At the risk of sounding overly complacent or delusional, I want to tell you why not to be concerned about the next recession and why I’m more bullish long term than I have been in my career in over a decade.

Today, I was looking at long-term charts of key markets that show the health of the stock market. I looked at interest rates, the yield curve, the US dollar, gold, oil prices, and the recession cycles over the past decades. What strikes me the most is that recessions are often accompanied by lower stock prices, but stocks peak first, and the values of the other indicators were all over the map. The most consistent indicator is the yield curve. This is a very long-term indicator and it takes months, even years, for the stock market to line up with what the yield curve is telling us.

So why do I bring this up? Because I don’t care if we are headed toward a recession. I don’t think it really matters much for investors and smart traders who take control over their strategy. Let me explain.

When you look at what transpired in prices before and after recessions, you could have bull runs or bear falls. Usually stocks will peak ahead of the recession and bottom before the trough. If you are a disciplined investor or trader, it really won’t matter much 5, 10, or 20 years from now, because a sound strategy will make money over longer time frames. Opportunities will flourish when the news is gloomy, and most people are pessimistic. During a recession, it is best to stay level-headed, knowing that values are being created. Short-term traders can adapt their approach to take advantage of different asset classes and shorting downtrends.

We Are Due for a Recession, but It May Not Happen Right Away

Right now, when I look at the longer-term trends, there are many indications that we are due for a decline in stock prices, but it may not happen right away. In the short term, momentum is still strong, and the internal technical indicators of supply and demand are holding up. In the long term, we do see the yield curve sloping downward toward zero. Federal Reserve Chairman Jerome Powell and his vast team of economists are diligently trying to decide if the Phillips Curve is still in existence. In other words, will the low unemployment rate of 3.8 percent lead to higher inflation as it has in the past, or will some new relationship keep this from happening?

Mental Gymnastics at the Fed

The Fed is simulating scenarios and debating whether they should continue to tighten. Some economists think we are being too proactive; others think we are closer to being on the right track. But does this matter? Recessions occurred before a Federal Reserve ever was in existence, and I’m sure that won’t change, regardless of what they do. They could, however, make it worse. In any case, the risks are higher now for a recession and a stock market pause or decline. But if you have strong risk management rules and a disciplined approach to find opportunities and you don’t give up and throw in the towel like the vast majority of people, you will come out ahead. Is this a guarantee? No, of course not — but just looking at history and experience, I am more optimistic today about the long-term results than I have been in a long time.

A Real Reason for Optimism Long Term

I’m more optimistic in the long term because it appears that the world is moving toward free markets and innovation. We see major innovation and a new generation of young people who are dynamic, entrepreneurial, and smart. Do they act like the baby boomers? No — but they have their own drive that will bring us to a new growth pattern even after the next recession. They will get a little wiser, buy homes, have a family, and — YES — become great investors. So, we could have a recession here pretty soon — maybe in the next year or two. But that will NOT be the end of the world or something to fear; instead, it is opportunity knocking. In the meantime, the trend is your friend. The most important thing to do is stay in the game.

How Important Is the President?

As for President Trump — or any president for that matter — we shouldn’t get too upset. He is making judgments that will look smart in hindsight, and others that will look downright ignorant. With that said, objectively, we are seeing some positive things already from recent polices. My shop reads earnings reports and listens to conference calls, and what do we see? We see many of our companies getting a solid boost from lower taxes and gaining the ability to hire more people and invest in the future. We haven’t seen a big investment in CAPEX yet, but the groundwork has been laid. That’s reason to be bullish longer term.

Satisfied to Be Dissatisfied

There will always be people who are not satisfied. When wages fell rapidly, the politicians in power blamed their predecessors. Now, wages are rising, and economists are concerned about inflation. Which way is it going to be? Having a little wage inflation at this stage is OK. We need an increase in demand, robust wage growth, and, yes, maybe a little inflation could result. In the meantime, many opportunisms will come up, but it won’t be a straight line to the moon.

Bright Future in the New Generation

Recently, I did an analysis of Zillow. A research firm filmed me presenting the idea and distributed it through to their subscribers. Zillow has innovated the real estate industry by creating a customer-focused database for residential real estate. This is different from the MLS that caters to real estate agents. Zillow is another example of a company that is providing new technology that could democratize information for buyers and seller in real estate giving everyone a better deal. Some in the real estate industry don’t like it because they see it as a threat that will change how things were done for decades. But they should adapt and position themselves to benefit from it by increasing volumes, even if prices decline. It’s no different than the stock and bond industry. We see more information come to everyone, yet professionals who are smart adapt and thrive while a large amount of lazy people in the industry become mortgage brokers or tech support people and do other jobs.

Creative Destruction Is Constructive

It’s creative destruction, and it’s a great thing. That is the beauty of the free movement of labor and capital. If we resign ourselves to only do what we did in the past because it is comfortable, we are doomed to failure. The only thing we should embrace is change for the better. It’s not always easy, but it’s better in the long run.

So, if you are worrying about a pending recession, maybe taking a look at the long-term charts could help. Instead, focus on your process for improvement now before that recession hits.

Are you looking for a great investment opportunity? You might want to start looking at America’s favorite snack company, Hostess Brands.

ARE SUGARY SNACKS DEAD?

In a world of healthy eating and technology, we see Hostess Brands as an opportunity for investors.  Hostess Brands ($TWNK) is that familiar, iconic, American brand you’ve heard of. They make the Twinkies and the Ding Dongs and the Ho Hos – all those frankly unhealthy snacks that Americans love. What’s interesting about this company is they went bankrupt due to a myriad of problems but now they’re in a much better footing to make profits for investors. In this trade alert, we will discuss the fundamentals and then we’re going to move on to the technicals on how to trade this opportunity.

REMOVING DEAD WEIGHT FROM THE PAST CAN LIFT HOSTESS

Hostess Brands was a company that was in trouble. They had some big problems. Before they went bankrupt, they had challenges with very expensive labor driven by union contracts. Their outdated manufacturing processes and inefficient distribution channel hurt profits. Overtime, they bled so much cash that they took on more and more debt which led to their insolvency.

CLEAR DEMAND STILL SEEM TO EXIST FOR TWINKIES

The good news is they went bankrupt and came back with new management, a stronger financial structure, and better manufacturing.  Basically, they resolved their biggest problems. There was a big uproar within the community with people saying, “Hey, I miss my Twinkies.” Because of that, there was a clear understanding that demand existing for Hostess products and a vision was born that they could transform the company.

