Day Hagan Smart Sector® with Catastrophic Stop Strategy Update December 2024
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Day Hagan Smart Sector® with Catastrophic Stop Strategy Update December 2024 (pdf)
Catastrophic Stop Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model (Figure 1) held steady in November and entered December with a fully invested equity allocation recommendation. If our models shift to bearish levels (below 40% for two consecutive days), we will raise cash.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index
Figure 2: The Global Purchasing Manager Index is still in expansion territory. The recent moves higher for both manufacturing and services are encouraging. It would be concerning if the Services PMI (light blue) dropped below 50, joining the weak manufacturing PMI reading.
The U.S. dollar index fell below 106 last week, marking its first decline in nine weeks. This pullback followed the nomination of Scott Bessent as U.S. Treasury Secretary, which eased market concerns about potential policy shifts under the incoming Trump administration. The decline accelerated after U.S. PCE inflation data met expectations, indicating little change in the Federal Reserve’s approach to interest rate cuts. Markets are now pricing in a 66.5% probability of a 25-basis point rate cut in December, up from 55.9% the previous week. Despite this week’s drop, the dollar index is still on track for a 2% rise in November, as Trump’s election spurred expectations of fiscal expansion and fewer inflationary policies.
In manufacturing, the S&P Global Flash U.S. Manufacturing PMI rose to 48.8 in November 2024 from 48.5 in October, indicating ongoing deterioration in the goods-producing sector but at a moderated pace. Conversely, the S&P Global U.S. Services PMI surged to 57 from 55, surpassing expectations and reflecting significant growth in the services sector. For November, the S&P 500 climbed 5.7%, the Dow Jones jumped 7.5%, and the Nasdaq rose 6.2%. These gains reflect optimism that a second Trump administration will implement a more business-friendly strategy, potentially adopting a more moderate trade tariff stance.
Our models’ indicators show that manufacturing weakness and valuations are negative, but technical indicators including momentum, mean reversion, and breadth are bullish, with ETF inflows, sentiment, and business conditions also supportive. Overall, we remain fully invested as the markets remain near all-time highs.
Sector Outlook
Sector
Consumer Discretionary
Consumer Staples
Communication Services
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Real Estate
Utilities
Outlook (relative to benchmark weighting)
Overweight
Neutral
Neutral
Neutral
Overweight
Underweight
Neutral
Neutral
Underweight
Neutral
Neutral
Sector Commentary
Sector Review
Now that the lion’s share of Q3’s earnings reports have been released, we are featuring a brief earnings summary from some of the largest companies in each sector along with model commentary.
Consumer Discretionary: Amazon showcased strong revenue growth, with an impressive 11% year-over-year increase, excluding foreign exchange impacts. The company’s operating income surged by 56% to reach a record $17.4 billion, marking its highest quarterly performance ever. Additionally, Amazon achieved its seventh consecutive quarter of operating margin improvement across its North America and International segments. However, the report also revealed some challenges, including unpredictability in results influenced by economic conditions and customer demand, making accurate demand forecasting difficult. Furthermore, Amazon anticipates capital expenditures around $75 billion in 2024, primarily to enhance its AWS platform and fulfillment network. On Tesla’s side, the company reported record deliveries in Q3 despite a broader industry decline. Its energy storage solutions, including Megapack and Powerwall, are gaining traction. The internal 4680 battery cell is positioned to be the most cost-competitive in North America. Nevertheless, Tesla faces potential hurdles, notably the challenge of maintaining automotive margins against a tough economic backdrop. Additionally, energy deployments may fluctuate based on customer readiness rather than actual demand, and the company warns of a potential decline in order volumes next year due to external shocks like economic crises. The majority of Internal and External indicators remain positive, with measures of trend, overbought/oversold, relative valuations, and positive earnings surprises bullish. We remain overweight.
Figure 3: The relative forward price/earnings ratio remains near the lower end of the 10-year range.
