Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The market has had a volatile week, topped off with Tuesday’s lower open after the US and China escalated ongoing trade war tensions. Yet, stocks managed to turn the corner and could now be looking to work their way higher. Why was the market able to seemingly shake off the news so quickly?
Stovall: I think investors are under the impression that this is the President’s negotiating strategy, and while it’s not something that they initially embraced, they’ve reconsidered what he’s attempting to do and have tried to put it into perspective. Also, when you get commentary from Lloyd Blankfein, Warren Buffett, and Jamie Dimon that they don’t think this trade skirmish will turn into a trade war, I think it helps to calm investors’ nerves.
EQ: Is the market adapting to President Trump’s behavior, similar to what we saw earlier in his presidency when he would tweet at specific companies? Is this something the market is getting used to?
Stovall: I think it is, but at the same time, investors are paying close attention because they’re wondering whether he might end up just going a little too far. The real question is, does he know when to accept a compromise? Or is it his way or the highway? I think investors are still going to be unnerved by any escalation of trade tensions.
EQ: Last week, the Federal Reserve raised interest rates by another 25 basis points and may have also indicated that it will likely hike rates another two times this year. Does this impact your outlook for the rest of the year?
Stovall: Yes, it does. It actually caused us to now believe that the Fed will be raising rates four times this year; not the three times that we had initially projected. Also, we now think that the Fed will be raising rates three times in 2019, possibly putting the terminal Fed rate increases at the 3-3.25% area.
It does seem as if Fed Chair Powell is taking advantage of a very strong economy to add arrows to his quiver in the form of higher interest rates so that the next time we do slip into recession, he will have something with which to fight that recession.
EQ: We’ve discussed the outperformance of momentum groups during this market environment, but in your recent Sector Watch report, you also identified some lagging sub-industry groups that could be positioning to play some catchup as well. How did you set out to identify these “diamonds in the rough?”
Stovall: Each week, I like to look at the percentage of sub-industries in the S&P 1500 that are trading above or below their 10-week (50-day) moving average. There are 145 sub-industries in the S&P 1500, and a few weeks back in the latter part of March, we had touched one standard deviation below the mean. That implies that maybe we’ve overdone it to the downside, and as a result, we could end up seeing the market work its way up higher. Sure enough, it did. We ended up having more than 70% of the sub-industries then trade above their 10-week moving averages.
But then there were some sub-industries—eight in particular—that were not trading above their moving averages, but our analysts that follow the stocks within these group had above average buy, hold or sell recommendations on them. Specifically, these were Airlines, Cable & Satellite, Distillers and Vintners, Housewares & Specialties, Life & Health Insurance, Metal & Glass Containers, Tobacco, and finally, Water Utilities.
So, I chose an individual stock to serve as a proxy for each of these sub-industries that are trading below their moving average, but for which we have a buy or a strong buy recommendation.
The following are investment rationale snippets from CFRA Stock Reports of why the firm’s equity analysts believe these S&P 1500 index constituents have favorable price-appreciation potential.
- Altria Group (
MO57 *****): Although domestic cigarette industry volumes will likely contract over the long term, we see cigarette companies still having the ability to raise prices, and thus margins. As the largest U.S. cigarette manufacturer, MO should lead this pricing strategy. Moreover, we look for more limited commodity input cost pressures than in other industries in the consumer staples sector.
- American Airlines (
AAL44 *****): We see strong profitability and operating cash flows along with a robust share buyback program offsetting high debt level versus peers. We find the valuation attractive.
- American Water Works (
AWK79 ****): We think AWK will benefit from customer additions, capital expenditures and a focus on cost control.
- Comcast Corp. (
CMCSA32 ****): The recent tax reform will likely boost ongoing capital allocation commitments to share buybacks and dividends as well as potential acquisitions.
- Constellation Brands (
STZ224 *****): We see strong consumer demand for the company’s imported and craft beer products as the company boosts marketing spending in support of new product launches, which we see leading to increased distribution.
- Newell Brands (
NWL24 ****): NWL’s long-term game plan will likely be to expand into higher-growth markets funded by enhanced productivity and cost savings.
- Owens-Illinois (
OI18 *****): OI is aligning production with customer demand, while reducing costs and improving margins, as part of its value-over-volume strategy. Longer term, we expect strategic initiatives abroad to improve OI’s footprint and we see a rising emerging middle-class market boosting demand for OI’s products.
- Prudential Financial (
PRU100 *****): We see interest rate risk and regulatory pressures easing, which, coupled with PRU’s superior top-line growth prospects, will likely provide the shares with a catalyst.
EQ: Since hitting its all-time high in late January, the S&P 500 has spent most of this year trying to recover from the subsequent correction. It’s still about 100 points, or about 3.5%, off from current levels. Do you think it will retest those highs in the near future, maybe before the midterm elections?
Stovall: Yes, I do. The reason I think that is because while small-cap stocks (as defined by the S&P SmallCap 600) also went through a near-10% decline starting on Jan. 26, they got back to break-even and started hitting new all-time highs on May 9. That is a broadening of stock market participation; not a narrowing. That would imply more of a favorable outcome to the S&P 500’s correction. Also, we saw the Nasdaq hit all-time highs. My feeling is it’s just a matter of time before the large caps also break into new high territories.
With that said, I still believe that the third quarter of mid-term election years are among the most challenging—not only from a price change basis, but also from a volatility standpoint. Third quarter of midterm election years tend to see a 23% increase in average daily volatility as compared with all third quarters since World War II. So, fasten your safety belts.