Zeller Kern’s Investment Monitor

A Bubble In The Making - Part 2

November 8, 2017

By Steve Zeller

As we wind down the current earnings season for the third quarter of 2017, the reports have been on the favorable side. As per a recent report released by Factset, with 74% of the S&P 500 companies reporting (As of November 3rd), and 66% of the companies reported positive earnings surprises. For the third quarter of 2017, the blended earnings growth rate for the S&P 500 is 5.9%. On September 30th, Factset reports the estimated earnings growth rate for Q3 2017 was 3.0%. Seven sectors have higher growth rates today, compared to September 30th, due to upward revisions to earnings estimates and upside earnings surprises. These positive reports were led by Energy, Information Technology, and the Materials sectors.

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Among the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) Amazon reported a big earnings surprise, with Revenue coming in at $43.7 billion versus an expectation of $42.14 billion, according to Thompson Reuters. Also, Earnings per share came in at 52 cents per share. Revenue increased 34 percent from the same time last year, partially due to the $1.3 billion in sales from Whole Foods. North American sales were $25.4 billion, up 35 percent from last year and international sales grew 29 percent to $13.7 billion. Amazon’s Web Service remains to be the growth driver with sales growing 42 percent.

Facebook earnings rose to $1.59 per share versus the $1.28 per share consensus estimate from Thompson Reuters. Facebook’s revenue surged 47 percent to $10.3 billion, beating expectations of $9.84 billion. However, the company’s CFO, David Wehner said that 2018 operating expenses will rise between 45 percent and 60 percent, which is notably faster than expected sales. Netflix’s revenue came in at $2.98 billion, barely beating the expected earnings of $2.97 billion. Their EPS came in at 37 cents versus the 32 cents estimate. Netflix also added 5.3 million additional subscribers

This week will be the first full week of November and the season will be winding down over the next two weeks for the Q3 earnings season. This week, there are 1050 companies releasing earnings reports. Next week there will be only 217, as this will wind down to the finale for Q3.

Investors are excited – Excited to the point that is pushing positive sentiment to record levels, which is a concern for us. In the recent “Financial Forecast” from Elliott Wave International discusses the data, they point out that the Investors Intelligence weekly data shows that there are now 4.4 stock market bulls for every stock market bear, a surge that places the ratio at its highest level since 1987. Things are approaching extremes, if you will.

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As we have mentioned in the prior issue of the “Investment Monitor”, we discussed that the major element that was missing for the current Bull market to peak was a high level of enthusiasm, until now. We are now at levels that could argue for a market top to be forming, however, our wild guess is that investor sentiment will make one final push higher before the top is in, mainly due to a passing of a tax reform bill, and an increased appetite for investors to take on more risk. You are now seeing it everywhere – Everybody, once again, has it all figured out…. “buy the dips”. This reminds us of the days back in 1999, with the popular stock trading commercial with a character named “Stewart.” This commercial was out during the market peaks of the dot com bubble.

Among the forming mania, you are seeing headlines such as a USA Today headline that said “Stocks May Slip” but any decline won’t Kill the Bull”; and the statement “While Wall Street pros won’t rule out a drop of 3% to 5%, they are not calling for a collapse”: source: Elliott Wave Financial Forecast. You are also seeing articles that argue that the conditions that would cause a replay of past market meltdowns aren’t in place, and that “any drop will be brief and that stocks will rebound and make even higher highs”, coupled with the comment that “we are years away from the peak.” So, when investors are piling onto the “buy the dips”, and the experts are touting that “this time is different”, that is usually a bad sign for things to come, in our opinion. 

As far as other indicators, the Chicago Board Options Exchange (CBOE) Volatility Index recorded its least volatile month in its 27-year history in October. The S&P 500 has now gone 250 days, and counting, without declining more than 3% before its record high, which is the longest streak ever. In the last issue of the Investment Monitor, we discussed how it can be argued, and we tend to agree, that the market is within its latter stages of a cyclical “bull” market that is now over 8.5 years old. Statistically, most cyclical bull markets last 5 – 7 years, with a few lasting ten years.

Our current guess, is we will see additional new highs, at least in the near future. But, there are some concerning indicators that exist, such as while we experience record low volatility, on Friday of last week, the S&P 500, Dow Industrials, and the NASDAQ Composite all closed record highs, but the majority of securities on both the NYSE and the NASDAQ exchanges declined on the day.  The Sentimenttrader.com points out that this has happened three times in the last month, in which the breadth has been negative while the major indexes push to new highs. That has only happened one time before, and that was in 1999. Some “Bulls” may argue that this is simply because there is a rotation going on from one stock group to another. That might be the case, but as the Sentimenttrader.com points out, there is only one time that this has occurred when breadth was negative and stocks rallied unscathed, and that was in 1995. So, as we may continue upward for a while, the terrain is certainly becoming risky, in our view.

Many of the main drivers of the market pushing upward continue to trade with very high valuations. Amazon currently has a P/E ratio of 285.10, as of Monday morning, November 6th. But, as I write this issue, it has been announced that Jeff Bezos has sold $1.1 billion worth of Amazon stock. According to Bloomberg, Bezos sold a total of 1 million shares over the course of three days last week netting roughly $1.1 billion. But the sale represents only 1.3% of his total stake in the company, and leaves him with 16.4% of the company’s shares outstanding. I guess that reinforces the old saying – “Buy on the rumors and sell on the news.”