Consumer Staples: Costco is executing its top-line growth strategy effectively by offering high-quality goods at competitive prices, which resonates with its member base. The company’s e-commerce segment is thriving, particularly in categories like appliances and health products, boasting double-digit growth. Additionally, Costco has managed to lower prices on various Kirkland Signature items, benefiting consumers directly. Conversely, Procter & Gamble’s core business, which accounts for 85% of its sales, is showing consistency with a 4% growth rate over recent quarters. The company is experiencing market share growth, particularly in North America and Europe, with strong performance across several categories. Procter & Gamble’s innovation plans for the latter half of the fiscal year aim to sustain this growth trajectory. Nonetheless, the company is grappling with challenges, particularly in China and the Middle East, where organic sales have declined markedly. Additionally, its baby care segment is under pressure from declining birth rates, and the SK-II brand has seen a troubling 35% drop in sales in China, posing significant hurdles for resurgence in that market. The composite model remains weak, with technical and operating measures negative. Credit conditions, sector-related credit spreads, pricing power, and the positive economic backdrop (staples are defensive holdings and typically do better when the markets are under duress) are headwinds.
Figure 4: The sector is oversold but needs to reverse back above the lower bracket before we would consider adding exposure.
Communication Services: Since the sector includes three of the “Magnificent 7,” we thought it worthwhile to discuss each. Meta continues to experience significant user growth, with over 3.2 billion people engaging with its apps daily. The rapid adoption of Meta AI and Llama is positioning the company as an industry leader in AI technology. Additionally, momentum for the Threads app is strong, boasting nearly 275 million monthly active users. However, Meta faces notable challenges, particularly within its Reality Labs segment, which reported a substantial operating loss of $4.4 billion in Q3. Furthermore, increasing legal and regulatory pressures in both the EU and U.S. may hinder its business operations and financial performance. As they expand their infrastructure, Meta anticipates significant growth in infrastructure expenses in 2025, further complicating their financial outlook. In contrast, Google has experienced promising growth in its cloud segment, with revenues increasing by 35% year-over-year, largely fueled by advancements in AI infrastructure and generative AI solutions. YouTube also saw a 12% rise in advertising revenue due to a boost in brand and direct response advertisements, while subscription platforms and devices reported a 28% revenue increase. However, Google faces challenges such as a 2% decline in network advertising revenue and a substantial $607 million charge related to optimizing its office space globally. Additionally, the strength of advertising revenue in the latter half of 2023 is expected to be impacted as APAC-based retailers exert more influence. Similarly, Netflix has enjoyed a revenue growth of 15% year-over-year, with operating margins increasing from 22% to 30%. The planned content slate for 2025, featuring new seasons of popular shows and films from notable creators, adds to its optimistic outlook. Netflix’s advertising business is making strides, contributing to over 50% of sign-ups in ads-supported countries. Yet, the company has faced setbacks, including a slight membership decline in Latin America following price changes and disruptions caused by Hollywood strikes, which have affected the content lineup in early 2024. Moreover, Netflix continues to refine its advertising monetization strategies, as substantial growth in this area is not anticipated until after 2025. The composite model is mixed, with measures of trend, overbought/oversold, momentum, and earnings revisions positive. Valuations, sales growth trends, and higher relative volatility are negative. We remain neutral.
Figure 5: Better sales growth trends are starting to appear. A rise above the 156-week trendline would be bullish.
Energy: ExxonMobil has showcased impressive financial performance, reporting earnings of $8.6 billion—one of its strongest third quarters in a decade—reflecting the effectiveness of its enterprise-wide transformation. The Energy Products division has seen earnings nearly double compared to 2019, driven by cost reductions and selective divestments. Additionally, ExxonMobil has consistently increased its annual dividend for 42 years, earning its place among the elite “Dividend Aristocrats” in the S&P 500. However, the company has faced challenges, including operational disruptions caused by a tornado at its Joliet Refinery, which significantly impacted fuel supplies in the region. Furthermore, upstream production in Guyana declined by 30,000 barrels per day due to the ongoing Gas-to-Energy project tie-ins, with quarter-over-quarter earnings also dipping. Similarly, Chevron has demonstrated strong financial and operational results, achieving record cash returns for shareholders and making notable advancements on major projects like TCO and Gorgon. Its operations in the Permian Basin continue to exceed expectations. Nevertheless, Chevron faces hurdles, including intricate commissioning work for the TCO Future Growth Project, which has an uncertain startup timeline. Additionally, decreased downstream earnings have occurred due to lower refining margins, while the company grapples with regulatory and policy challenges in California that could lead to higher gasoline prices. Technical (price-related) indicators are generally negative, while sentiment is overly pessimistic, cash flow yields are historically high, and crude spot prices are oversold. We remain neutral but will add if the technicals indicate that sellers are exhausted.