“There was an uproar in the community – I miss my Twinkies!”

NEW LEADERSHIP AND PRIVATE EQUITY TO THE RESCUE

The new leadership that took over Hostess ($TWNK) is led by two gentlemen who have a strong track record. They’ve been able to turn this company around. What they did was they basically took the company; they said, “Look, we need to increase our automation. We need to make our operations more efficient.” They did that.

“We need to lower our debt.” They lowered the debt. Now the debt is about 37.5 percent of total assets. “And the other thing we need to do is we need to get our distribution channel centralized so that we have a warehouse set up and we can quickly get our products out.”

The company is being run by two key executives – Dean Metropoulos and Andrew Callahan. Dean Metropoulos has a strong record. He was involved with the turnaround of Pabst Brewing and Pinnacle Foods.  He teamed with Apollo to purchase Hostess out of bankruptcy for $410 million in 2013.   Andrew was recently appointed the CEO who served in various capacities at Tyson and Hillshire Brands, formerly known as Sara Lee. These changes that they’re making have added to the bottom line; have increased their cash position, lowered their debt burden, and increased profit margins.

HIGHER PROFIT MARGINS THAT THEIR COMPETITORS FROM TRUE BRAND AWARENESS

Hostess commands a higher price than the largest competitors. A lot of people don’t really recognize because most people are focused on the obvious trend of healthy eating.  But in reality the numbers are telling a different story – what’s happening is people are willing to pay a higher price for Hostess products.

We see this in the real numbers. Hostess has been able to price their products up to 80 percent higher than their biggest competitor, which is Little Debbie, a private company.  Hostess average price has been 30 percent higher than the whole category as well. Their average price is $4.74 per pound compared to the industry average of $3.40 per pound, so that’s a big difference. This has led to high return on capital and has led to profit margins for the investors. In our estimates, the stock currently does not represent this value potential.

MORE DEFENSIVE VALUE IN AN EXPENSIVE TECH WORLD

The stock is trading at a low multiple.  As of 7/5/2018, the price/earnings ratio is 6.3, price to book is 1.6 and price to cash flow is 8.4.  This is well below the S&P 500 ratio and the industry too.  The industry according to Morningstar groupings is trading at 12.4X earnings.

Analyst currently estimate that TWNK can grow 20.3% in 2019.  The mean analyst 5-year growth forecast is 14.1%.  But let’s be conservative in our valuation.  If you just assume that Hostess is going to grow cash flows at 3 percent and you require a discount rate of 8% the company could be worth between $16 and $22 a share. Right now, Hostess is trading at around $14 a share, so it’s a compelling valuation.

ROTATING OUT OF OVERVALUED STOCKS

We think that TWNK is a good addition to portfolios right now, especially since technology, consumer discretionary stocks have had a huge run up in price.  With the Federal Reserve increasing rates and the fact that we are later in the business cycle, we think it is smart to diversify some high-flying winners into more defensive issues like TWNK – especially since many investors have been overlooking the merits of this unloved stock.

RISKS WE SEE THAT WOULD CHANGE OUR MIND

There are three big risks that we see with Hostess Brands. The first is they have fierce competition from in-store private label brands.  Grocery stores tend to push their own private-label products to consumers.  Because TWNK is priced higher than other products, and the fact they are moving into helping grocery stores produce products in-house, we think TWNK can mitigate this risk to some degree.  If that changes, we would change our mind about the stock.

The second big risk we see is that people want to be healthy, and if we see that consumers just shun the product, then that could really hurt sales. As of now, we’re actually not seeing that a slow down as hard as expected. The reason why I think we’re seeing the growth — and not only with TWNK, but also with other competitors, is that consumers seem to want to eat healthy every day, but on occasion, they want to indulge in something that tastes good with full fat and sugar.

HOW WE WOULD TRADE THE STOCK

So now we just want to summarize how to implement the trade of TWNK. We want to enter this stock right at about where it is right now, which is $14. We see it going to about $22.50. If the stock moves up to about $16, we would take off about a third of our positioning.

We want to have a stop level to protect our capital at around $10.50 a share. That is just to allow us to have some normal market movement and allow it to breathe, because you don’t want to put a stop too close. Otherwise, you can get out of the stock and it moves higher.

Timeframe-wise, we want to hold this longer-term. We want to hold this 12 months or more because it does take time for value to be created.

Again, we think TWNK can be a great addition to portfolios because the stock market is more vulnerable, and we want to have more investments in safe-haven type stocks. We think consumers are going to be buying Twinkies and are still going to be eating cupcakes even if the market goes into recession.

All in all, we are experiencing a firming of the stock market internals in the past week.

The US stock market came off a short term oversold area and is firming toward the end of the week. Our momentum indicators area neutral but breadth is improving – this is a good sign. We also see an improvement in the number of advances and declines when reviewing the McClellan oscillator and the Advance-Decline line.

Stock prices rose above the highs of the recent trading range. Many short-term analysts could view this as a short-term buy signal.

We are closely watching the difference in yields between high-quality bonds and low-quality bonds. This credit spread indicator measures the appetite for risk investors seek. The indicator is near the low end of the range and needs to hold up for it to remain bullish. So far it appears to be holding well.

High yield bonds peaked relative to the investment grade as banks are tightening monetary policy. Global liquidity is declining for the first time in nearly a decade which is leading to higher volatility, especially in the riskier segments of the fixed income market.

The US dollar has been rising but the momentum has been waning. Gold futures have been heading down and are in an oversold condition. Many traders could be looking to trade the opposite side of the recent move buying gold and selling the US Dollar.

One of the biggest issues in the market continues to be trade tariffs. We created a special index of stocks in countries rely on trade for growth. The stocks of these countries were outperforming the US market a little while after Trump took office but recently we have seen a significant decline. Which suggests we are seeing a reversal in outperformance due to recent government policies. Some big companies in the U.S. are also struggling, including Caterpillar Inc. and Boeing Co. Chinese trade policies have hurt the agriculture sector and concerns continue to rise about restrictions in sport utility vehicles and medical instruments.

Last week we discussed how the FED has given a green light to bigger banks to buy back more share and increase their dividends which was a big win. But some smaller banks could benefit as well from lower regulations. Huntington Bancshares (HBAN) is a company to watch because the auto industry is being protected from the trade wars. HBAN is positioned strongly in the auto industry which could help earnings in future months.

