings over the last few years. The general assumption is that earnings estimates are too optimistic. FactSet reports that the expected y-o-y growth in Q1 is 9.1%. You probably do not see that data very often, unless you are wisely following Brian Gilmartin, who has been on top of this story for many months.
  • Rail traffic growth continues although the pace is a bit slower. Steven Hansen has the full story, including charts and analysis.
  • New home sales increased 6.1%. Calculated Risk, the go-to source on housing matters, calls this a solid report. Despite the 12.8% y-o-y increase, Bill notes the downward revisions to prior months. The key upcoming issue is whether builders will provide affordable housing.

 

The Bad

  • Jobless claims increased to 258,000.
  • Existing home sales dropped 3.0%. This was also a small miss of expectations. New Deal Democrat embraces the overall housing strength, calling this the “least important” housing indicator. Calculated Risk has an important summary about existing sales:

    To repeat: Two of the key reasons inventory is low: 1) A large number of single family home and condos were converted to rental units. In 2015, housing economist Tom Lawler estimated there were 17.5 million renter occupied single family homes in the U.S., up from 10.7 million in 2000. Many of these houses were purchased by investors, and rents have increased substantially, and the investors are not selling (even though prices have increased too). Most of these rental conversions were at the lower end, and that is limiting the supply for first time buyers. 2) Baby boomers are aging in place (people tend to downsize when they are 75 or 80, in another 10 to 20 years for the boomers). Instead we are seeing a surge in home improvement spending, and this is also limiting supply.

The Ugly

Hate groups in the U.S. are flourishing. GEI Editor John Lounsbury regularly includes articles that you might miss otherwise, including this important story.

 

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. This week’s award goes to Charlie Bilello, whom we also featured on Stock Exchange. This is double recognition that is unlikely to be repeated!

Why is this so important? Because so many are being “scared witless” (TM OldProf euphemism).

Most pundits, media, “smart money”, experts on valuation have been completely wrong for many years. If you have wisely stuck with the fundamentals, you are called part of a “sucker’s rally.”

For some years, the top “fear indicator” has been VIX. No matter that few understand how it is calculated. The VIX has remained low, despite the insistence of many that risk is high. Instead of accepting the results of an indicator embraced for many years, the true believers take the only course possible: Find a new indicator!

Many of them have seized upon SKEW, which shows that the risk of a crash has never been higher. Bilello’s analysis pushes deeper, asking the excellent question of how predictive SKEW has been in the past.

The conclusion is that widely-perceived fear, whether in regular options or tail risk, does not predict a severe decline.

What does? A business cycle peak (AKA a recession). That is the reason for our careful monitoring of that topic.

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have a rather light week for economic data.

The “A” List

  • Consumer confidence (T). This is the Conference Board version. Will the amazing strength continue?
  • Michigan sentiment (F). The Michigan version, which includes a continuing panel in the sample, is important.
  • Personal income and spending (F). Until and unless more business spending kicks in, consumers are crucial.
  • Initial jobless claims (Th). The series seems to be flattening at record low levels.

The “B” List

  • PCE prices (F). The favored Fed measure is approaching the 2% target.
  • Chicago PMI (F). Best of the regional indicators gets special attention as a hint about the ISM report.
  • Wholesale inventories (T). Advance Feb data. Desired or undesired? That is always the question.
  • Crude inventories (Th). Recently showing even more impact on oil prices. Rightly or wrongly, that spills over to stocks.

     

The Fed Speakers Bureaus have been busy. Expect a daily dose of FedSpeak.

Next Week’s Theme

There is little in the way of scheduled fresh news. The health care vote came at the end of the day on Friday. It will be open season for the punditry. Speculating about the President, the legislative agenda, the Speaker, and the market provides plenty of grist. The commentary next week will raise the question:

What does the failure of the Obamacare repeal mean for stocks?

