361 Capital Weekly Research Briefing

361 Capital portfolio manager, Blaine Rollins, CFA, previously manager of the Janus Fund, writes a weekly update looking back on major moves, macro-trends and economic data points. The 361 Capital Weekly Research Briefing summarizes the latest market news along with some interesting facts and a touch of humor. 361 Capital is a provider of alternative investment mutual funds, separate accounts, and limited partnerships to institutions, financial intermediaries, and high-net-worth investors.

361 Capital Weekly Research Briefing

July 7, 2014

Timely perspectives from the 361 Capital research & portfolio management team

Written by Blaine Rollins, CFA


Had enough yet? Welcome to the most hated bull market of 2014…

Stocks extended their gains this week and the present environment is beginning to feel a lot like 2013 (where equities enjoyed a very steady and linear advance). The SPX is now up >7% YTD, but more impressively has surged ~6% since mid-May in what has been a relatively uninterrupted move (the R2K and DJIA are both up less than 4%). The story for this tape remains not so much what happened, but instead what hasn’t – the >2yr-old macro narrative is only being reinforced in what is now clearly a virtuous cycle. Optimism is far from universal – many of today’s buyers are only participating begrudgingly, skeptical of the fundamental backstop, but forced long by performance considerations. The extreme cynicism of the recent past (of this all being just a deliberate artificial bubble fueled by the Fed and other complicit central banks that will inevitably end “in tears”) has quieted, but for a lot of people stock prices at present are still “inappropriate”.


One reason it is so hated is that even in a very accommodating stock picking environment, the professional long only managers are getting out fished by their indexes…

More than 74% of actively managed funds that invest in shares of big U.S. companies are lagging behind the S&P 500 Index, up from 50% last year. It is the second-worst performance on record going back to 2004, according to the fund researcher. The story is similar across many categories of funds investing in small- and midsize stocks. This development has frustrated many stock pickers who were hopeful at the start of 2014, following years in which many of them were unable to post returns in excess of market benchmarks.


Meanwhile the records continue to pile up for the indexes. Small Caps are having an amazing quarterly winning streak…

@RyanDetrick: $RUT up 8 quarters in a row for the first time ever.

And a big 14 year milestone now looks within reach…


Hopefully your clients also had a slug of Government Debt in their portfolios for 2014…


Back to the U.S. equity markets, note the change in risk appetite in the last 7 weeks. Defensive stocks are being shown the exit door and investors are buying more cyclical exposures to benefit from a pickup in the economy. It would be very difficult as a portfolio manager to be underweight U.S. economic growth given Thursday’s jobs data.


Next on deck for data is the Q2 earnings period and all of the 2nd half guidance that companies are about to hand out. And while I would typically want to fade a strong market into any earnings period, this one is a bit tricky to fade. Especially when you have earnings growth rates picking up. The question for the Q3 & Q4 guidance will be, “How Strong?”

With all the hoopla over the Dow topping 17,000 out of the way, the market’s next focus will be whether the fast-approaching earnings season can justify U.S. stocks continuing their climb further into record territory. Many factors point to a second-quarter earnings season poised to surprise substantially to the upside, with an outside chance that profits for S&P 500 companies could return to double-digit growth for the first time in nearly three years. On the heels of Thursday’s strong U.S. employment report, some economists have begun talking up prospects for a 4.0 percent annual growth rate in gross domestic product for the April-through-June period, a dramatic snap back from the first quarter’s contraction of 2.9 percent.

“It’s a strong report that capped off a strong quarter. Everything in the report points to 4 percent growth in the second quarter,” said Stuart Hoffman, chief economist at PNC Financial Services in Pittsburgh, referring to the jump in June’s nonfarm payrolls. Analysts polled by Reuters are calling for earnings growth for the second quarter of 6.2 percent, and a return to double digits in the third and fourth quarters: 10.9 percent and 11.9 percent, respectively. The last time that S&P 500 earnings achieved double-digit percentage growth was the third quarter of 2011 – at 18 percent.