Figure 6: The Energy sector’s sentiment measure has reversed ever-so-slightly from overly pessimistic levels. If this is confirmed by our technical indicators, we would seek to add exposure.
Financials: Berkshire Hathaway Inc. continues to demonstrate strong revenue growth, reporting $354.41 billion for the twelve months ending September 30, 2024. The manufacturing segment stands out, contributing $76.88 billion, or 21.69% of total revenue. Furthermore, earnings per share (EPS) saw significant growth of 40.76%, reaching $74,275.80. However, the company faces challenges, including considerable volatility in EPS over the years and decreased revenue in certain segments like McLane and Pilot Travel Centers. JPMorgan Chase reported robust financial results, with a net income of $12.9 billion, EPS of $4.37, and revenue of $43.3 billion, achieving a return on tangible common equity of 19%. Their Consumer & Community Banking segment delivered record revenues, and the Commercial & Investment Bank experienced a 31% rise in investment banking fees. Despite these positives, the bank anticipates a 6% decline in net interest income in Q4 2024 and an overall increase in expenses due to rising compensation and employee growth, alongside higher credit costs. Visa also showed strong financials in Q4 2024, with a 12% increase in net revenue and a 16% rise in EPS. The consumer payments business thrived through innovation, and revenue from value-added services grew 22%. Nevertheless, Visa is contending with a Department of Justice lawsuit, low growth in Asia Pacific payments volume, and an expected increase in incentives that may impact future profitability. Our model shows a positive interest rate environment, steady GDP growth, and low unemployment rates bolstered consumer confidence, promoting increased borrowing and financial activity. Overall, U.S. financial stocks exhibited strength, fueled by better-than-expected earnings and favorable economic conditions. The composite model improved due to lower relative volatility, U.S. dollar strength, and credit spreads (OAS) for financial companies continuing to narrow. We increased exposure.
Figure 7: Financial sector option-adjusted spreads have narrowed, indicating that investors currently don’t envision a major market disruption.
Health Care: Eli Lilly demonstrated impressive revenue growth of 42%, excluding the impact of its divested olanzapine portfolio, largely fueled by the success of new products like Mounjaro and Zepbound. The company also made significant progress in its pipeline, with approvals for Ebglyss, targeting atopic dermatitis, and Kisunla for Alzheimer’s disease. Lilly’s commitment to expansion is evident through its substantial investments in manufacturing, including a $2 billion facility in Ireland and the $4.5 billion Lilly Medicine Foundry. However, Lilly faced challenges, including volatility in channel inventory that impacted sales of Mounjaro and Zepbound. Additionally, the company reported $2.8 billion in acquired IPR&D charges, primarily from the Morphic Therapeutics acquisition, which negatively influenced its effective tax rate. Marketing, selling, and administrative expenses also surged by 16%, reflecting efforts to promote ongoing and upcoming product launches. Meanwhile, UnitedHealth Group experienced robust revenue growth, reaching $100.8 billion—an increase of $8.5 billion year-over-year. The company’s consumer base expanded by 2.4 million to a total of 29.7 million, and Optum Health revenue rose by $2.1 billion, driven by enhanced value-based care services. However, challenges included rising medical costs, with the medical care ratio increasing to 85.2%, and the absence of favorable developments related to medical reserves, which adversely affected earnings. Additionally, a cyberattack on Change Healthcare had negative repercussions on third-quarter earnings. The composite model is bearish with measures of trend, momentum, breadth, volatility, and earnings revision breadth negative, while at the same time, sector-specific credit spreads are widening. We are underweight.
Figure 8: A decisive reversal confirmed by our array of technical indicators would allow us to increase exposure.