Once again, there is a hidden question which will be the focus for most – the impact on the Trump agenda. While health care is important, the market strength is more related to tax issues and infrastructure spending. Here are the key viewpoints:

  1. The defeat weakens the President and signals lower chances for the economic agenda.
  2. Getting this issue out of the way permits more rapid attention to corporate tax reform.

These issues are most important to those who believe that the post-election rally is all about Trump. More observers are joining me in crediting the stock strength to resolving the election uncertainty and overall economic improvement. Scott Grannis has a helpful chart.

Even the usually sour Barron’s lead column says that an improved global economy accounts for about half of the U.S. stock rally.

Those who focus on the economic fundamentals (nice piece by a semi-anonymous blogger with whom I have corresponded) and corporate earnings emphasize a base of continued modest growth. Improvements in tax policy are an upside kicker. Eddy Elfenbein has his usual incisive and clear explanation of the history of the “Trump trade.”

The single best analysis I saw was from Dan Clifton of Strategas Research Partners. This video is packed with information, so watch it twice and take notes!

What does this all mean for investors? As usual, I’ll have a few ideas of my own in today’s “Final Thought”.

Quant Corner

We follow some regular featured sources and the best other quant news from the week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

 

The Featured Sources:

 

Bob Dieli: The “C Score” which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment. (see below).

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has several interesting approaches to asset allocation. Try out his new public Twitter Feed.

Georg Vrba: The Business Cycle Indicator and much more.Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli’s enhanced aggregate spread, considering when it might first give a recession signal. His interpretation suggests the probability creeping higher, but still after nine months.

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. His most recent post notes that the expected growth rate in S&P earnings is now 8.41% — the highest level since October, 2014.

Doug Short: The World Markets Weekend Update (and much more). His Big Four chart is the single best method to monitor the key indicators used by the National Bureau of Economic Research in recession dating. The latest update now includes most of the February data.

How to Use WTWA (especially important for new readers)

In this series, I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. Most readers can just “listen in.” If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have eight different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

Most of my readers are not clients. While I write as if I were speaking personally to one of them, my objective is to help everyone. I provide several free resources. Just write to info at newarc dot com for our current report package. We never share your email address with others, and send only what you seek. (Like you, we hate spam!)

 

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and the top sources we follow.

Felix, Holmes, and Friends

We continue with a strongly bullish market forecast. All our models are now fully invested. The group meets weekly for a discussion they call the “Stock Exchange.” In each post I include a trading theme, ideas from each of our five technical experts, and some rebuttal from a fundamental analyst (usually me, but sometimes some guest experts). We try to have fun, but there are always fresh ideas. Last week the focus was on dealing with news-driven risk.

Top Trading Advice

 

Be careful in your backtesting! Sean McLaughlin understands the issues and provides practical advice.

Brett Steenbarger identifies seven training resources for developing traders, including helpful links.

Are you too confident about your skill at technical analysis? Price Action Lab shows how cognitive bias can lead you astray, including some great examples.

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would Chris Kacher’s popular and insightful chart, spread widely by Sue Chang. The various soft times in market history are considered. My own conclusion is that you had better have a good reason to fight the trend.

Stock Ideas

 

Deep value in a solar stock? Andrew Bary of Barron’s features SolarEdge Technologies (SEDG), citing a possible 40% upside. He quotes my friend Bob Marcin, who is very fussy about deep value, noting that the company “makes a category-killer product for a secular growth industry.”

Chuck Carnevale considers the implications of rising interest rates for stocks. His wide-ranging analysis, which you should read carefully, looks at historical macro effects as well as analyzing individual stocks like Johnson and Johnson (JNJ), McDonalds (MCD), and other important names.

Josh Brown explains why homebuilders are strong in the face of rising interest rates.

Our Stock Exchange always has some fresh ideas. There are ideas from five different approaches. Our momentum newest member, Road Runner, trades upward-sloping channels, seeking attractive entry points. This week’s idea is Netflix (NFLX). You will probably identify with one of the characters, and your questions are welcomed.