The jobs report suggests wage inflation remains low and job growth is strong. Economists are speculating that we could have more room to expand our jobs without seeing inflation rise too much. Rates went down on the news partially because the participation rate is at 62.9% and new people are entering the workforce. This could mean that the workforce could expand more that anticipated. Inflation has been holding at 2.7% and it seems we are in a great spot.

Take a look at my June 29th weekly analysis and trade smarter.

Here is the rundown…

Are we late in the economic cycle? Concerns over fears of the fed tightening too much are leading to worry.

Trade and technology restrictions are the biggest concern as the market doesn’t like excessive tariffs or restrictions on trade.

In technology this past week, oil prices, utilities, and real estate defensive sectors were moving higher.

The banks got a bit of relief from the government this past week. The federal reserve said the top 35 banks are looking great with regards to a stress test. Withstanding a recession well, they gave banks the go-ahead to increase buybacks and raise dividends.

Wells Fargo was a beneficiary even though they had been scrutinized for scandals and unfair sales tactics that were hurting the companies reputation. The government restricted them more and increased fines but this will be a relief for them as their stocks were up over 4%.

The breadth numbers are slightly to the bullish side, but many of the market indicators remain mixed. For example, the sentiments market and emerging markets risk of failing aren’t showing optimism.

Yield spreads, credit spreads, and junk bonds vs AAA bonds are optimistic from a sentiment perspective.

Stock market price patterns have been in a consolidation phase and a period of indecision so this week might be a little rough because of how Friday ended.

Positives: I like what is happening with the banks and there are some pockets of value that can be found. Take a look at Hostess Brand Inc. and the research exposé that we did on them.

Happy Trading!

Let’s make your money more productive!

We continued to see many crosscurrents in the markets last week.   The financials, industrials and technology stocks continued to lead in the United States. Small companies also rallied faster than their large cap brethren.

The financials have recently displayed an uptrend but in early 2018 we saw a bit of a decline and experienced a consolidation phase. Last week we discussed how the financials could start rising and we have actually seen a spike up in relative performance from a 63-week average.

The industrial sector has many similarities to the financials lately, lagging since early this year but currently trying to reinvigorate which could be a positive sign for our economy. Tech is continuing its rally and leading in the markets, even breaking into highs and continuing to outperform other sectors.

For a deeper study, Wealthnet examined the intra-day volatility in the markets from 1982 to 2018 and compared it to the close-to-close volatility and the findings are dramatic. We found that S&P 1500 stocks had intraday volatility twice as volatile as close to close volatility.

 (Wealthnet Investments, LLC S&P 1500 stocks as of 7/17/2017, S&P 1500 Constituents from Optuma Database)

What does this mean? If you are an investor putting stop orders, resting in the market you are likelier to get stock taken out in the middle of the day. There is an upward slope in intraday volatility but close-to-close is relatively the same. If intraday volatility is twice as much as close to close volatility investors would need to reduce their position size by approximately half to keep the same impact to their portfolio.

Diving back into the markets, let’s focus on what is happening with trade and the international vs. domestic markets in the USA.

Export Markets Are Testing Lows Since Election

Last week’s market call included the 10 largest countries that export to us. I created a ratio of their stock markets compared to the USA since the election. If you recall, we saw an outperformance in those companies over the U.S. immediately after the last election, but they have recently accelerated down, and we are where we were before the election. These markets are testing what the impact will be on these import countries and if the impact is less than expected we could see a significant outperformance of those stocks because most market players are betting against international markets.

(Source: Wealthnet Investments, LLC Export Country Index. Database from Optuma)

Chinese Stocks Relative Trend Breaks Downward

China’s stock market had a nice outperformance relative to the US but has recently broken a trend line. Which means they are no longer outperforming currently and we haven’t seen tons of buying stepping up. Japan has been underperforming and recently turned to the downside as well.

Commodities are continuing to trend downward. We saw a break below key moving averages and commodities are testing a support level.  Gold continues to lag. We are seeing a downward trend and is continuing to move lower. Agriculture commodities have been the worst performing commodities and energy has been the best.

A Unique Health Care Stock Interests Us

A stock that interest us is IQVIA Holdings Inc. It is an outsourced R&D company for big pharma and biotech companies. The company is a result of a merger between IMS Health and Quintiles, which allowed them to get data and technology information that is unique. Because of their service model, they have developed strong customer relationships. The stock is also trading at reasonable valuations with an earnings yield of 5.3% compared to the S&P 500 4.9%. and has good growth prospects ahead.

(Source: Morningstar Direct Database, 7/17/2018)

Taking a closer look at the micro-level. The stock broke out from a resistance level at 106.33 and could have a return to support at 106. We believe we could see the share price pull back ahead of earnings expected to be released on July 21^st. Longer term, we estimate that company can continue to grow earnings as pharmaceutical and biotech companies continue to outsource their R&D to IQVIA.

In this video Louis Llanes, founder of Wealthnet Investments, discusses how to interpret earnings and even try to profit from mistakes from swings after earnings are announced.

Wall Street can punish companies with less-than-expected earnings, pound companies with good earnings and reward companies with ho-hum earnings. Analyst often revise their earnings estimates each quarter as companies report their profits. A knee-jerk sell off or rally can occur. During those times, savvy investors and traders can look for ways to either take profits or add on to trades.

Louis explains the three techniques that investors should use to minimize the impact from wild swings during earning season. He also talks about mind-set necessary to stay alert to opportunities.

Louis provides real-world examples of earnings reports and shows whether earnings beat or missed expectations and how the stocks reacted in isolation and how the average effect to the model portfolio was virtually nothing. He explains “idiosyncratic risk” how fundamental diversification and smart position sizing can mitigate and avoid mistakes in your portfolio. He also explains how equity market risk can be mitigated by non-correlated assets.

Two companies that rose sharply include GrubHub (NYSE: GRUB) and IQVIA (NYSE: IQV) and two companies to fell hard include Hostess Brands (NYSE: TWNK) and Zillow (NYSE: ZG). Louis discusses those that missed or beat estimate and how longer-term future performance rarely determined by a single earnings report.

