Performance

The market rocketed higher on Friday fueled by a big increase in nonfarm payrolls (see further below). The report signaled the economy continues in slow growth mode and alleviates fears that a recession is right around the corner. The SPY (SP500 ETF) was up 1.30% for the week, closing at 212.65, just shy of its all-time record of 213.50 on May 21, 2015.

Short-term investors are faced with a huge quandary here. On the one hand, the level of uncertainty around the world, which the market never likes, is at historic highs. The US economy appears steady in slow growth mode, but around the world, especially with the possible negative impact of Brexit, there is a greater threat of recession. In addition, while the US economy is not in recession, US large caps have been in an earnings recession going on five quarters now. The US presidential election increases the uncertainty level like never before. Based on traditional metrics, equities look overvalued. On the other hand, bond yields are at all-time lows, which make equities look inexpensive (see further below). Lower bond yields encourages investment in dividend paying equities. Uncertainty and negative interest rates overseas pushes investment into the US. The SPY is $0.85 away from hitting an all-time high and if it breaks through there is the chance for a further run higher. So there are lots of reasons why the market can break higher or lower in the near term, which might explain why it has been trading in an approximate range between 200 and 212 on the SPY for most of the last several months.

Bonds were up 0.53% on the week, the US dollar rallied by 0.21% and crude fell by 7.31%.

The 10-year hit another all-time low closing at 1.366%. The yield curve continued to get flatter.

Using a model of the spread between the 10-year and 3-month Treasury rates the NY Fed projects the chance of a recession in the next 12-months at 8.10%.

Technical

The market is as close as you can get to setting a new high. In six previous attempts, a failure to set a new high has led to a sell-off. In the event that the market does set a new high, a failure to hold the high, called an “upthrust” (described in our column on May 27), would signal a possible sell-off. However, the market has been trading sideways for a long-time now, and breakouts after such a long sideways trading period often indicate a pretty good move higher.

Valuation

Ben Levisohn writes in this week’s Barron’s that stocks, despite selling at a historically high P/E, look cheap on a relative basis. If you flip the price/earnings ratio of 16.7, you get an earnings yield of 5.99%. Subtract the 10-year treasury yield of 1.38% and the difference is 4.61 percentage points, close to the highest level of the last 15 years.

That spread, of course, is no guarantee that stocks are a no brainer buy here. As we have documented in this column in the past and up above, there are many arguments as to why the market is overvalued, including all of the traditional metrics such as price/earnings, price/book, etc.

Economics

Factory orders fell 1% in May. Nondurable goods were up 0.3% but durable goods were down 2.3%. Year over year, factory orders were down 2.5%. Light vehicle sales dropped 4.5% in June, year over year, they are down 2.0%. The ISM New York Current Conditions Index was up 8.2 points to 45.4 for June.

Employment

Nonfarm payroll jumped by a giant 287k in June, an eight-month high. That offset the weak May report which was revised lower to 11k. Jobless claims dropped by 16k last week to 254k. That was the fewest since mid-April and close to historic lows. Average hourly earnings were up 2.6% year over year, the fastest rate of increase in seven years. Taken all together, it looks like the low May nonfarm payroll report was a one-off and the labor market continues to be tight in the US. The unemployment rate increased to 4.9% from 4.7%, and back to where it was in January. The increase was mainly due to more people entering the job market.

Global PMI

Global PMI remained the same at 51.1 in June, indicating slight expansion. Most of the survey was done pre-Brexit. Manufacturing rose to 50.4 and services fell 0.1 to 51.3. During previous recessions, PMI has been less than 50. However, with uncertainty courtesy of Brexit and the US election, we are still on a global recession watch. The Eurozone composite was at 53.1. The US measured 51.2. Japan was at 49. Russia increased to 53.4.

Brexit

Multiple British real estate asset managers put a temporary halt on investors taking money out of their funds. The British real estate market has been booming, but investors are worried that will go quickly into reverse. Many of the investors are foreigners, so declining real estate values doubled with the pummeling of the British pound could lead to a “run” on the funds. Contagion could lead to other sectors.