Industrials: In the third quarter of 2024, GE Aerospace showcased impressive financial results, with orders up 28%, revenue rising by 6%, operating profit increasing by 14%, and free cash flow conversion exceeding 140%. The company is making notable advancements in LEAP engine durability, introducing a new high-pressure turbine blade that simplifies manufacturing, which should enhance time on wing and boost production output. Additionally, GE Aerospace is expanding its maintenance, repair, and overhaul (MRO) capacity, collaborating with third-party providers, and utilizing its FLIGHT DECK technology to improve shop visit efficiency and reduce turnaround times for the growing LEAP fleet. However, challenges persist, as the Defense & Propulsion Technologies (DPT) segment reported an 18% year-over-year profit decline due to inflation, engine mix issues, and investments in next-generation products. LEAP engine deliveries are anticipated to decrease by approximately 10% year-over-year in 2024, although a sequential increase in output is expected in Q4. Moreover, the delay of the 777X program introduces uncertainties regarding the financial and operational impacts for GE Aerospace. Conversely, Caterpillar ended Q3 2024 with $5.6 billion in enterprise cash and reported a year-to-date operating profit margin of 20.9%. Despite this, total sales and revenues fell by 4% compared to the previous year, and margins dipped to 19.5% in Q3. Caterpillar also anticipates slightly lower sales and revenues in Q4, influenced by decreased machine sales to end users. There was some slight model improvement with the December update, showing short-term momentum turning positive. However, most external indicators, including cash flow yield, sales yield, oil futures, and weaker commodity trends are negative. We remain neutral.
Figure 9: Relative price momentum has reversed back to a buy signal.
Information Technology: Apple (AAPL) showcased its commitment to innovation with the announcement of new products and software across its Mac, iPad, iPhone, and Wearables lines. The company reported a robust 13% year-over-year growth in services revenue, demonstrating the strength of its services segment. Additionally, AAPL’s gross margin improved to 46.2%, rising from 44.1% the previous year, largely driven by cost-saving measures and an advantageous product mix. However, challenges emerged as net sales in Greater China fell by 8% year-over-year, attributed to declining iPhone and iPad sales and the weakening Chinese renminbi. Furthermore, the Wearables, Home, and Accessories category reported a 7% drop in sales, and an increased effective tax rate of 24.1% resulted from a $10.2 billion one-time tax charge linked to the State Aid Decision, along with a higher rate on foreign earnings. NVIDIA (NVDA) demonstrated significant revenue growth, fueled by strong demand for its Hopper computing platform tailored for AI and data center applications. The company broadened its data center product offerings to include solutions that bypass export control requirements, enabling continued revenue growth, especially in China. Gross margins benefited from an increased proportion of data center revenue. Nevertheless, NVDA faces looming supply constraints, anticipating that demand for its Blackwell data center architecture will outstrip supply in several quarters in fiscal year 2026. Additionally, as the frequency of new product transitions rises, the potential for quality issues and revenue volatility may increase, compounded by new U.S. export control restrictions that threaten its competitive standing. Microsoft (MSFT) reported a 22% increase in Cloud revenue, reaching $38.9 billion, with Microsoft 365 Commercial cloud revenue climbing 15% and Azure services expanding by 33%. This cloud growth reflected increasing demand, particularly for AI services. However, ongoing investments in cloud and AI infrastructure are expected to elevate operating costs, potentially pressuring margins. Furthermore, extended disruptions in the supply chain for device components may hinder timely manufacturing of consumer devices. The sector’s technical indicators have turned negative on balance, with the external model still supportive. We remain neutral.
Figure 10: Longer-term overbought/oversold indicators are rolling over from overbought, generating sell signals. If the external composite turns bearish, we’ll move to an underweight allocation.
Materials: Linde (LIN) delivered a modest increase in sales, up 2% in the third quarter and 1% year-to-date, primarily fueled by higher pricing strategies. Adjusted operating profit saw a notable rise of 7% in both the third quarter and year-to-date, benefiting from the same pricing initiatives and enhanced productivity measures. Additionally, adjusted diluted earnings per share (EPS) grew by 9%, attributed to an increase in adjusted net income and a reduction in diluted shares outstanding. However, the company faced challenges, with a significant $145 million in costs related to reduction programs and charges, far exceeding figures from the previous year. Interest expenses also surged, jumping 70% in Q3 and 57% year-to-date because of rising debt interest rates. In contrast, Sherwin-Williams (SHW) reported a slight 0.7% rise in consolidated net sales for the quarter, with store sales in the Paint Stores Group that had been open for over a year increasing by 2.2%. Diluted net income per share climbed 7.8% to $3.18, while EBITDA experienced a 1.2% growth to $1.282 billion, representing 20.8% of net sales. However, the firm struggled with a 7.5% decline in net sales from its Consumer Brands Group, largely due to weaker DIY demand and unfavorable foreign currency translations. Consolidated SG&A expenses rose by $137.2 million, reflecting strategic investments and increased employee costs. The composite model declined, with trend measures negative and valuations relatively expensive given the growth prospects. With global manufacturing still struggling, we remain underweight.