Yield Plays

Blue Harbinger does a deep dive into dividend aristocrats. He begins with the membership of the SPDR Dividend Index (SDY) and then moves to his likes and dislikes. It is an excellent and thorough piece. In a somewhat more speculative vein, Mark has a provocative analysis of CVR Energy (CVI), including Carl Icahn’s involvement and possible link to his role as a Trump advisor.

Simply Safe Dividends provides an absolutely first-rate analysis of the potential for utility stocks. There is a good analysis of the likely impact of higher interest rates, and how to pick companies that will hold up the best. Especially interesting is the argument for keeping some utilities in your portfolio no matter what you expect on interest rates.

Some REITs might be fine, even when rates are rising. Here are ideas from Salvatore Bruno.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. If you are a serious investor managing your own account, this is a must-read. Even the more casual long-term investor should make time for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. As usual, investors will find value in several of them, but my favorite is the practical tax-time advice on what records you can safely discard. More abstract but very powerful is this discussion of the trade-off between financial assets and human capital.

In his regular column, Seeking Alpha Editor Gil Weinreich raises an important question: Can even the rich afford to retire? He cites several great sources as well as some possible solutions. My advisor colleagues should join me in making this a regular read, but it is usually helpful for DIY investors as well.

If you have been stock on the sidelines, evaluating possible worries, you might want to read my (free) short paper on the top investor pitfalls. It is a good test of whether you can successfully fly solo. Send a request to main at newarc dot com.

 

Watch out for…

 

Companies with “suspicious earnings.” Rupert Hargreaves explains the warning signs and provides some starting ideas.

Final Thoughts

 

Astute and intelligent investors closely follow the news. That will be a special challenge in the week ahead. Most of what you read about the health care decision will be worse than unhelpful. It will steer you astray.

Most sources will discuss what the health care defeat means for Trump or for the Republicans. That type of story is easy to write and invites readers to join in the speculation. The financial outlets might do a little better with some ideas about the impact on tax reform.

The implications for investors demand more sophisticated analysis. This was a test of two things:

  1. The intransigence of the Freedom Caucus
  2. The GOP leadership and the President’s ability to craft a compromise.

If a “layup change” like Obamacare repeal cannot be done within the Republican party, the entire agenda will require some compromise with Democrats.

This affects both the probability of success and the nature of the resulting policies. This conclusion is much more important for investors than the specifics of the health care legislation. It is also more sophisticated than knee-jerk commentary on the change in the “Trump agenda.”

 

A Conclusion for Investors

I know from my travels and discussions that there is a high degree of market concern right now. Part of it is uncertainty about Trump policies (from investors of both parties), and a general sense that the rally is extended and markets are “high.”

This type of concern is exactly why we must invest based upon data, not emotion.

None of our indicators currently warn about the end of this business cycle. Business cycles do not have an expiration date. They do not die of old age. (Yardeni). These are emotional ideas that feel right, but lack empirical support.

There is plenty of “upside risk.” Earnings growth is improving, even in the environment of modest growth. The recent market strength could go on for years without any policy changes. If some of the Trump agenda (probably with Democratic support) becomes law, it could mean a spike in both economic growth and profits. We already see improved business and consumer confidence.

Three Great Interviews

In the flood of news, it is easy to miss the very best stories.  In my regular Weighing the Week Ahead series I include plenty of links to great sources.  Sometimes there are other items that deserve special attention.  This weekend I recommend that you settle back with some popcorn and enjoy these three videos.

In each case you will get some very solid stock ideas from a great source.  You will also learn a common theme, understood only by a few market experts.  Let us take the stories one by one, and summarize the theme in the conclusion.

John Calamos

John runs the (very) largest investment firm in Naperville, our town.  His office — now a building — is a few blocks down the street from ours, and his assets a few zeroes higher.  I take a special interest in following his commentary.  I sometimes think that viewers might be giving him short shrift when compared to the slick guys from New York.  Someone told me that we midwesterners have an accent!  Really?  It sounds normal to me, and you should not let it deceive you.  John's success comes from a great team and good stock selection.