GDP

The Atlanta Fed’s GDPNow forecast for Q2 growth fell to 2.4% from 2.6% last week. The drop was due to a cut in second-quarter real consumer spending growth due to slower light vehicle sales. The forecast of the contribution of net exports also fell. The NY Fed’s Nowcast forecasts Q2 growth at 2.1%, unchanged on the week. Q3 estimated growth ticked up to 2.3% from 2.2%.

SUMMARY

The market is right there, knocking on the door of setting a new high. It has failed in six previous attempts, each of which led to a sell-off. The US economy continues in slow growth mode and solid payroll reports reduced recession fears over the next few months. Brexit is a potential problem as evidenced by the temporary closing off of several real estate funds in the UK.

PERFORMANCE

What a week! The market fell hard on Monday by 1.79% and then put in a blockbuster 4-day rally advancing 5.17%. For the week the SP500 (SPY) was up 3.34%, international (VXUS) advanced 4.16% and the aggregate bond index (AGG) was up 0.71%. The US dollar was flat and crude moved up by 3.12%.

While Brexit is a big deal, and while the uncertainty factor is sure to slow growth in the UK and maybe the EU, the market may have initially overreacted. At least for now, Brexit is a political not an economic event. And there was even some talk during the week that maybe the UK won’t even invoke Article 50, which would begin the withdrawal process, and give the EU time to reform itself. The EU would be wise to concentrate their union on the benefits of free trade and leave most of the other issues to traditional political negotiation.

TREASURY RATES

The 10-year Treasury note touched its lowest yield ever at 1.385% on Friday before closing at 1.46%. Let us emphasize “ever”. As in since the founding of the union. Led by fears of the impact of Brexit, investors are betting on more world wide stimulus and/or a weaker economy. Negative yields around the world are dragging down US rates.

Bank of England Chief Mark Carney said on Thursday that the bank’s expectation was slower growth as consumers and businesses react to uncertainty by cutting spending. Carney indicated that the central bank would cut its key rate over the summer. The yield on the two-year British government bond fell into negative territory for the first time after the comments.

Overall treasury rates were down on the week. The curve got flatter. The difference between the 2-year and the 10-year note declined by 6 basis points. The difference between the 5-year and the 30-year declined by 10 basis points.

South Korea

South Korea announced a $17b stimulus package. They join Canada in using fiscal stimulus to get their economies going. Going forward, we will probably see more of this around the world.

Economic Reports

The Richmond Fed Manufacturing Index fell to -7 in June, its lowest level since January of 2013. The Texas Services General Business Activity index fell to -7.7. The near-term outlook declined.

The Chicago PMI came in at 56.8. That is the highest level in eighteen months represents a 13+ point increase over the last six-months. According to the Bespoke Investment Group, in seven of the eight previous times the index increased by that much in that time span, the economy was coming out of recession.

Personal consumer expenditures (PCE) were up 0.4% for May. The combined increase for April and May was the biggest two-month gain since August of 2009. Personal income was up 0.2% in May.

The Philly Fed State Leading Indexes, which are six-month projections of economic activity, show that 40 states are expected to expand, seven to contract and three to remain unchanged.

Pending home sales fell for the first time in four month, dropping 3.70%.

The Weekly Retail Chain Store Sales Index rose 1.5% last week. It is now up 3% from last year.

Initial claims for unemployment insurance rose 10,000 to 268,000. The four-week average is 266,750, that is close to the lowest level since 1973. The labor market remains tight.

GDP

Q1 GDP was revised up to 1.1% from 0.8%. The original estimate was 0.5%. The actual growth is now more than double the original estimate.

GDP estimates for Q2 and Q3 continue to remain stable. The Atlanta Fed’s GDP estimate for Q2 growth is 2.6% and the NY Fed’s Nowcast came in a 2.10%, both estimates were unchanged for the week. The NY Fed’s Q3 estimate ticked up by 10 basis points to 2.20%.

SUMMARY

The market reversed course on Monday and had a huge rally to close out the week. We are back to about where we started pre-Brexit. Estimated economic growth for Q2 is still projected at 2% plus, an improvement on Q1 and consistent with the slow growth mode we have been in for years.