Definitely helping equities in the last 4 weeks has been the slowdown in negative pre-announcements. You couldn’t ask for better if you are an earnings growth focused investor…

EPS Guidance Numbers Trend Positive for 2nd Straight Quarter – Positive Shift in Information Technology, Health Care, Industrials, and Materials Sectors since Q4 – Since hitting a peak in negative EPS guidance in Q4 2013, companies in the S&P 500 have issued fewer negative EPS preannouncements and more positive EPS preannouncements for the second consecutive quarter. For Q2 2014, 84 companies have issued negative EPS guidance and 27 companies have issued positive EPS guidance. The number of negative preannouncements is below the record high of 95 set in Q4 2013, and the number of positive preannouncements is above the record low of 17 also set in Q4 2013. If these are the final numbers for the quarter, it will mark the lowest number of negative EPS preannouncements since Q4 2012 (79) and the highest number of positive preannouncements since Q4 2012 (34).


One sector that has really risen from the ashes in the last 7 weeks has been the Consumer Discretionary names. The group has even put in a good relative base versus the S&P 500. Could portfolio managers be running to this under owned group as a way to try and get 2nd half outperformance? Again, the Thursday jobs data makes it even more difficult to be underweight the Consumer. Just wait until wage growth accelerates.

Here is a list of Consumer Discretionary names that have outperformed the XLK ETF by 50% in the last 7 weeks. It shows you the type of names that investors are running to: Leisure/Travel, Retail, Advertising/Media and even Autos.

So, about those Thursday jobs numbers, Dan Greenhaus sums it up well…

The lowest unemployment rate in six years…The seventh best five month rate of private sector job creation dating back to 2001. A revision to April’s data that made April the third best month for private sector job creation of the entire recovery…and the strongest six month pace of job growth since 2006. It’s fair to say that the job market is, for now, “en fuego.” At the same time, despite a drop in the unemployment rate to near 6.0%, wage growth remains muted at just 2.0% year-over-year. Worries over growth and the economy, partially validated/incited by the first quarter contraction, seem wholly inappropriate at this point. The economy expanded nicely in the second quarter; that’s a fact.


And Neil Dutta’s chart illustrates why it is so difficult to stay short the Consumer now…

Over the past year this is the 8th time and 5th month in a row that NFP recorded a reading above +200k, this should leave no doubt that the economy is heading in the right direction, and not what the pessimists are saying who are reading too deep into the Q1 GDP readings.


Personal Spending is starting to lift, but the real test will be what happens when wage growth finally lifts. And after this weekend, you know that it is coming. Service has deteriorated to uncomfortable levels at many businesses with payrolls running too lean.


If you are betting on a pickup in inflation, then you will like this chart from Deutsche Bank…


Looking elsewhere for inflation (signs of improving U.S. economic growth) will also point you toward gasoline prices…


The largest part of a consumer’s spending is on housing. We know housing prices are up, but rental prices are really starting to rip…

Effective rent growth was 2.4% on a quarterly basis nationwide in April-June 2014, the highest quarter-to-quarter rate since the 2.9% of July-September 2000. Occupancy in the second quarter of 2014 was 95.0%, the strongest since the 95.6% of January-March 2001. Both rent growth and occupancy exceeded expectations. Effective rent growth was soft in January and February, perhaps because of the major winter storms and bitter cold temperatures that gripped much of the nation during the early part of this year. But March, April and May was one of the strongest three-month stretches we’ve seen in the 19 years Axiometrics has been tracking apartments.


Effective rents—which tend to be lower than asking rents—were up in all 79 U.S. metro areas tracked in the Reis report. West Coast cities that have been the model of recovery continued to top the list of highest rent growth for the quarter and over the past 12 months. Rent growth exceeded 6% over the past year in San Francisco, San Jose and Seattle. Even cities that aren’t normally associated with fast rent growth, such as Charleston, S.C., and Nashville, Tenn., posted strong growth over the year, up about 5% or more for the year. “You have definitely seen that recovery now spread to all of the major markets around the country, even if some of them were laggards,” said Ryan Severino, an economist at Reis. “It’s a very pervasive recovery.”


Signs of anticipated price inflation can even be seen in the financial markets as Industrial Metal Prices and their Miners are breaking out, Precious Metal prices have stopped declining and one of the most natural resource based economy, Canada, is surging…

Much interest in whether or not the downtrend has changed in base metals prices…


If the global economy is picking up, then Barron’s has some Energy ideas for you…

Surely, a pickup in the second quarter in the global economy has something to do with the high price of oil. Last week’s report that the U.S. added 288,000 jobs in June ought to put to rest recession fears created by the big drop in first-quarter gross domestic product. At the same time, a gauge of manufacturing activity in China rose to a level that indicates the Chinese economy is stabilizing. If global growth is improving, so will demand for oil, says Janney Montgomery Scott’s Mark Luschini. “We see a world of globally synchronized economic growth,” he says. “Regardless of the geopolitics, that bodes well for oil prices and the energy complex.”