He has great ideas for stocks that will benefit from rising rates, including some technology ideas!  Watch the interview for more.

 

Ron Baron

CNBC's Squawk Box featured an extended interview with one of the leading fund managers and stock pickers, Ron Baron.

This interview is loaded with help for the individual investor, including great ideas about which companies have enduring  business models.  Here are some key bullet points:

  • Very few succeed by trading the news!
  • The average person who invests in mutual funds makes 3% compounded.  The average mutual fund makes 7% compounded.  People think they are George Soros.  So wrong.
  • The stock market has been through a difficult 14-year period of time.  It is up 1-2% a year since 1999 while earnings have doubled.  It started at very over-valued levels. 
  • Stocks are currently trading at median P/E ratios when interest rates have never been lower.
  • Responding to a challenge from Doug Kass via email — Given the secular headwinds to economic growth, why should stock  multiples hold up?

6.8% a year since 1960 is the growth rate of the economy.  For the last 14 years it has been 4.4% and it is accelerating.  People talk about 2% growth but you have to consider inflation.  When you had stocks at 15 times earnings for 100 years you did not have interest rates at zero.  Look at the comparison.  Businesses are growing and growing faster.  Money is cheap.  Businesses are attractively valued.  When the economy grew at 6.8% stocks were growing by 6.1% plus you have to add dividends which makes it about 8%.  That's for 120 years.  Will it keep up at that rate?  Maybe it will be a little less.  We are using 7%.  That means a double in 10 years — 30K in ten years and 60K in 20 years.

As one who called for Dow 20K at the point of maximum skepticism, I understand and agree!  Once again, you will learn more by watching the entire interview.

 

 

Larry Robbins

Robbins is described by CNBC as a "hedge fund titan" who rarely does interviews.  Since I regularly hear misleading information from managers with high AUM's, I prefer to decide for myself when it comes to credentials.

Robbins demonstrated a special insight in the health and health management fields.  This is a great sector to study with plenty of cross-currents.  We have the demographic effects from an aging population and also the influence of ObamaCare.  We still do not know how the new policies will be implemented or which states will participate.

His interview includes several stock ideas in the health care field.

 

The Common Theme

All three sources demonstrated a very sophisticated understanding of the relationship between stocks and interest rates.  They all note that stock market multiples are actually strongest when interest rates are in the range of four percent.

  • Baron emphasizes the importance of stocks in fighting inflation.
  • Robbins notes the multiple, stating "When interest rates are between 3 and 7 percent, the long-term history
    of the market is to trade between 17 and 18 times earnings.  With our
    portfolio trading at 10 1/2, we'll take our chances."
  • Calamos notes, "…if you go back even 50,60 years, when the 10-year bondwas 4% to 6%, p/es were 20,which means it's a much moregrowth environment.so i think we have to, you know,re-educate investors that, youknow, going back to normal ratesis not a bad thing."

Most traders and pundits, as usual, have an overly simplistic rule linking interest rates and stocks.  Higher rates are worse.  The loudest voices telling stock investors to worry about ten-year yields moving higher from two percent said the opposite when rates were moving down to two percent.  On the way down, it was a sign of economic weakness.  And now, on the way up…..?

For those who prefer data to speculation, please check out my "Scared Witless" (TM OldProf euphemism) post.  I describe a "final destination" where a four percent ten-year yield is something of a sweet spot for stocks.

At the start of the week we saw the knee-jerk reaction to higher interest rates.  Eventually, the normal relationships will return.  It provides an opportunity for those in the know.

Investment Themes: The first step in finding a great stock.

Some stock pickers start with a screen.  I start with a concept:  Look for the hated!

I search for investment themes that are decidely contrarian.  That means that few like the concept, the sector or the stock.  The themes must meet several important critera:

  • Negative sentiment and/or polling
  • Analyst skepticism
  • Modest valuations

and most importantly — hatred.

I am going to list some themes and you probably will not like them.  That is the point.