Performance

Brexit was the driver of the equity markets all week, it moved the market higher through Thursday and then drove the market much lower on Friday in reaction to the “exit” vote.

Friday’s losses put the market into the red for the year (excluding dividends). Excluding dividends the SPY is down 0.36%. Including dividends the SPY is up 0.67% on the year. Worldwide, about $2 trillion in market value was erased on Friday. The FTSE 100, made up of the 100 largest companies listed on the London Stock Exchange, fell 3%. However, when taking into account the massive drop in the value of the pound (about 9%), the index fell about 12% in dollar terms. The SP500 dropped 3.6%.

For the week the US market was down about 1.64% (SPY), overseas was down 2.50%. The aggregate bond index stayed above breakeven, +0.06%, the dollar got a boost as a safe haven, +0.67% and oil fell by 0.98%.

Treasury rates fell about 5 basis points for 10-year bonds and less. The 30-year remained steady falling only 1 basis point.

Technical Analysis

The equity markets rallied from Monday through Thursday. The market was anticipating a “remain” vote on the Brexit. What was interesting is that the close on Monday, Tuesday and Wednesday was towards the low for the day. It was as if the “smart money”, which is generally believed to trade towards the end of the day, was saying “not so fast” on the anticipated “remain” vote. But that caution was thrown to the wind on Thursday as the market shot higher by 1.30%. It looked like the market was setting up for another run at the all-time high. The market was clearly anticipating a “remain” vote but “exit” is what it got, and that set up the market for the 3.6% drop on Friday. The SPY did hold support at about $203 as it has on two recent occasions. The problem would be if the market can’t hold support, there is lots of empty space below.

Brexit

On June 23, history was made when the United Kingdom voters elected to leave the European Union (EU). While free trade and regulation were on voter’s minds, limiting immigration was likely the main motivation behind the vote. The EU is a union of 28 states and includes four of the world’s seven largest economies. The UK is the world’s fifth-largest economy representing 4% of the global economy. While the result of the election had a huge impact on financial markets, it is important to remember that at least as of now, this is a political event, not a financial event. In other words, the market went down because of politics, not because of a pending immediate threat to the financial system (like a major bank going under).

The vote itself is not binding, and the splitting of the UK from the EU will likely be a long and complicated process, adding a lot of uncertainty to the process. An act of Parliament needs to be passed to give the EU formal notice of the UK’s intent to leave. Then negotiations begin on the terms of the exit. And to make matters worse, the UK Prime Minister, David Cameron, resigned after the vote and will leave office in a few months.

From an economic standpoint, the question is what happens to the trade agreements? Dropping EU membership means a possible loss of the favorable trade agreements that the EU provides. The EU is the largest trading partner for the UK, accounting for one-half of UK exports. The UK also needs to attract foreign capital to help cover its current-account deficit. That might be more difficult now.

Under two scenarios laid out by the International Monetary Fund (IMF), UK GDP will drop by 1% by 2021 (more favorable) or more than 4% (unfavorable).

But the impact on the UK is only one part of the problem. Another part is how this impacts the EU. This will affect the EU economy but it might also result in the EU itself splitting up. Other countries might be tempted to vote themselves out of the EU. Given that UK voters decided to leave mainly because of immigration policies, and because this same immigration policy is the main impetus for other countries to leave the EU, it would probably be smart for the EU to restructure itself to be primarily an economic (free trade) union, and leave everything else to traditional negotiation between countries.

A third impact is the knock-on effect on the US dollar and the Japanese yen. Both currencies are likely to increase in value, hurting exports and lowering domestic profits.

In sum, Brexit opens up a long period of uncertainty and markets do not like uncertainty. However, the world economy is not going to end, although there will probably be some short-term downside. Countries will still trade with each other and people are still going to live and buy products. Slow growth is expected to continue and the world will adjust. Even in the UK, many economists still expect growth. Deutsche Bank Chief Economist Mark Wall  is looking for UK GDP growth of 0.9% versus 2.1% had the UK remained in the EU. He see Eurozone growth of 1.1% instead of 1.5%.