A summary of the market action over the past 5 trading sessions is also reviewed to provide context in the market environment and how earnings are affected. The last 5 trading sessions were marked by a revival of technology, consumer discretionary, and financial companies. Mid cap stocks in the U.S. led the global equity markets and smaller companies and international companies lagged. Long bonds strengthen, and the U.S. dollar remains king in the past week, outperforming relative to major currencies. Commodities rebound from their downtrend but oil stocks did not keep pace with the commodity directly.

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The U.S. Stock market and risk-adjusted return ranks are covered, along with movements in the international market. The strongest sectors and countries are identified, along with geopolitical considerations and the organization’s outlook for the future.

We have put together a proprietary rank that focuses on performance for the week. We compare our ranking to a broad array of indexes around the world and use exchange traded funds as proxies for tradable instruments. We look at the returns, adjust it for risk, and then funnel into those markets that are having the biggest impact for the week. So, looking at the U.S. market, most are down quite a bit: 1.29 down on the S&P 500, 1.24% down on the MidCap, and 0.45% down on the SmallCap.

Small Caps

Even though Small Caps were down, they held up on a relative basis as expected from year-to-date. For the last year, the SmallCaps, have been up 28.41%. Energy stocks are selling off -4.78% with some additional sell-offs in technology and financials.

S & P 500

With the overall S & P, we are still in that trading range that started off in early 2018. There was a dramatic fall in February. We were testing a resistance zone now between 2874 and 2800. We are observing the market to see if we want to move higher.

Political and Geopolitical Risks

We have been wrestling with political and geopolitical risks.

Defensive Sectors Holding Up

Utilities, real estate, healthcare and consumer staples are holding up. This is a relative straight chart. So, if this is declining, it’s an indication that the sector is underperforming the market and vice versa. And the regression line shows that the general trend is down even though there is a stabilization in the utility sector. The regression line is moving toward the upper end with a movement up in price as well. This is similar for the real estate market, which continues to have great potential. We are in a three-month uptrend in price.

Healthcare Sector

The health care sector is getting close to the top end of the relative performance chart.

The U.S. and International Markets

With the relative performance and the absolute performance getting stronger, we want to go to the international broad market indices; there’s a real disparity between the U.S. markets and the international markets. The U.S. markets are holding up really well. One of the better performing stocks in the market has been Israel, which is in the 85^th percentile on a risk-adjusted basis; It’s been the same with Austria and New Zealand. In general, though, the market is not doing so well internationally, and the valuation metrics are looking stronger as the international markets are trading around 14 times earnings and .emerging markets are trading around 11 times earnings; their growth rates are negative. Turkey is at a multi-year low or very close to it, as seen from the monthly MSCI Turkey ETF, which allows you to go back to 2009. Turkey has a large current account deficit; it depends heavily on both private sector and government debt.

Bond, Commodity, and Currency Markets

There was a flight to quality, the long bond did very well unlike the other bonds. On a risk-adjusted basis, the energy sector held up well despite being down for the week. Gold also held up well. In general, we are still in a bear market in many of those commodities. Currencies were strong, in particular, the U.S. dollar, the strongest-performing class. The U.S. dollar, the Swiss Franc, and the Japanese yen were all at risk, showing that people were risk averse in the markets. The emerging market bonds continued to decline, and that’s a negative sign from a risk-averse perspective. The long bond has hit support and bounced off that support and is trying to hold up. We have added some long bonds to our portfolio. Since January 21^st, the U.S. dollar has been doing very well, though not quite at .the highs in 2017.

The Euro

The Euro was in a support zone between 11272 and 11143 and that support zone was violated and continues downward. Many technicians think this market and the dollar will continue to be strong and would weigh on international markets, meaning that, at some point, there are going to be good values.

The Australian Dollar

Though the Australian dollar is holding up well, it was still one of the laggards in the last week. It is heading toward a support area around 71 in this Australian currency share ETF.

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Overview

This week we are covering economic and political factors affecting the markets and what to keep an eye out for. We’re also looking at:

• Movement, momentum, and breadth of the S&P 500
• Volatility, emerging markets, and small caps in relation to large caps
• Index of common US export countries with the current tariff concerns

On Tuesday, August 21^st, stocks ignored news that Michael Cohen, President Trump’s lawyer, pled guilty to eight criminal charges. This is a positive sign for stocks, and the Federal Reserve is expected to raise rates again if the economy stays on track according to the Fed minutes from August 22nd. Higher fuel prices led American Airlines to change their plans for flight patterns, which is a reminder that inflation could impact businesses.

S&P 500 Movement and Momentum
The S&P 500 rose, stopping just short of ending its longest stretch without a closing record in two years. It has been coming closer to the January record of 2872.870.
From a technical point of view, an upside target of 11.83% from the current levels is possible. We’ll achieve that only if there is a successful breakout in the market.

S&P 500 Breadth
This chart shows two breadth indicators. The first is the McClellan Oscillator – this measures the number of issues that are advances versus those that are declining and what we see is that we are currently above the 39-point trigger range at 50.40, which is a bullish reading.

The next reading to look at is the market breadth, which shows the percentage of stocks that are above their 63-day moving average. This shows a reading of 70.89%. That’s on the upper end of the range, as most stocks in this index are in an uptrend.

Sentiment, Emerging Markets, and Volatility
This chart includes the sentiment, which shows that the small caps are beginning to accelerate faster than the S&P 500, which are large caps. This suggests that people are feeling confident in the market. That confidence carries over to the volatility numbers, where you’ll notice a decline since January.

We can also see the relative performance of emerging markets compared to the developed markets. When the line is declining, emerging markets are not performing as well as developed. What’s happening right now is that we are still in the downtrend. However, that line is now above the center of the downtrend. This indicates that the underperformance is slowing down.

Proprietary Index of Export Countries
This is an index we created to show relative strength of markets that are chief exporters to the United States compared to the S&P 500. When looking at this chart, you can see that tariff concerns are continuing, which isn’t surprising. Major countries that export to the US have continued to sell off since the election. Notice the trends following the election – looking at this chart, you’ll see that after the 2016 election, they outperformed the US. Recently they’ve been underperforming, and we’ve lost all the relative gains in the emerging and major exporting markets.

Conclusion
This week saw stocks staying strong despite some legal turbulence surrounding Michael Cohen and the Trump administration. The S&P 500 showed positive momentum, coming close to passing this year’s high. Small caps are accelerating quickly, showing confidence in the market and lower volatility figures. Major exporting countries are largely underperforming and leading to lost relative gains.