Even after their run-up, energy stocks don’t fully reflect the advance in crude. RBC Capital Markets, for one, estimates that large-cap oil stocks are pricing in oil at $93 a barrel, well below the current price of about $104. If oil prices stay high, that could provide a bigger boost for oil-company earnings — and shares. Energy remains among the market’s cheapest sectors even after its big gain. At the end of June, the stocks fetched 15 times the next 12 months’ expected earnings, compared with the S&P’s price/earnings multiple of 16.2. And it’s not as if investors are paying for slow growth: Energy-sector earnings are expected to rise 10% this year, after dropping 3% in the first quarter, according to Thomson Reuters.

The energy complex is under owned by active portfolio managers. At the start of the year, the managers’ energy weighting was 26% below their benchmarks, and it remained unchanged at the end of the first quarter, according to data from Bank of America Merrill Lynch. Even after the big rally, Merrill Lynch expects the managers to remain underweight energy. “Portfolio managers hate energy stocks today more than they ever have,” says BofA Merrill Lynch strategist Savita Subramanian. That makes the sector something of a contrarian play, despite its recent gains, she says.


LPL put together a good midyear piece. One of their key investment themes also highlights U.S. Energy plays. Below is a mind blowing chart on how the growth in U.S. energy production has benefited the railroad industry…

The United States is the largest producer of petroleum products in the world. According to the United States Energy Information Association (EIA), crude oil production continues to advance due to innovative technologies. Natural gas production is currently expected to rise by 56% between 2012 and 2040. The increase in the U.S. energy supply benefits the United States by both allowing us to become increasingly energy independent and balancing our international trade through increasing energy exports and curtailing imports. This may be done by rail or transport companies as well as by pipelines [Figure 14]. Oil and gas exploration companies, drillers, and companies involved in processing or transporting the fuel once it is out of the ground (rail companies, pipeline companies) should all benefit from this long-term theme.


Food for thought about the ignored U.S. Dollar…

Going to be a dollar shortage,” said the investor. “End of QE eliminates one source,” he continued. “End of U.S. energy imports eliminates another.” Unemployment is on track to crack 6% real soon. “I don’t care what Yellen wants, the Fed isn’t going to jeopardize 30yrs of inflation fighting credibility if unemployment has a 5-hande and inflation moves higher – rate hikes will drive dollar demand.” Which is nothing new, this story’s been around for a years. “But everyone’s given up, no one has it on any longer.”


One European country got the memo, read it, and rolled up its sleeves. It is no surprise that investors are running into its markets with open wallets….

In contrast to the disappointing results for La Roja in Brazil, the performance of the Spanish manufacturing sector provided plenty of encouragement in June. Sharp rises in output and new orders were recorded, while the rate of job creation picked up to its strongest since mid-2007. This all added up to the strongest monthly improvement in the health of the sector for seven years. Adding to positive signs was a second successive monthly rise in output prices as client demand strengthens.


For those looking for greener grass, this is a good survey to consider…


Dearest Airlines, please take back your old video/audio technology and give us back the foot & leg room…


A life lived VERY full…

Thanks to the 361 Capital fundholder who recommended Unbroken. One of the best books that I have ever read. R.I.P. Louis Zamperini.


In the event that you missed a past Research Briefing, here is the archive…

361 Capital Research Briefing Archive

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Blaine Rollins, CFA, is managing director, senior portfolio manager and a member of the Investment Committee at 361 Capital. He is responsible for manager due-diligence, investment research, portfolio construction, hedging and trading strategies. Previously Mr. Rollins served as Executive Vice President at Janus Capital Corporation and portfolio manager of the Janus Fund, Janus Balanced Fund, Janus Equity Income Fund, Janus Aspen Growth Portfolio, Janus Advisor Large Cap Growth Fund, and the Janus Triton Fund. A frequent industry speaker, Mr. Rollins earned a Bachelor’s degree in Finance from the University of Colorado, and he is a Chartered Financial Analyst.

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