Fed

Janet Yellen said the chances of a recession this year are “quite low”. A WSJ survey of economists puts the chances of a recession in the next year at 21%. Yellen noted that wages are picking up and that economic output has improved in the second quarter. Yellen indicated that rates would increase gradually and cautiously, she did not give any hint of when. She also said she was not interested in following Japan and Europe to negative interest rates.

Yellen’s comments were before the Brexit vote. Now after Brexit, the chances of a Fed rate hike, at least this year, have dropped dramatically. We are probably looking at Q2 of 2017 at the earliest.

Inflation

We wrote last week that inflation pressures are building in the system. The WSJ ran a story earlier in the week showing that the “sticky-price” CPI, items that fluctuate in price less, such as household furnishings and personal care products, rose at the highest rate since 2009. According to researchers at the Atlanta Fed, changes in “stick-price” items incorporate expectations about future inflation more so than other measures of CPI.

Economy

The US Coincident Index rose 0.2% indicating continued slow growth. Existing home sales increased 1.8% in May. Single-family sales were up 1.9%. the highest level since February of 2007. Distressed sales now represent only 6% of the market, a year ago it was 10%. The Architecture Billings Index increased by 2.5 points to 53.1, another good sign for growth. ATA For-Hire Truck Tonnage increased 2.7% in May. That was the first gain in three months and was up 5.7% year over year.

GDP

The Atlanta Fed’s GDPNow estimate for Q2 declined to 2.60% from 2.80% last week. The estimate for real residential investment growth fell to 1.7% from 3.6% after the US Census Bureau released data on new home sales, prices, and construction costs. The contribution of inventory investment also declined. Both factors resulted in the lower estimate. There was no change in the Q2 and Q3 estimates for the NY Fed’s NowCast. The NowCast projects growth at 2.10% for Q2 and Q3. If you split the difference between the two forecasts for Q2, and if the estimates hold at these numbers, the growth would be 2.35% versus 0.80% in Q1, an improvement for sure.

SUMMARY

The uncertainty created by the “exit” vote will likely dampen economic activity worldwide at least initially. Over the medium and long run markets should adjust. Brexit was a political event not an economic one, although you can make an argument that it can turn into an economic event down the road. Interest rates were pushed lower, which will offset some of the negative impact from Brexit. And with such low rates, equities arguably remain attractive. From a technical perspective, the market is resting on a major support line. If it breaks support expect further downside in the short run.

Performance

Brexit fears hung over the market as the SPY fell 1.18% (dividends included) on the week. International markets did about the same, the VXUS was down 1.19%. Bonds were up 0.16%, the US dollar fell by 0.68%.

Bond yields in Europe continued to fall. The German 10-year went into negative territory for the first time. Polls at the beginning of the week leaned toward the “exit” camp but in the last day or so the have tilted back to the “stay” camp. Basically it is too close to call right now. Ultimately, an “exit” vote will have to be put into legislation. The vote is not binding although there would be enormous pressure to follow the will of the voters.

Oil was down 2.22% on the week. Rig counts have gone up for three weeks in a row.

Treasury rates fell on the week. The 5-year fell 4 basis points and the 30-year dropped 1 basis point.

Technical Analysis

As in the five previous attempts, a failure to crack through to a new high has led to a sell-off. Helped by Brexit fears, the market is off 2.76% from its recent high on June 8th.

The market has now retraced about 60% of its gain from the low on May 19 to the high on June 8th. If the market is going to make a new high in the short run, right about here (206.52 on the SPY) would be a good place to put in a higher low and then advance. The outcome of the Brexit vote might provide the fuel in one direction or another. A “stay” vote will likely push the markets higher and an “exit” vote will send equity markets lower. The impact overseas is likely to be greater.

Earnings

Earnings for Q2 are now expected to decline 5.1% per FactSet. At March 31, the estimated decline was 2.8%. However, earnings estimates are normally revised lower during a quarter. The trailing 5-year average is a decline of 4.4%, versus 2.30% currently. The information technology sector has been the biggest contributor to the lower estimates. Earnings estimates for the sector are now -7.3% versus -0.1% at the start of the quarter. The forward p/e for the entire SP500 is 16.4. This compares to the five-year average of 14.6.