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Today’s Market Call is looking at markets in light of long-term perspectives. One important thing to begin with is that the S&P 500 is breaking out as we transition into fall. This is a very bullish sign for several reasons – First, fall is typically a volatile season. Historically, this is a time when there is a lot of selling off and higher unpredictability that happens in August, September, and sometimes October.

Upcoming Election and Increased Volatility

Another indicator is that we are approaching an unpredictable midterm election. A lot of people feel that the Democrats want to unwind Trump’s initiatives and that they have an opportunity to potentially gain some traction in the November 6^th midterm elections.

It’s important to understand what a midterm is – simply, it’s an election in which representatives are elected in the middle of a presidential term. Right now, the US Senate has 51 Republicans and 49 Democrats, including two independents. There are 35 seats up in 2018, 26 of which are held by Democrats. There seems to be an opportunity in many people’s mind that the Democrats can gain some control in Congress. However, considering how strong the economy is right now, I think the default way of thinking is that the Republicans will remain in control of Congress, but it is a close call.

The Debate Could Cause Increased Volatility

Typically, when the economy and markets are strong the incumbent remains in office. What we do expect, however, is more volatility to come in November because of this election.

We expect a spirited debate over the progress of Trump’s term so far. Democrats will probably argue that Obama is responsible for the improved economy and employment growth was really due to him. There may be a fair amount Trump-bashing from the Left as they argue Trump is doing poorly because crime is up and the number of people who have health insurance is down and wage growth is still sluggish.

On the other hand, Republicans will say the stock market is at highs, unemployment is down, less people are on food stamps, recent GDP growth is above 4%, and that we are getting better trade deals. The Right will probably also stress that corporations are benefiting from lower taxes which could increase employment and investment in the United States.

Corporate Profits Boom and GDP Growth Up

U.S. corporate profits boomed in the second quarter, up 16.1%, according to the Commerce Department. Lower corporate tax rates were signed into law last year, which means taxes paid by US companies were down 33% from last year. The US economy grew at 4.2% in the second quarter, which is much higher than the average growth the prior administration had been seeing, so that will be a part of some debates. Unemployment is down and home prices are higher. With all that said, we want to reiterate that there’s likely to be more volatility if the debates get spirited or something out of the ordinary happens.

Positive Breakout in Seasonal Weakness

The S&P 500 broke out into the approaching fall-season and into the uncertainty of elections. This could be viewed as a bullish sign into the remainder of the year.

Technology and Consumer Discretionary Stocks From a Longer Term Perspective

Switching gears, we’re going to look at the sectors currently leading the market, which are Technology and Consumer Discretionary. These two sectors have been the darlings of Wall Street recently, but we want to look at it from a longer-term perspective.

First, the technology sector; what this chart shows is the tech sector going all the way back to the dot-com bubble that happened in March of 2000, when tech topped out at around 653. Below the price chart is the relative strength index compared to the S&P 500. You can see that we had a major top and relative performance in March 2000, and since that time, the technology sector has yet to surpass that high in relative performance compared to the general stock market since the dot-com bubble.

Some would argue this means that we’re going to have better performance in this sector even over a longer period of time. Keep in mind, having a sector focus can be very dangerous, especially if one was focused on tech over this time.

Continuing the theme, this chart compares the technology sector versus the consumer discretionary sector, with the same long-term time frame as the previous one. The consumer discretionary sector involves the industries that are affected by consumer spending that isn’t staple, or necessary. This sector is basically discretionary spending; things you buy when you’re feeling flush.

Looking at the relative strength chart at the bottom, you can see that consumer discretionary stocks have far outperformed technology since the dot-com bubble, so the moral of this story is that it’s important to have diversification. It’s important to have a strong portfolio process and to not get lost in the short-term details and lose track of what’s happening in the long-term.

What is More Attractive – Tech and Consumer Stocks, or Emerging Markets?

The emerging markets show a very interesting development. Looking at the long-term, going back to October of 2007, there was a peak in the emerging markets ETF. Following that peak was a dramatic drop in November of 2008. Since that time, we’ve been in a massive, multiyear congestion zone with a significant high in May of 2011.

The bars on this chart are monthly, and if you look at this month’s action, you can see that we’re at the low end of that trend line and we’ve been getting significant support. There’s been bullish monthly market action as the emerging market stocks bounce off the monthly lows.

At the lower end of the trend line, we have what technicians call a “hammer pattern” where the market sells off dramatically and then rallies off the lows. This was happening in the congestion zone, so it’s a bullish sign. We’ve been seeing the emerging markets underperforming, but now it’s possible that we could see some stabilization.

Looking at the valuation and growth metrics, these columns show the comparison of the price to earnings, price to book, price to sales, price to cash flow, dividend yields, and the long-term earnings growth. This really highlights the difference between emerging markets on the left column, technology in the middle column, and consumer discretionary on the right column.

The point of this is that sometimes we get into these modes where the market is on a trend and it’s important that you stay on that trend. The valuations are giving us a warning sign and we want to be careful with the current leadership. Even though it’s currently bullish, there are signs that we need to be careful.

In summary, the markets look bullish from a technical standpoint, but complacency is dangerous. Stocks are performing better than they generally do in the fall, but volatility should be expected around the November midterms. The default view is still that Republicans will keep control because the economy is currently strong and a different outcome is going to cause some disruption. Technology and Consumer Discretionary are still leaders, but the valuation there is a big warning sign. Emerging markets are stabilizing and could offer longer term profit potential due to valuation and long-term growth prospects. Trim & Trail your winners and introduce new positions in longer term attractive investments.

Sincerely,

Louis B Llanes, CFA CMT

Founder, Wealthnet Investments

The Truth About New Highs in Stocks and the Market in Recent History

What does it mean for investors when stocks are at new highs? Does it really matter? On this Market Call, I compare the performance of stocks reaching new highs versus those starting to go up after a 50% or more decline. I compare them in bull and bear markets to see the performance in different market environments. The results may surprise you. I know it has surprised some of my colleagues that are long-term pros in the investment business.

There is a lot of confusion when it comes to Wall Street wisdom. We always strive to test out theories to see if they have some validity rather than just accepting the common wisdom.

I will explain what it means to buy stocks that are at new highs. This is currently crucial because we’re at near new highs right now in the stock market and many people are concerned that the market is overbought and that it’s going to turn negative soon.

