Day Hagan Research Update




General commentary regarding the global financial markets, and an update for the Day Hagan Tactical ETF Strategy.


Donald L. Hagan, CFA


Octobor 3, 2016


I was recently asked why oil prices seem to have such a powerful impact on the day-to-day volatility in the stock market. My answer was that there are several reasons, from the effects on business cost inputs to consumer spending and liquidity to producer nation solvency. But perhaps the most direct stock market link is as follows:

  • According to FactSet, analysts covering S&P 500 energy stocks are projecting WTI crude oil prices to increase to $55.88 (on average) by the end of the third quarter of 2017. (Data as of 9/23/2016.)
  • If this were to occur, S&P 500 energy sector earnings would increase from $4.3 billion in the second quarter of 2015 to $14 billion by Q3 2017 – not a lot in terms of the U.S.’s corporate profitability. Perhaps a more dramatic statistic is that for 2017, analysts are projecting the energy sector’s earnings growth to be 307% higher than 2016. Nonetheless, when taking all of this into account, the upshot is that the expected increase in the energy sector’s earnings is one of the largest “swing variables” in overall earnings for the S&P 500’s potential 2017 final results.
  • In other words, investors are counting on those energy sector earnings to come through for the S&P 500 to be worth what it is today. The fact is, those expectations are already priced in.
  • The energy sector is currently forecast to contribute about 4% to 2017 S&P 500 earnings. Therefore, a little simple math indicates that if 2017 earnings come in around the expected $132 (it will change, but that’s what it is now), then the energy sector’s earnings would contribute about $5.28 to the total (4% x $132). If we assume a P/E of 19x (which I think is generous), then each $1 of earnings is worth about 19 S&P 500 points. Therefore, the energy sector’s earnings are currently “worth” about 100 total S&P 500 points (19 x $5.28). This is why, when oil prices spike up and down, the S&P 500 index usually trades around a 4.5% range.

Bottom Line: If WTI crude oil prices look like the $55.88 price can be realized by Q3 2017, then this part of the stock market equation will hold up. If oil looks like it is headed lower or will not surpass this hurdle, then the “hit” to the S&P 500 is probably worth no more than 4.5% of the index price. While recent OPEC rumblings around a crude production “freeze” have buoyed prices over the past few days, our view is that production is likely to continue to exceed demand for the foreseeable future, and that prices are likely to stabilize between $35 and $50 per barrel WTI. Currently, within our ETF portfolio, we hold the iShares Russell 1000 Value ETF (symbol: IWD) which has 13% exposure to the energy sector. By virtue of our ETF holding, our full direct exposure to energy companies is around 3% of our total portfolio.

Notwithstanding the energy sector, keep in mind that approximately 57% of the S&P 500’s Q4 2017 earnings are expected to come from the Information Technology (23.8% of total S&P 500 earnings), Financials (17.3%), and Health Care (15.6%) sectors. From a valuation perspective, the Financials and Health Care sectors are trading Forward P/E levels consistent with their 5- and 10-year averages, at 15x and 12x respectively.  However, Information Technology’s Forward P/E is 16.9x, higher than its 5-year average of 14.6x and 10-year average of 15.8x. This is a bit of a headwind for the sector. Overall, the S&P 500 is trading at 16.6x forward earnings vs. the 5-year average of 14.8x and 10-year average of 14.3x. This is clearly not cheap, and partially reflects why our strategy has held some cash. Because of the outsized influence of these sectors, we are  keeping a close eye on the yield curve and recent upheavals in the financial sector (Deutsche Bank’s liquidity and Wells Fargo’s litigation exposure, for example), as well as any negative impact Congress’s attention to pricing might have on Health Care companies’ profitability.

We would also point out that U.S. earnings growth expectations are still hinged on Q4 2017 being very strong.  That’s a long time from now, especially in “market time.”

Among other reasons that we remain only slightly bullish, as outlined last month, is that global economic growth is still subdued and political uncertainty is putting a damper on risk-taking and capex plans.

Which leads me to another often-asked question: “What are your thoughts around the election?”

There are a couple of ways to answer: 1) refer to historical precedence, and 2) give you my best guess. FYI: Using historical precedence will keep you out of trouble.

With regard to historical precedence, there is a ton of data and one can slice and dice it any way they like. For example:

  • Since 1928, one of the best predictors of a Republican win has been if the DJIA is up for the 25 day period before the election. Historically, it has been up 14 times out of 15 observations when a Republican won, and 8 out of 14 times when a Democrat won.
  • Since 1901, when there has been a Democratic President, the DJIA has gained at a 7.78% annual rate of return. During Republican Presidents’ tenure, it was a 3.02% annual return.  But the best returns were seen when there was a Democratic President and a Republican Congress, at 9.16% annual return. Yes, the returns are skewed by some very big up and down years. (Source: NDR)
  • History is replete with large market declines and large gains during both Republican and Democrat presidencies. My view is that the prevailing stages of the monetary, fiscal, economic, business, valuation and credit cycles matter more than who is President. While the President can affect certain change with longer-term social policies, the near- and intermediate-term moves in the market will ultimately correct to a balanced state from excess. How long that takes depends on available liquidity – which is why we focus intensely on this factor. At this point, central banks are providing ample liquidity. Nonetheless, any reversals in stimulus by any major central bank at this stage are likely to be far more important to our financial lives than the election.

With regard to my best guess? I have no idea who will win. (No one else does either.) But I do know that this is not the most “controversial election ever,” or anywhere near it. If you’ve seen the play “Hamilton,” you know that VP Aaron Burr killed Treasury Secretary Hamilton in a duel a few years after Hamilton rallied the House to vote for Jefferson (I just saved you $850 on tickets). Lincoln/Douglas (and Breckenridge) also comes to mind as America fractured into pieces. Remember Bush/Gore and hanging chads? Truman/Dewey? We could go on, but the reality is that from a market perspective, it’s just as, if not more, important to keep an eye on the House and Senate. As polls indicate, the House of Representatives is likely to maintain a Republican majority. While the Senate’s balance is less clear, the polls seem to be also leaning toward a Republican majority.

Holding my feet to the fire, my view is that, sadly, regardless of who wins, gridlock will continue to be the result of our elected officials’ efforts. 

Which leads us back to our quantitative approach to investing based on the weight of the evidence.

Our models and indicators remain neutral to slightly bullish for the intermediate- and longer-term perspectives. We continue to favor the U.S. equities over international equities. With regard to capitalization and styles, we remain neutral. We are maintaining our low duration bond holdings and are overweight cash. Like last month, our models’ message is that this isn’t the time to be overly bearish (negative), nor is it the time to be overly aggressive. A more neutral/mildly bullish stance is currently warranted. We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities. At this point, the competing number of bullish and bearish indicators illustrate that markets remain vulnerable and are likely to continue to meander until economic growth can find a more solid foothold.

If you have any questions or comments, please feel free to call any time.


Donald L. Hagan, CFA

— Written 10-01-2016

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