Brexit impact on SP500

The Brexit vote takes place on Thursday. According to data compiled by FactSet, the aggregate revenue exposure of the SP500 to the UK is 2.9%. The UK represents the third highest country-level revenue exposure. The US is at 68.8% and China is at 4.9%. Thirty SP500 companies get more than 10% of their revenue from the UK.

Fed

The Fed released their latest version of the dots plot at their meeting this week. The “dots plot” is the Fed Governors estimate of the future path of interest rates. Eleven participants called for two rate hikes this year and six called for one rate hike. The estimate for this year is 0.875%. The 2017 estimate is now 1.625% versus 1.875% in March, implying three rate hikes. For 2018, the estimate is now 2.375% versus 3.00% in March, also implying three hikes. The long term median estimate fell by 25 basis points to 3.00%.  James Bullard of the St. Louis Fed thinks the FOMC should hike one time this year and then leave rates stable for two years.

Economy

The consumer price index (CPI) was up 0.2% in May and is up 1.0% year over year. Energy prices rose 1.2%. Food prices fell 0.2%.

Core CPI increased 0.2%. Shelter rose by the biggest amount since February of 2007, up 0.4%. Apparel prices jumped 0.8%. Medical services increased by 0.5%. Medical care commodities fell 0.2%. Year over year core CPI is up 2.2%.

Core service inflation hit the highest year over year rate since September of 2008, rising by 0.3% for the month and 3.2% year over year. Given the current tight labor market, higher wages will begin working their way through the pipeline and probably push service prices higher in the near to intermediate term. So while inflation might be slowing building in the system the Fed is reducing estimates for the future path of interest rates.

Housing starts fell slightly, by 0.3% in May. Starts have been stable at around the current 1.164 million annual rate for the last year. Building permits rose by 0.7%.

The Philly Fed General Business Activity Index increased to 4.7 in June, reflecting moderate expansion in factory activity. But the Empire Services Business Activity Index dropped 2.3 points to 3.2, indicating slightly slower activity.

Jobless claims rose to 277k, the first increase in five weeks.

Retails sales were up 0.5% for May. Over the last two months, retail sales are up 1.73%. That is the strongest two-month performance since April of 2014.

Demand for Debt

The yield on Germany’s 10-year bond dropped into negative territory. As of Tuesday it was yielding -0.008%. There is now about $10 trillion in global sovereign debt with negative yields. Corporate debt is also at ridiculously low yields. A Unilever 2020 bond now yields -0.02%. Toyota Finance issued $186 million (in yen) of three year notes yielding 0.001%.

GDP Estimates

The Atlanta Fed’s GDPNow increased their Q2 GDP estimate by 0.30% to 2.80% due to improved forecasts for real consumer spending growth and real residential investment growth. The NY Fed’s NowCast decreased by the same amount, falling to 2.10%.

Summary

This week should be all about the Brexit vote. Equities fell slightly last week. German 10-year bonds went negative. The outcome of the vote will likely determine the near term direction of the market. As has been the case for a long time, economic data was mixed as the economy continues in slow growth mode.

http://www.wsj.com/articles/aha-the-case-for-buy-and-hold-investing-1465833316

PERFORMANCE

The SPY (SP500 ETF) made a run at its all time high on Wednesday, but fell short. The SPY closed at 212.37, the all-time high was 213.50 set on May 21, 2015. The market sold off after that closing on Friday at 210.07, dropping a little more than 1% from Wednesday. The market has now made six attempts over the last year at cracking the high but has failed. However, it still is holding above the declining trend line dating back from last year.

According to this week’s Barron’s, 23 times since 1929 has it taken 300 days or more to make a new high. But when it has happened, the SP500 has advanced an average of 15.6% during the following year.