There are two competing thoughts and frameworks on Wall Street. One of them is to follow the trend. This theory says “the trend is your friend until it bends at the end.” A lot of people follow this strategy which is often called a momentum strategy.

The other common strategy is to buy stock that are beaten down. Many pros in the business who are value investors subscribe to this theory. They like to buy “fallen angels” that have gone down 50% or more so they can pick up a bargain.

Testing New Highs Versus Beaten Down Stocks in the S&P 500

We tested stocks in the S&P 500 from March 24, 2000 to March 8, 2013. I picked this period because this timeframe includes two bull and bear markets and they are very extreme. This gives us the ability to see new highs and beaten down stocks perform in different markets. We are going to shed some light on what happens with new highs and buying stocks that are beaten down during both bull and bear markets.

Volatile Bull and Bear Markets

This chart shows the bull and bear markets and you can see that they were extremely volatile. We hit a high in March 2000 and then it came down really strong in October 2002,
which was a big move. It had a big rally and then it came back down. In general, if you look at that whole period from that high that hit in March of 2000, we never really made any further progress.

Removal of Survivorship Bias

When testing the signals for this chart, we wanted to ensure our data wasn’t biased, so we took out all the survivorship bias problems and only looked at the historical constituents of the market. This is important is because you can have stocks that went out of business, companies that did poorly or went through mergers and acquisitions, and we wanted to test that with what really was able to be traded during that timeframe.

Equal Weight S&P 500 Benchmark to Measure Performance

We also compared the performance of our signals to an equal weighted S&P 500 benchmark to determine when the signal was adding value versus buying a stock at random. The reason we did that is because an equal weighted index means you put the same amount of money in each stock that you own, which inherently has an upward bias relative to the S&P 500. In other words, the equal weighted index tends to outperform the market. We were conservative and made our benchmark the harder-to-beat equal weighted benchmark.

This chart shows on the top, the usual one that you see in the news which is market cap weighted, and the one on the bottom shows the equal weight. You can see over the test period between those two vertical lines that it had an upward bias during that period of time. So what we’re benchmarking to is something that outperformed the market.

Bear Market Signal Test

These are the bear market signals that we tested hitting new highs. The top section shows that this one was from March 2000 through October 2002. The second bear market was from October 2007 to March 2009.

We did a test in which we took the stocks that were getting within five percent of their high and then we bought them and held them for a year and analyzed what happened over that time period. We also included statistics that show the mean or average return, the median return, and the percentage or probability of gain over the year. Following that, we looked at the distribution to 80th percentile, or the stocks that really went up a lot versus the 20^th percentile, which were at the lower end of the range. This gives us data to analyze the risk of the distribution of returns.

Stocks Near Highs Statically Had Better Outcomes in Bear Markets

This chart compares that crossed within 5% of the 252-trading day high. 252 trading days is approximately one year. These stocks that were five percent from high were analyzed to see how they performed for the next year. We did the same thing with stocks that were 50% below their 252-trading day high and bought them crossing above that 50% retracement line.

The column on the right shows an interpretation comparing the two. When it says “better”, it means that the five percent stocks are doing better than the 50 percent stocks.

The statistics show that stocks near highs have performed better than those fallen angels that started to move up from a 50% retracement.   We see this in both bear markets under study. So

This suggests that during bear markets, buying stocks that are closer to the highs is smart and statistically will have better outcomes.

Stocks Down 50% Starting to Rise Have Higher Risk

This chart above details the return distributions of the different signals. We want to find distributions that have positive returns and tighter ranges that are less spread out.

The two graphs on the left are the five percent from high signals and the two on the right are the 50 percent from high signals. Looking at these, you can easily see that the five percent from high has a much more concentrated distribution and it’s not as sporadic. The 50 percent from high has a very wide distribution, suggesting that there’s a lot of risk in buying those “fallen angel” stocks, which contain a tremendous amount of risk.

Bull Market Signal Test

This chart is consistent with the previous Bear Market Signal Test, but this time we are looking at Bull Markets.

In the first bull market, you’ll notice that buying five percent highs was worse than buying the stocks that were down 50 percent which makes a lot of sense, because when the economy is doing better, a lot of companies that were selling off or not doing well were starting to come back to life. With that said, there’s still a lot of risk with the fallen angels.

What we see in the second bull market is the main return in the five percent from high signals was better than the 50 percent from high. All other statistics show the 50 percent form high performing better, so it’s not as conclusive in that time period that buying highs outperforms.

This is something that we’ve seen consistently with the data – buying new highs doesn’t necessarily mean that those stocks are going to outperform during a bull market.

Beat Down Stocks Do Better in Bull Markets!

Looking at this distribution charts, you see the same phenomenon from the bear markets. There is still a really wide distribution, suggesting that it’s not reliable to buy stocks that are 50 percent off their high. It’s dangerous even in bull markets. It’s important to notice on the left side, the stocks five percent from the high a year after you buy them. They tend to have a tighter pattern of returns and they may not necessarily outperform the market, but you don’t have as many sporadic, large downdrafts.

Stocks tend to Mean Revert in the Short Term After New Highs

This chart shows what happens during both bull and bear markets when you buy new highs. We’re looking at both bull and bear markets to see the general tendency of returns on a daily basis going forward for the next year.

The red line shows how much the basket of stocks that are getting the signals are outperforming or underperforming the market. If it’s above zero, that’s outperforming, if it’s below zero, it’s underperforming.

The green line is the signal line that’s showing you the results from the signal and shows the confidence bands around it. You can see that right after you hit new highs, there’s a tendency for mean reversion where the generally underperforms in the short term. In the long term, up to about 130-140 trading days, they outperform. After that, the tendency is the lag.

This is important to understand because a lot of times when you’re trading these highs, you have an opportunity to buy them on pullbacks and that is a valid strategy based on this chart and statistics that we’ve seen in this timeframe.

The other thing to point out is that it does keep up with the market fairly well within the confidence bands all the way out to almost a year. However, it does tend to have a decay factor – the longer these new highs have been going on, the higher chances are that you can start underperforming.

This is one of the reasons why when we do technical analysis, we always explain that you don’t want to buy multiple highs after this.

Recapping Long Positions

This recaps the long positions across the board. It might look a little confusing, but basically it illustrates that the distributions on the bottom two are very wide.

When you try to buy these 50 percent droppers, you are dealing with a lot of risks.

If you’re buying new highs, you have a tighter return pattern, but that doesn’t necessarily mean you’re going to outperform the market.