It remains to be seen whether or not we are indeed reaching a major top in the market, or whether this market will continue upward for a while longer. The market is arguably over extended. Ex-energy, earnings are expected to be up a mere 5.6% on a year over year basis for the third quarter, and yet, the S&P 500 has climbed over 24% over the past 12 months. This has caused a lot of market performance by rising P/E multiples, which the overall multiple for the market has expanded around two points to its highest level in 17 years. And as we have mentioned several times in the past, the Shiller P/E ratio is at levels similar to the 1929 peak. Although, there has been recent criticism of the Shiller P/E ratio its relevance has been questioned in this new world we live in. So far, we have only discussed the asset class of Equities, we haven’t gotten into the current risk levels of certain areas of debt, such as non-investment grade European debt. But we will have to save that for another time, as I am confident we will once again discuss the risks that exist within the bond market. Then there’s the “Bitcoin.”

We still have the anticipated tax reform to grapple with, and we yet to see who will be the real winners and the real losers in this circus. The word is, that the current winners in the bill, that is currently out there, are small cap companies, with their highest marginal tax rate coming down the most, then old-economy industrials, and financials – and yes, including hedge funds. The losers are currently projected to be homebuilding stocks, wind power, electric cars, and pharma. You don’t see any politics going on there, do you? There isn’t much in it for technology companies, but they already have several breaks. The technology sector gets to take advantage of huge tax breaks including Research & Development tax credits. Apparently, some tax breaks could be disappearing for the oil & gas sector. It may not be a good time to invest in oil & gas partnership investments.

All in all, though, it does look like an overall pro-growth tax bill, and not only, that the U.S. corporate tax code is in desperate need of a face lift. But, this is just the beginning, it still needs to go over to the Senate, and that’s where the real lobbying takes place.

The tax reform, at this point, is crucial for this market to remain intact, or for a hope that it does. The economy is dependent on it too. From the looks of it, a lot of the recent data was positively impacted from the hurricanes. David Rosenberg recently pointed out that the comments within the ISM reports have footprints of post hurricane stimulus all over it.. Secondly, 120,000 of Friday’s 261,000 payroll gain was from the hurricane stimulus. Plus, 40% of the gain was strictly from the Bureau of Labor Statistics’ guesstimate of net business creation. Third, if it were not for the 765,000 plunge of labor force participants, the jobless rate would have jumped to 4.5%. In other words, for every new job created, almost three people dropped out of the work force. Fourth, housing is in a declining trend as is commercial construction, according to Rosenberg. The consumer spending, adjusted for the decline in savings rate to a decade low of 3.1%, is actually closer to 1%. Plus, more importantly, in my opinion, the employment reports suggest that we experienced yet another month of contraction in “real disposable incomes”, which even before the October data, had not shown any growth over the prior four months, Rosenberg points out.

Hopefully the recent loosening of regulations and, the passing of a significant tax reform bill, can kick the can down the road a little longer.

 As we come into this week, it’s typical after we’ve seen the employment situation come out as there are very few economic reports to be released. In fact, there are no material releases this week at all so the markets will be driven purely by earnings. With no new fundamental releases, this suggests that the markets could go back into a dormant stage with low volatility. This is reflected through the VIX which closed on Friday at 9.14 and was as low as 8.99 which is a historic low. Market participants remain fearless suggesting more of the same is likely this week as we will push into new highs.

Looking back on last week

Overall, the markets traded in a very choppy range last week, hovering along the flat line from last week’s closing value. Once again, we see very low volatility with a daily range hardly exceeding 0.3% on any session. The market rallied on Friday after the release of the employment situation represented 90% of the entire week’s returns.

Despite the miss on the employment situation, with expectations of 300,000 and new jobs coming in at 261,000, the employment rate dropped to 4.1%. This is the type of report that the stock market should appreciate because it holds true to that Goldilocks theme of being neither too hot nor too cold. It was just right to ensure that the Fed will stick to its own theme of raising interest rates gradually--which is the key take away from the report.

U.S. Treasuries traded flat throughout much of the session, but ended the day with modest gains. The yield on the benchmark 10-yr Treasury note slipped one basis point to 2.34%. The 2-yr yield also dropped one basis point, settling at 1.61%. Meanwhile, the U.S. Dollar Index climbed 0.2% to 94.84.

Also of note, WTI crude futures quietly climbed 2.1% to $55.66/bbl, settling at their best level since July 2015. The commodity benefited from the weekly Baker Hughes rig count, which showed that the total number of active rigs in the U.S. decreased by 11 last week to 898.

For the week, the Nasdaq, the S&P 500, and the Dow finished with gains of 0.9%, 0.3%, and 0.5%, respectively.

Apple set the stage for Friday's performance on Thursday evening, which is when it released its fiscal fourth quarter results. The tech giant climbed 2.6% after beating both earnings and revenue estimates, in addition to reaffirming its guidance for the fiscal first quarter, which will feature the mass production of its flagship product--iPhone X. Apple finished the week at a new record high, extending its 2017 gain to 48.9% and its market cap to $891 billion.

Friday’s action was driven by the employment report as well as the release of apple earnings on Thursday night’s release. This set the tone for a positive session after a slightly lower open.  The key to Friday was that it was able to close above the key pivot level of 2585.40 at 2587.84.

This close confirms the upward objective towards the 2650/2690 level, representing a 2.5% to 3.9% gain from current levels.  The expectations are for this target zone to be reached by the end of Q1 of 2018.

The key level on the downside is now 2574.50. A penetration of this level would indicate a decline back toward the 2568/2558 levels.  The is currently only a 30 percent probability for this to occur.

Once again, similar trends are evolving from the markets as upward surges are followed by sidewise trading patterns.

Therefore, the daily or short-term patterns remain flat with the longer-term trends driving the markets higher over time. The intermediate trends are solidly in up-trend as all three PPM’s remain well above .25 suggesting there is less than a 40% probability for the equity markets to decline at this time.

Best Wishes,

Zeller Kern Investment Committee