Of course, there is also the chance that the failed attempt will lead to a sell off, as did the previous five attempts. There is a negative divergence between the moving average convergence divergence (MACD) histogram on the bottom of the chart and the price action up top (see the yellow lines). The MACD, which measures the relationship between the 26-day and the 12-day moving average, is trending down while the SP500 has been trending up. That is called a negative divergence. Sometimes, certainly not always, such a divergence indicates a weakening of price momentum that will signal a near-term decline in the market.

For the week, the SPY was down just barely, -0.10%. International markets took the bigger hit, the VXUS (international x-US ETF) dropped 2.09% on the week. There is new concern that the UK may actually vote to leave the European Union. The markets have been pretty much forecasting a “no” result, but if sentiment begins to trend towards the “yes” camp we could be in for a wild ride in equity markets. Bonds and oil were up on the week, although oil fell 4.2% on Thursday and Friday.

MARKET VALUATION

There has been a tug-of-war between those in the overvalued versus the undervalued camp. We have stated before that based on traditional metrics the market is somewhat overvalued (you can argue about the degree), but when taking into account low interest rates, the market might be somewhat undervalued. Here is another notch in the undervalued camp, albeit a very slight undervaluation. Bloomberg Intelligence Economics has recreated Nobel Prize-winning economist James Tobin’s Q ratio. The Q ratio measures corporate net worth and compares the total value of corporate shares against the replacement cost. The ratio is currently 0.97 indicating that the stock market is valued just less than the replacement cost of its assets. An even reading of 1.00 would be fair value.

FED/INTEREST RATES

Janet Yellen gave a speech on Monday and was relatively upbeat. Yellen says positive economic forces still outnumber negative forces. Yellen did not give any guidance on a June or July rate increase.

Interest rates fell this week across the curve and got slightly flatter. The 2-year dropped 7 basis points, the 10-year was down 9 basis points and the 30-year was down 11 basis points. There is so much debt at negative yields around the world that investors continue to be drawn to higher yielding US securities. In the chart below, Japan, Germany, France and Italy are all yielding negative rates going out a few years.

JOBS

Jobless claims declined to 264k. It was the third drop in four weeks. The Job Openings and Labor Turnover Survey (JOLTS) report for April showed that total job openings are now at their highest level ever. The rate for all separations (people quitting, terminations and retirements) remained roughly flat. Together, these reports are at odds with the negative non-farm payroll hiring report from last week. There might be a mismatch between job openings and the applicants with the proper skills to fill those positions.

ECONOMIC INDICATORS

The OECD U.S. Composite Leading Indicator moved up 0.02 points to 98.9 in April. This was the first increase since July of 2014. Service revenues rose 3.6% year over year during Q1, that was the fastest pace in three quarters. The Freight Transportation Services Index was up 1.3% in April, its first increase in three months.

GDP

There was no change in the estimates for Q2 growth for either GDPNow or the NowCast. GDPNow is projecting 2.50% and the Nowcast forecasts 2.40% growth for Q2.

SUMMARY

The market came close, but could not break through to a new high. In the 5-previous attempts, the failure led to a sell-off. However, this was the first attempt above the declining trend line.The market is beginning to get nervous about a “yes” vote on the Brexit.  Economic data was decent for the week.

PERFORMANCE

The equity markets were flat to slightly up. The SP500 (SPY) was up 0.02%, the overall US market as measured by the VTI was up 0.28%, international markets advanced 0.86% and the aggregate bond index was up 0.61%. The US dollar declined by 1.96% and crude fell by 0.91%.

The SPY has held just above the declining trend line that it broke through last week. On Thursday the SPY closed at 210.91. That was the high for the year. The all-time closing high was 213.50 set on May 21, 2015. However, when adjusting for dividends, the Thursday close of 210.91 represents the all-time high. The May 21, 2015 adjusted close is 209.04 after dividends (per Yahoo Finance).

On each of the first three days of June, the market has started lower and worked its way up to close towards the high of the day. Some market-followers would consider that a bullish sign as supply could not overcome demand, even with the terrible payroll report (see further below).