In summary, statistics show that buying highs beats buying lows in bear markets.

Another thing to remember is buying lows is dangerous and can lead to significant losses, especially in a financial crisis or regular bear markets.

Buying lows is a high-risk/high return strategy. It requires more bottom up analysis, truly understanding your companies, and smaller position sizes. You don’t want to have a position size that increases your risk, and you want to have much more diversification when you’re doing that.

Buying highs has a tighter distribution with less large losses, but it doesn’t always beat the market. There has been a tendency for mean reversion in the short term after highs, but outperformance in the intermediate term.

When you buy highs on a rolling basis, you tend to beat the market to about 140 trading days.

Bottom Line: You can make money in both a “fallen angel” and a “trend is your friend” strategy. Neither is superior at all times, but what is very certain is that it’s a higher risk strategy to try to buy those beaten down stocks.

Today we’re going to touch on the tradeoff between technology and emerging markets. There’s a lot of talk about the tariff negotiations, and the elections that are coming, which could affect the negotiations if the Republicans lose control of Congress in the midterm elections. Trump has been able to implement tariffs unilaterally based on a rule that allows for this to be done if intelligence and national security is compromised. This whole concept, however, could be challenged if Democrats take control of Congress.

Tariffs are being opposed by different trade groups in the US that are hurt by these changes and these groups could continue to lobby harder to stop them. There is a theory that Trump will be even more aggressive in pursuing more tariffs, regardless of the outcome of the midterms – the reason for this is if the trade pacts in the EU and Mexico are formed, it could help the US in a multilateral assault against the Chinese anti free trade practices.

Those practices bring along problems such as stealing of intellectual property, government protection of Chinese companies, blocking foreign firms from free trade with high regulations and red tape, and currency manipulation. This is important and relevant because right now the Chinese stocks and emerging markets are down and underperforming the US.

If continued improvement happens on the tariff front, one contrarian view could be that the emerging market stocks could do well compared to the US because we’d have kind of a move back towards the norm and that viewpoint will make more sense after looking at the valuation of Chinese stocks.

Chinese Stocks Attractive Compared to U.S.

Let’s take a look at the Chinese ETF, symbol MCHI. The price to earnings multiples is a valuation metric and the lower, the better. Right now Chinese stocks are trading at 10.52 times earnings, compared to a basket of large US companies trading at 17.36 times earnings. MCHI is also outperforming the Large Blend US in the Dividend Yield category, with 2.55% compared to the 2.19% from the US.

Also important, the expectation for long-term growth in China is faster than that in the United States. If you look at the Wall Street long-term earnings per share, a five-year growth estimate, we’re at 16% growth in China versus 12% in the US. According to these metrics, China looks more attractive.

With that said, it’s best to look for stabilization before you start picking these stocks up. The value players are probably nibbling at it now, but we would personally like to see some stabilization before we’d get aggressive with that.

We do have some Chinese stock positions that look attractive to us, particularly in the consumer and tech areas.

S&P – Positive Strength & Momentum

We’ve been asked a lot recently what we think of the stock market in general. Let’s look at factors with the ability to give you some probabilities; the first factor would be the valuation multiples. As mentioned earlier, the US stocks are trading at about seventeen times forward earnings. That’s over a five percent earnings yield, and if you compare that to the 10-year treasury today, which is at 2.977, it’s a reasonable valuation.

If interest rates stay relatively stable, and don’t rise too fast, the valuation squeeze shouldn’t be too bad, so that’s a bullish sign.

The other thing is we have momentum on our side. We’re at the highs of the trading range now. Our momentum and breadth indicators are still showing positive strength technically, which indicates a positive market moving forward.

Tech Sector in an Uptrend

Now for a look at technology stocks. If we look at the relative performance of these stocks, they have been in an uptrend and now they’re at the top end of the trend line. What that indicates is that these are a little bit overbought in a relative basis and we’ve seen that the relative performance has stalled at the end at that level a few times.

So is that a sell signal for tech? We believe that’s just an early warning sign to be careful that these tariffs can have an impact on tech stocks, and that makes a lot of sense because many of the supply chains that our tech companies rely on come from China.

Medtronics – Medical Devices with Good Valuation

Now for two stocks that we’re looking at. The first that looks very interesting is Medtronics – one of the largest medical device companies. They develop and manufacture therapeutic medical devices for chronic disease. We like this because the bullish case is that they have attractive treatments for atrial fibrillation and aortic stenosis. It’s a good demographic and their leadership position is very strong relative to the sector along with looking good on a valuation basis as well.

Huntington Bancshares – Regional Bank with Room to Grow

Another stock that we like is one we’ve talked about on a previous Market Call – Huntington Bancshares.
They’re a regional bank headquartered in Columbus, Ohio, and most of their exposure is related to the auto industry. They’re in blue collar states, Ohio and Michigan and they have very high concentration in autos.
Given the fact that there is a positive backdrop for autos, we think this could be an exceptional grower and on a valuation basis they look attractive compared to other financials.

These are the types of companies that make sense to trim and trail, where you would trim back some of your winners in tech and move into some of the other names that look better on a valuation basis in our opinion.

Summary

In summary, tariffs are impacting various sectors in the market. It’s theorized that Trump will continue his aggressive stance in regard to tariffs regardless of the midterm outcomes.

Chinese stocks are set up for some long-term growth and look relatively strong compared to some large US companies at this time. That being said, it’s important to look for stabilization before taking an aggressive approach.

The general market should have a positive forward move, providing interest rates stay stable. We’ve got momentum on our side along with high earnings yields.

The tech sector has been in an uptrend but is leaning towards overbought. This isn’t a sell sign necessarily, but it does call for some caution due to the impact tariffs could have on this industry.

We like Medtronics and Huntington Bancshares – two strong and attractive stocks. One is a medical device company with good valuation, the other a regional bank with great growth potential in the financial industry.

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Connecting Your Own Dots

When I was in college I had a professor in communications that really impacted me. This particular professor gave us an easy first assignment. He told us to pick up any newspaper we wanted and read it from cover to cover for an entire week. Our task was to underline only things that are facts and backed up by data or by a reliable source. It was a really interesting exercise. I chose the Wall Street Journal, I went through the entire week and highlighted only the facts.

I was astonished because less than 20 percent of the entire newspaper was actual facts. What that brought to my attention was that there is very little fact in newspapers and in the news in general; most of it is opinion or fluff. I also learned that each individual author is connecting dots and coming up with a conclusion.