My mission here is to provide some specific ideas as well as suggestions about how the individual investor can search for and find profitable investments.

Contrarian Concepts

One problem is determining what most people believe.  That is the only way to find the contrarian (and possibly undervalued) side of the trade.  I want to encourage a free-wheeling discussion that will be helpful to all, but let me suggest two rules:

  1. Nothing political.  I understand that you may think that Europe is in a socialist decline or be offended by Romney, but that is not the point.  This is about investments, not political philosophy.  We can predict political outcomes, but the purpose is to find investments.
  2. The time frame must be reasonable.  I personally screen using three to six months.

Theme Ideas

Here are a number of themes that  I nominate for consideration.

The Economy

This is an easy choice.  Even the most optimistic economic forecasters only look for growth of 2.5% or so.  There are many recession callers including many/most pundits (especially non-economists) and the ECRI.  The recession forecasters have influenced earnings forecasts, now showing little growth in 2012, and stock prices.

Time frame:  uncertain.  The recessionistas started making their forecasts last Spring at the time of the Japanese earthquake.  Q3 economic growth did not support the theory.  Perhaps another strong quarter will move attitudes.

Stocks:  Cyclicals and Tech.  Caterpillar (CAT) and Oracle (ORCL) are contenders, but the nominations are open.

Europe Crisis

This is open to some debate.  The credit market has not shown any recognition of improved prospects.  Some think that stocks have recently been "euphoric" but it could also be a reaction to the good earnings season.

Time frame:  week to week, but some specific tests within two months.  I think the verdict (for US investors) will be in within eight months, although the social issues may linger.

Investments:  Greek bonds, Italian bonds, credit default swaps, European banks, the dollar/euro spread, US banks, US stock market — listed in order of declining risk and reward.  My own play is lightly long US banks via JP Morgan (JPM).  Those taking either side should declare a time frame and also what would make them change opinions.

Value Trap Stocks

There are many stocks that nearly everyone agrees are cheap on a P/E basis.  The stocks remain "cheap" because of a general consensus that they will not appreciate no matter what happens.  The popular descriptive but unhelpful term is a "value trap."  It is supposedly a silly mistake to be invested in these names.

Time frame:  this quarter or next.  Many names in this category have continued to improve in value.  At some point this will be recognized.  Catalysts might be technical breakouts above key moving averages, changes in leadership, or an exceptional earnings quarter.

Investments:  Cisco (CSCO) and Microsoft (MSFT) come to mind.  Nominations welcome!

Obama Re-election

This seems like a toss-up, mostly because the Republicans are floundering in the search for an opponent.  Key factors in the race will be the economy and employment, reductions in troop commitment, and the qualifications of the GOP candidate.

Time frame:  the stock effect could occur well before the election, depending upon changes in the factors listed.

Investments:  Health care stocks lead this list, since every Republican is committed to unwinding ObamaCare.  There are many candidates, including insurance companies like United Health Care (UNH) and Wellpoint (WLP) and ETFs like XLV.  Many other drug stocks and device makers are also worth consideration.

The Supercommittee

This is my favorite current theme.  There is a lot of skepticism about progress and ultimate success.  The uncertainty has cast a pall over the sectors destined for cuts in the absence of a successful outcome — mostly health care and defense stocks.

Time Frame:  the committee action is due  by November 23rd and an extension seems unlikely.  Congress and the President will need to approve, but the first hurdle is imminent.  Check out my preview from August.

Investments:  The health stocks are good candidates here as well, but so are defense names.  United Technologies (UTX), and Boeing (BA) are leading choices.

Please Join In

Do you like this approach?  The ideas here are a work in progress.  New themes and stock ideas are encouraged in the comments.

In addition, you can participate in a real-time discussion.  I have recently joined a group of investment experts at Wall Street All-Stars.  I am writing about investment ideas and responding to questions in a daily investment diary.  I invite readers to check this out and also to consider the free trial (just email our office:  main at newarc dot com).   There is also free content and other diaries on various subjects.  It is worth checking out.