PAYROLL

Non-farm payrolls rose only 38,000 in May. This was a huge miss. Estimates were for 100,000 plus. It was the lowest number in almost six years. Numbers were also revised downward for March and April.  The number probably would have been about 35,000 higher without the Verizon strike but that is still much lower than expectations. The disappointing payroll number significantly lowered the chance of a Fed rate increase in June, given that one of the conditions to increase rates was continued improvement in the labor markets.

The Vanguard economic model, which we talked about at our April webinar, forecast a high likelihood of a “growth scare.” Vanguard defined that as a fall in monthly nonfarm payrolls below 50,000, exactly what happened. Writing on May 5, Vanguard economist Joel Davis said, “At this stage in our long economic expansion…slowing job growth is not a sign of recession. It’s a symptom of a labor market near full employment…our analysis of financial and economic variables puts the odds of a near-term recession at about 10%. So brace for bad headlines. Prepare to put the data in a broader – and less alarming – economic context. And fight the fear with patience and perspective.”

But economists at JP Morgan are placing a much higher probability of a US recession in the next 12 months. Putting the probability at 36% this week. That is the highest level during this economic recovery.

“Goods-producing” payrolls dropped by 38,000 in May. It was the fourth consecutive month that payrolls have fallen in this sector. According to David Rosenberg, chief strategist and economist at Gluskin Sheff, “this is precisely the sort of rundown we saw in November 1969, May 1974, October 1989, November 2000 and May 2007” that foreshadowed a recession by an average of five months.

The unemployment rate fell to 4.7% but that was due to about 500,000 people leaving the work force.

But even with the fall in new jobs, average hourly earnings was up 2.5%, year over year, indicating a tightening labor market.

On a more positive note, the initial jobless claims report came in at 267k, down 1k from last week. 267k is a historically low number.

GLOBAL RISK

The probability of a global recession is also increasing and is much more likely than a US recession. We have been on recession watch outside the US for several months now. The global manufacturing PMI fell by about 0.1 to an even 50.04 in May, indicating flat manufacturing activity.

One bright spot, 71% of the reporting entities were in expansion mode, up from 60% last month.

OTHER ECONOMIC REPORTS

The ISM Non-Manufacturing Index fell to 52.9. Anything above 50 is considered as expansion, but 52.9 was the lowest number since September of 2013.

There were positive personal income and spending reports. Nominal incomes were up 4.91% year over year and spending rose 0.94% month over month. The savings rate is 5.3% indicating that US consumers are in decent shape.

Factory orders were also a positive. They rose 1.9% in April, the most in six months.

GDP ESTIMATES

Even in the face of the non-farm payrolls report, the GDP estimates held in there. The Atlanta Fed’s GDPNow estimates Q2 growth at 2.50% (down from 2.90% last week). The NY Fed’s Nowcast forecasts Q2 growth at 2.40% (up from 2.20% last week).

SUMMARY

Economic news tilted negative this week but there were some positive reports. The non-farm payrolls report was such a huge miss it is hard to ignore. The global economy did take a step back and appears closer to a global (not US) recession. The equity markets held strong.

The SP500 broke higher on Tuesday and then finished strong on Friday to close at its highest closing price since 11/4/2015. It is, however, a little bit shy of its intraday high from April 20th. Overall, the SPY (SP500 ETF) was up 2.31%, the US markets (VTI) were up 2.38% and international (VXUS) advanced 2.06%. The aggregate bond index was about flat (+.08%), the US dollar moved higher (+0.39%) and oil continued its advance (+2.43%).

Equities managed to rally even though Fed Chair Janet Yellen made it clear on Friday that there is a good chance of an increase in rates in the near future. Assuming that economic data continue to show some type of growth (even if it is just above zero) and if payroll numbers continue to be strong, an increase in June or July is on the table. The federal-funds futures market is pricing in a probability of 34% for a June increase and 58% for a July increase.

TECHNICALS

The SPY (SP500 ETF) broke through its declining trend line dating back to May of last year. For the long term trend to turn positive it will have to hold above this line and then push through last year’s high. On April 20th, the SPY did the same but could not hold the advance. In technical terms, this is called an “upthrust”. Market participants expect that when the price moves through a line of resistance, it will go on to higher prices from there as demand should now more easily overtake supply. When the expected demand does not show up, the price quickly falls.