This means you could come up with your own conclusions that may be different from what is in the news if you just highlight the facts and then connect your own dots. One of the things that I find to be extremely helpful in investment is to be that person who highlights the facts and then connects their own dots. Listen to what other people’s opinions are, but don’t necessarily take that as being the gospel truth.

Is It a Waste of Time to Consume News?

The reason I bring this up is that in the last few weeks, and throughout my career, there has always been a camp of people that say not to read or listen to the news, that it’s all worthless. I would say, for the most part, that is absolutely true. There are, however, a couple of caveats that apply to that.

The first is that there is a tremendous amount of information inside the news from a sentiment perspective. This means that we can get a good feel for what the prevailing bias is, get into the mind of the market, and watch the movements of the prices themselves.

If you see a variance between what the sentiment is and what the prices are doing, you have as potential setup for a significant trend change. That’s one reason to listen to the news – you can actually see these setups occurring. You can see these divergences between what the prices are telling you versus what the news is saying and what the prevailing opinion is.

One recent example of that would be the Bitcoin craze. When we saw that exponential move up, the prevailing bias was that the cryptocurrency was going to change the world. Meanwhile, we had a complete trend break and all technical indicators were flashing sell signals to get out. We then saw a massive drop in Bitcoin.

China Gets No Respect

A lot of times if you do your homework, you can look in a group and find investments that make sense from a longer-term perspective. I want to mention the emerging markets, specifically China, because we have this prevailing bias right now that nobody wants to own international or emerging markets.

Not long ago I had a phone call with a new, high net worth client that was coming in and we were looking at their entire portfolio. This client had virtually no international exposure and in the conversation, they said that it hasn’t been the place to be, and that client was 100 percent correct. It was not the place to be and it hasn’t been for quite a while, but that could be changing.

If you’ve seen previous market calls, you’ve likely heard about how emerging markets peaked a long time ago, and for that reason, there was potentially a value setup, but we needed to see some stability. While that is true from a general market perspective, from an investment management perspective, I believe that savvy investors can look inside the group and find opportunities to start nibbling now.

China Telecom – Growing In and Out of the Market

A company that I find especially interesting is China Telecom. It is the largest fixed line operator in China, covering 21 southern provinces. They have about 120 million fixed line subscribers, 141 million broadband customers, and 282 million wireless subscribers. The firm is increasing, it’s cross selling across the product lines and they’re adding additional services such as cloud computing.

Why this particular company? Simply put, they are trading at multiples that are substantially lower than what we would see in other investments. They have an earnings yield of around seven percent, whereas the general market earnings yields are substantially lower than that. They’re growing at about nine percent according to what analysts are estimating, compared to other firms that are growing at a slower rate and have multiples that are not as attractive, and the stock has been basing for a long time.

This is a monthly chart from 2003 to the current year. Looking at this, you can see a long-term support area at $41-$42 per share, which was established with a peak in 2003, and has been tested multiples times. This particular stock peaked out in the nineties and now it’s trading at around $48 per share. If you look at the volume weighted average price of the trading from that peak until now, you can see that we’re testing that upper end of that range and the stock is oversold from a very long-term perspective.

The lower part of the chart is the Chaikin Money Flow indicator, which essentially shows you the money moving in and out of an instrument. Any technician can see that this stock is oversold and at support levels. I want to stress that when looking at the valuation, they have a competitive valuation compared to the industry and their top competitors. They also have that competitive growth; the firm has increased its wireless base by more than six times since it acquired the business in 2008, much faster than its competitors.

There’s a backdrop of sentiment where we have pessimism and Chinese stocks concerned about the dollar possibly being overblown. I believe that over time, a long-term investor can pick up these types of companies. Although, a whole country or asset class in emerging markets is not bottomed yet. This is where you can find some fertile ground for opportunity.
There are obviously some risks involved with this. China Telecom is controlled by the Chinese government, and their objectives may or may not be aligned with those of the minority shareholders and competitors.
Their competitors are marketing very aggressively and they have more scale. And of course, we have emerging market risks with currency and tariffs.
This is not without risk but taking a reasonable position size and keeping the risks in mind could turn the risk into opportunity.

Smaller Scale, but Still Competitive

This chart shows China Telecom on the top and one of their biggest competitors, China Mobile, in the middle chart. The bottom chart shows the relative comparison of the performance between China Telecom and China Mobile.

When that line is moving higher, China Telecom is outperforming China Mobile. Since July, we’ve seen that steady increase in outperformance there. Despite not having the scale of their larger counterparts, the market participants are showing indications that they’re buying for a few reasons.

One of the most probable reasons is that the relative performance is better than their top competitors since July. We’ve also had a significant support level that has been tested multiple times, and that would indicate potential for stealth buying.

Where Can This Company Go?

Let’s look at where this company could go. If we view it from a cash flow perspective, we’ve seen estimates from analysts that the fair value of that company could be as high as $82 a share with the stock trading around where it is right now. If we have a confirmation bullish move up, the stock would break above 51, which would be right around the volume weighted average price, and that could be a reasonable entry.

Obviously, there’s no perfect knowledge that it is occurring, but we might have a higher indication of that happening. If that is the case, the stock could have the potential upside of about $31 a share. Looking at the volatility of the instrument and trend change, you’re looking for downside risk of around $13 per share down to $38. That’s a reasonably good return risk profile.

So this is the kind of thing that I think investors can do within the context of a diversified portfolio. If you look at the relative strength of this stock compared to the S&P 500 on the bottom part of this chart, you see that the downtrend in performance is starting to slow now. So we’ve seen, you know, it’s, it’s just gradually slowing.

This is still in the early stages; it’s not a completed base. This would be an anticipation type trade where you’re looking to be a little bit ahead of it and taking a smaller position size would make more sense.

Summary

In summary, when reading/watching/listening to the news, it’s important to notice how much it is fact versus how much is opinion. Identify the facts and connect the dots for yourself to form a more reliable picture. That being said, it doesn’t make sense to me to ignore the news entirely; it can be a very good indicator of sentiment that might not necessarily be evident otherwise.

China Telecom is looking good in the long-term valuation game. Despite being on a smaller scale, it’s outperforming larger companies. It’s beating out its other opportunities in both growth and valuation. Keeping the potential downsides in mind, smaller position sizes could turn risk into opportunity.

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