Day Hagan Strategy Update

DAY HAGAN STRATEGY UPDATE

SEPTEMBER 2016

SUMMARY

General commentary regarding the Bureau of Economic Analysis of the second quarter GDP report, the global financial markets, and an update regarding the Day Hagan Tactical ETF Strategy.

WRITTEN BY

Donald L. Hagan, CFA

POSTED

September 1, 2016

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The rollercoaster ride continued in August, and, like rollercoasters, most major markets ended up where they started.

During the month, the Bureau of Economic Analysis released the preliminary second quarter GDP report, which indicated that the U.S. economy grew at a real annualized rate of just 1.1 percent in second quarter. This followed annualized growth rates of 0.8 percent for the first quarter of 2016 and 1 percent for the fourth quarter of 2015. Clearly, overall U.S. economic growth has yet to gain traction.

Usually, several interesting points within the report serve as useful indications of what is driving our economy and what isn’t. While many inputs influence our ultimate conclusions about economic activity, the GDP report provides a good overall view. Of note:

  • The good news is that consumer spending has been, and continued to be, a driving force through Q2. Spending was up a healthy 4.4 percent year-over-year. Consumer spending now accounts for 68 percent of U.S. total GDP, with spending on goods coming in at 23 percent of our economic output and services at 45 percent. Spending on autos was brisk and recent retail sales, employment, and personal income reports indicate that consumer spending is likely to stay strong.
  • An increase in Research and Development spending was also somewhat positive. The 17.1 percent annualized growth rate was the second highest on record, according to Ned Davis Research. Interestingly, increases in R&D spending have often led increases in economic activity, according to a study by Begun Erdil Sahin. She found that “According to the study including 15 OECD countries, the impact of R&D expenditures on economic growth is found to be positive and statistically significant. It has also been found that an increase in R&D expenditures by 1 percent leads to an average increase of 0.61 percent in the economic growth.” (Study dates: 1990-2013). R&D spending resides within the GDP category of “Nonresidential fixed investment,” which is also known as “Capital Expenditures.” This is one of the components of GDP that we have been looking for as a harbinger of potential economic improvement. Lately, our view has been that companies have been eschewing investing in their own businesses (funding R&D, upgrading technology and growing capacity) in favor of financial engineering machinations such as engaging in large stock buyback programs. We are looking for this to shift as a new Capex cycle begins. Currently, nonresidential fixed investment accounts for 16 percent of GDP.
  • That was about it for the good news from the report. We also noted that state and local government spending is down -2.2 percent year over year (y/y). While many might argue that less government spending is a good thing, that spending represents 18 percent of GDP and created a drag on economic growth.
  • Inventory investment was also a drag, decreasing by -$12.4 billion. This was the first decline in inventory investment since the third quarter of 2011. While inventory-to-sales ratios for Retailers, Businesses, Manufacturers and Wholesalers retreated a bit, they remain at high levels relative to the last decade or so. Our view is that there are still some inventory adjustments to come that may continue to create headwinds for growth near term.
  • Residential investment declined -7.7 percent y/y. That’s the most in six years. Residential investment trends are often leading indicators and we are watching this closely.
  • Given the positives and negatives of the report, the final arbiter of whether it was good or bad is ultimately corporate profits, which fell -1.2 percent quarter over quarter, evidencing the fifth decline in the past six quarters. Year over year, domestic nonfinancial company profits were down -4.7 percent. Additionally, cash flow from current production was down -1.1 percent y/y.
  • Lastly, to confirm the GDP report, we also review the Gross Domestic Income (GDI) release, which showed just a 0.2 percent annual growth rate vs. the 3.4 percent historical average since 1947. Based on this measure, NDR states that “economic activity nearly stalled in the first half of 2016.” This indicates just how slow things really are overall.

Our outlook for the intermediate term is that economic growth will remain sluggish. But the question is whether it is ready to rebound toward the end of the year. At this point, outside of employment, which just three months ago looked dismal with only 38,000 non-farm jobs gained in June, most economic series are mixed, including housing.

When combined with weakening global economic growth, we remain neutral to mildly bullish in our equity invested position. We are underweight bonds and overweight cash. We continue to favor U.S. equities over international equities, and we are neutral on Large Capitalization companies versus Small Capitalization companies and the Value style versus Growth style. With regard to the strength in consumer spending, we are maintaining exposure to the consumer discretionary sector, and our addition to the Russell Small Cap Value ETF provides additional exposure.

Our international exposure continues to be primarily focused on Emerging Markets, Asia ex-Japan, Canada and the Hedged Japan ETF as the expected near-term improvements in response to recent QE initiatives we mentioned last month start to come to fruition.

Also 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.

Sincerely,

Donald L. Hagan, CFA

— Written 09-01-2016

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