The opposite happened on May 19th. On that day, the SPY fell below support. Market participants might think that the SPY was now going to head lower and the supply would swamp demand. But it turned out that the selling was declining going into that point and there was no more fuel to push the SPY lower. When that happens, that is called a “spring”. That set up the run we had last week.

ECONOMY

GDP

Q1 GDP was revised up to 0.8% from 0.5%. Q2 continues to track stronger than Q1. The Atlanta Fed’s Q2 estimate hit its high, coming in a 2.90%. The NY Fed’s Nowcast increased to 2.20%. Growth now shows some modest acceleration coming off of a weak Q1.

However, poor profit numbers over the last year, coupled with somewhat weak Regional Fed surveys (see the Richmond survey below) and company estimates of spending point to lower capital investment by business. There is a high correlation coefficient (0.84) between GDP growth and changes in capital investment. The slower investment will most likely hurt GDP growth going forward. The economy needs improved corporate profits to help increase capital spending.

Manufacturing

The Richmond Fed Manufacturing Activity Index fell in May by 15 points to -1. it was the biggest drop in a decade. However, the individual activity indexes looked good pointing to modest expansion down the road.

Housing

Mortgage applications have been improving. New single family home sales exploded higher, up 16.6% month over month and 18.1% year over year. It was the biggest increase since 1992 and sales hit the highest level since January of 2008. Pending home sales hit a post-crisis high.

Employment

Jobless claims fell again, the number came in at 268k. We had a couple of weeks recently where the claims shot higher but the numbers are now back in sync with the strong reports we saw earlier in the year.

MARKET SENTIMENT

The American Association of Individual Investors bullish sentiment dropped to the lowest level in more than 10-years, coming in at 17.75%. But bearish sentiment also fell, dropping to 29.39%. The majority is now in the neutral camp at 52.86%. In the past, very low bullish sentiment readings have often been associated with positive market performance over the following year.

Barron’s Cover Story – “Why the Market Won’t Crash – Yet”

Barron’s has a good article this week on the near-term threat of a recession and a bear market. We have covered all of these topics over the last few months but this is a good review. Barron’s writes that the market is headed for another crash, but it always is headed for another crash, and it probably won’t be for a while. Market crashes are usually caused by a recession, although the decline usually begins before the recession arrives. Right now there does not appear to be a recession around the corner. Barron’s defines a market crash as a decline of 20% or more that lasts longer than 12 months.

Key reasons why there likely won’t be a crash soon:

HOUSING – A crash in housing prices preceded the last recession, but prices are below the 2007 peak. The median price today is 12% lower than in July of 2007.

OIL – The price of oil usually jumps much higher before a recession. That is not the case today.

YIELD CURVE- when the curve is flat or inverted, is often signals a recession is on the way. That is also not applicable today.

Reasons that might signal a problem ahead:

VALUATIONS – the current market p/e is 20.3, which is greater than the July 2007 p/e of 16.3. The offset to that argument is that earnings in 2007 reflected inflated earnings from the financial sector that eventually disappeared and that earnings today are understated by the problems in the energy sector. Another difference is the 30-year treasury bond yield was 5.1% in 2007 with a 2.9% dividend yield (on equities that pay dividends). Today, the 30-year yields 2.6% and dividends are yielding 3.2% (on equities that pay dividends). It would make sense that equity prices would be much higher given the lower bond yields, thereby, resulting in a lower dividend yield. But that hasn’t happened. Equities that pay dividends have a higher yield today even though the bond yields have declined dramatically.

POSSIBLE GLOBAL SLOWDOWN – the international economy is barely above recession level.

TRUMP / TRADE WAR / DEFICIT- Trump raises the uncertainty level in key areas that can impact the markets including his position on trade and the deficit.

SUMMARY

The market appears to be setting up for another shot at its high. It failed the last time around April 20th. The economy has made some progress over the last few weeks. The Q2 GDP estimates are up the last couple of weeks and the employment numbers are solid.

Source: Callan

(from this week’s Barron’s)