Sectors

Today we update our Millennial Basket as TSLA and UBER have gone vertical this month rising 29% and 46%, respectively. Specifically, we rebalance the basket back to an equal weight with AAPL, UBER, LEN, and TSLA being rebalanced lower, and AMZN, HD, MSFT, NFLX, SPOT, and V higher. Our Millennial Basket is up 116% in absolute terms and 68% relative to the SPX since inception in our June 11, 2018 Special Report. In addition, we also recommended investors overweight our Millennial Basket on a secular ten year view basis, predicated upon our Millennials spending theme. While profit potential has not changed, recent news and price action in TSLA (eerily reminiscent of the YHOO inclusion in the SPX announcement 21 years ago on November 30th 1999!) compel us to rebalance this basket back to equal weight. We also add another layer of risk management in order to protect cyclical-only profits and institute a rather wide rolling 18% stop. Bottom Line: We reiterate our structural and cyclical overweight stance on our Millennial Basket, but today we recommend an 18% rolling stop in order to protect cyclical-only profits. The ticker symbols in the US Equity Strategy Millennials Basket are: AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, and V.  

This week we removed the S&P insurance index from our underweight list capitalizing gains of 38% since inception. The underweight served its hedging purpose and softened the blow from our previous exposure to banks. Importantly, the macro environment is also set to improve according to our insurance indicator; thus it no longer pays to be underweight this financials sector sub-group (second panel). Simultaneously, we are reluctant to swing all the way to an overweight stance. Insurance CEOs have been anything but disciplined. Headcount is surging and industry wages are also accelerating. While executives may be preparing for a durable rebound in the coming months, a spiking wage bill will eat into insurance margins (third & bottom panels). Bottom Line: We upgraded the S&P insurance index to neutral from previously underweight locking in gains of 38% since inception. For more details, please refer to this Monday’s Weekly Report. The ticker symbols for the stocks in the S&P insurance index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, AJG, UNM, AIZ, RE, GL, WRB.

Since late summer we have published a number of reports arguing for a rotation out of expensive tech titan stocks and into beaten down late-cyclicals. Taking a closer look at the Nasdaq 100/S&P energy ratio is instructive. In just 7 trading days, the share price ratio has collapsed 20% from its November 6th high, once again highlighting the violent ongoing rotation within the US equity universe. Vaccine announcements were undoubtedly the catalyst that accentuated this rotation, but once the news of what appears to be peaking US COVID-19 cases hit the wire, this healthy rotation will likely reaccelerate (see chart). Bottom Line: We continue to recommend investors remain exposed to the economic reopening trade that news of effective vaccines has brought to the forefront.

Similar to last Monday, the SPX opened weekly trading with gusto courtesy of the MRNA’s 94% efficacy vaccine news, but failed to breach previous all-time highs. In the short-term there are high odds that the SPX will move sideways, before rallying higher, in order to digest the recent up move and work off overbought conditions. According to the American Association of Individual investors (AAII), bulls are back in droves and the AAII bull/bear ratio has slingshot to the highest level since January 2018. This is cause for near-term concern as it has historically served as a reliable contrary signal (Chart 1). The knee-jerk equity market reaction on the back of the positive vaccine news has also pushed the percentage of SPX stocks trading above their 200-day moving average to a zenith, warning that the SPX will most likely move laterally (Chart 2). Chart 1 Chart 2   Bottom Line: We remain cyclically and structurally bullish, but in the shorter-term, chances are that the SPX will take a breather. For more details, please refer to this Monday’s Weekly Report.