Figure 11: Emerging Market strength has historically been bullish for the Materials sector. Emerging Markets, however, have rolled over. If our technical indicators begin to show signs of renewed strength, we will reallocate accordingly.
Real Estate: Prologis (PLD, a logistics facility operator) demonstrated considerable potential for growth, particularly through lease renewals, which are expected to enhance organic net operating income (NOI). With a robust development pipeline, the company anticipates investing $36.0 billion in new buildings, creating substantial value. Furthermore, PLD’s strategic capital initiatives and strong balance sheet enable it to seize opportunities in the market. However, caution looms as the company faces challenges; customers are expected to be conservative in leasing decisions throughout 2024, influenced by economic and geopolitical uncertainties. Additionally, a slowdown in development activity has been noted, with fewer new project starts and a decline in build-to-suit ventures compared to the previous year. Rising general and administrative expenses due to inflation and increased compensation costs also present hurdles. On the other hand, AMT has made significant strides, including the $2.2 billion sale of its India operations, which bolstered its efforts to reduce existing debt. Its adjusted EBITDA saw a modest increase of 1% for the nine months ending September 30, 2024, while attributable adjusted funds from operations (AFFO) rose by 9%. Nevertheless, the company faced challenges, such as a $1.2 billion loss from the sale of ATC TIPL due to translation adjustments, elevated churn rates in its U.S. and Canada property segment driven by T-Mobile’s lease cancellations through 2025, and a $322 million goodwill impairment charge related to its Indian operations. The composite model remains neutral, with technical indicators still largely negative. The external composite is constructive (no pun intended), so if the technical picture improves, the foundation is set for a rally. We’ll add when the model’s message shifts bullish.
Figure 12: Decisive improvement in breadth would likely lead to an upgrade.
Utilities: During the three- and nine-month periods ending September 30, 2024, NEE reported a notable increase in FPL’s net income, attributed to ongoing investments in plant service and property, alongside NEER’s (NextEra Energy Resources) improved results, which benefited from the absence of an impairment charge linked to NEP in 2023 and higher earnings from new ventures. Additionally, FPL implemented a twelve-month interim storm restoration charge of approximately $1.3 billion, primarily addressing costs related to Hurricane Ian and Nicole. Conversely, there were some drawbacks as well. Corporate and Other sectors saw a decline in results due to adverse non-qualifying hedge activities. NEER’s interest expenses rose, impacted by unfavorable changes in the fair value of interest rate derivatives, coupled with increased average interest rates and debt levels. Furthermore, NEE’s effective income tax rates were lower compared to the same periods in the previous year. Similarly, Southern Company faced mixed results. Georgia Power initiated operations for Plant Vogtle Units 3 and 4, contributing to heightened retail revenues, while Southern Power progressed with the Millers Branch solar facility, expected to generate 512 MW upon completion. However, Alabama Power experienced a $36 million impairment loss from the halted development of a multi-use commercial facility, and Georgia Power incurred pre-tax charges of $160 million in Q3 2023 due to revised project cost forecasts for Plant Vogtle. Rising interest expenses across the Southern Company and its subsidiaries further negatively impacted results. The Internal and External composite models are mixed and we remain neutral.
Figure 13: Rising interest rates are negative for the debt-laden utility sector.
Our goal is to stay on the right side of the prevailing trend, introducing risk management when conditions deteriorate. Currently, the uptrend remains intact. As has been the case for all of 2024, the broader-based composite models calling U.S. economic growth, international economic growth, inflation trends, liquidity, and equity demand remain constructive. The Catastrophic Stop model is positive, and we are aligned with the message. If our models shift to bearish levels, we will raise cash.
This strategy uses measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk and where to place that capital.
For more information, please contact us at:
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Day Hagan/Ned Davis Research
Smart Sector® With Catastrophic Stop ETF
Symbol: SSUS
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