Highlights Portfolio Strategy The hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. A resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal policy, election and COVID-19 uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P asset management & custody bank index. Stay overweight.  Recent Changes Upgrade the S&P insurance index to neutral and lock in relative gains of 38%, today. This move also augments the S&P financials sector weighting to a modest overweight stance. Table 1 Feature News of a vaccine last Monday turbocharged equities to new intraday all-time highs, following up from a stellar performance the week of the election as odds of a “Blue Wave” collapsed. One of the implications is that the Trump corporate tax cuts will remain in place and investors breathed a sigh of relief (tax policy uncertainty shown inverted, Chart 1). While a smaller fiscal package owing to a split government postponed the rotation trade, the PFE vaccine efficacy news brought it back with a vengeance. This set up caused equities to discount all the good news in a heartbeat as typically happens when uncertainty is sky high and investors stampede into stocks. As we have argued here a VIX with a 40 handle was overdone and thus we crystalized our gains and closed our long VIX December futures trade prior to the election. We have been preparing our portfolio for such a looming rotation and this has been most evident in our long “Back To Work”/short “Covid-19 Winners” equity baskets. Last Monday they went in polar opposite directions and compelled us to put a trailing stop at the 10% return mark in order to protect profits (top three panels, Chart 2). Chart 1Tax Policy Uncertainty Relief Our recent preference of small caps at the expense of large caps that we first recommended a week before the election also depicts the ongoing equity market rotation out of overvalued tech stocks and into beaten down laggard cyclicals (bottom panel, Chart 2). Importantly, the economic reopening trade is still in the early innings, and we remain cyclically bullish on the prospects of the S&P 500 with a fresh end-2021 target of 4,000 that we updated last Monday in a Special Report before news of a vaccine hit the wires. Nevertheless, the recent parabolic rise in equities raises the obvious question: have stocks run too far too fast? Chart 2“Back To Work” Recovery First, there is no doubt that equities are overextended in the near-term as the collapse in the equity put/call (EPC) ratio highlights. Over the past year, the EPC ratio has formed a clearly defined range and a reading below 0.4 suggests overbought conditions (EPC ratio shown inverted, Chart 3). Second, while the violent rotation has pushed the SPX higher despite the deflating tech sector, we doubt that in the coming weeks the SPX will continue to gallop higher without the heavyweight tech sector partially participating in the rally. As a reminder, adding FANG (FB, AMZN, NFLX & GOOGL) weights to the GICS1 tech sector’s weighting results in a roughly 40% market cap weight of tech-related stocks in the S&P 500 (Chart 4). Chart 3No More Hedging Chart 4Tech Is 40% Of The Market   Third, according to the American Association of Individual investors (AAII), bulls are back in droves and the AAII bull/bear ratio has slingshot to the highest level since January 2018. This is cause for near-term concern as it has historically served as a reliable contrary signal (Chart 5). Fourth, the knee-jerk equity market reaction on the back of the positive vaccine news has also pushed the percentage of SPX stocks trading above their 200-day moving average to a zenith, warning that the SPX will most likely move laterally (Chart 6). Chart 5Bull Stampede Chart 6Too Far Too Fast? Finally, following a rough September and choppy October, seasonality is now in favor of owing stocks and given diminishing odds of year-end tax loss selling, equities should grind higher as 2020 draws to a close. Netting it all out, in the short-term our going assumption is that, barring exponential moves in the reopening trade similar to what we witnessed last week, the SPX will likely move sideways in order to digest the recent up move and work off overbought conditions. This is especially true if a selloff in the bond market continues to weigh on the tech sector’s still lofty valuation footprint. This week we make a sub-surface financials sector tweak that pushes this early cyclical sector to a modest above benchmark allocation. Time To Lock In Gains On Insurance The shifting macro landscape signals that it no longer pays to be bearish insurance stocks; thus we are upgrading the S&P insurance index to a neutral weighting today, crystalizing relative gains of 38% since inception. This cyclical underweight exposure in insurance stocks – as part of our barbell portfolio strategy within the financials universe – has cushioned the blow from our positive bank exposure and served its hedging purpose. Now that the election uncertainty is waning and given the recent positive PFE news on the effectiveness of their COVID-19 vaccine, insurance stocks will at least catch a bid. The economic reopening underscores that home and auto sales will continue to climb as nonfarm payrolls make a run for the pre-recession highs likely sometime in 2021. Keep in mind that consumers’ plans to buy a new car and a home are recovering smartly according to the most recent Conference Board survey (third panel, Chart 7). This upbeat demand backdrop for these key insurance end-markets should boost industry profits (bottom panel, Chart 7). Already a hardening insurance market (second panel, Chart 8) owing to pent-up residential real estate and automobile demand is a boon for underwriting results. Chart 7Insuring Gains Chart 8Hardening Market Importantly, the latest national account data corroborates firming final demand for insurance services: consumer outlays on insurance are galloping higher. The upshot is that the insurance valuation de-rating will transition to a rerating phase (bottom panel, Chart 8). Our Insurance Indicator does an excellent job in encapsulating all these moving parts and heralds rosier days ahead for relative share prices (second panel, Chart 9). However, there is a caveat that prevents us from swinging all the way to an overweight stance. Insurance CEOs have been anything but disciplined. Headcount is surging and industry wages are also accelerating. While executives may be preparing for a durable rebound in the coming months, a spiking wage bill will eat into insurance margins (third & bottom panels, Chart 9). Netting it all out, a hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. Bottom Line: Upgrade the S&P insurance index to neutral today, cementing relative profits of 38% since inception. This upgrade bumps the broad S&P financials sector to a modest overweight stance. The ticker symbols for the stocks in the S&P insurance index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, AJG, UNM, AIZ, RE, GL, WRB. Chart 9One Positive And One Risk Stick With Asset Management & Custody Banks While we have moved to the sidelines on the S&P banks and S&P investment banks & brokers groups, we have maintained bank-related exposure via the S&P asset management & custody banks (AMCB) index and today we reiterate our overweight stance in this early cyclical group. Recent news of industry M&A activity has propped up stocks in this index. Any reduction of supply is great news not only because investors have fewer constituents available to deploy capital to, but also because of oligopolistic power with positive industry pricing power knock-on effects. Tack on the recent selloff in the bond market and factors are falling into place for a durable outperformance phase in the S&P AMCB index (top panel, Chart 10). In fact, the stock-to-bond ratio has caught on fire of late forecasting a pickup in momentum in relative share prices (middle panel, Chart 10). Fund flows are also emitting a bullish signal. Historically, increasing bond and equity fund flows have been positively correlated with the relative share price ratio and the current message is positive (bottom panel, Chart 10). Our view remains that the economy will continue to reopen in 2021 and news of the PFE vaccine reiterates our thesis. Thus, as economic uncertainty lifts, it should lead to multiple expansion in this beaten down early cyclical industry (middle panel, Chart 11). More broadly speaking, receding fiscal and election uncertainties should push down the still high equity risk premium and boost the allure of the S&P AMCB index (bottom panel, Chart 11). Chart 10Increasing Flows Are  A Boon Chart 11A Play On The Economic Reopening Securities lending is another source of income for the industry. Oscillating margin debt balances are an excellent demand gauge for such income producing services. Recently, margin debt has made a run for all-time highs in level terms, expanding at a near 20%/annum clip, underscoring that an earnings led advance is in the offing (bottom panel, Chart 12). With regard to earnings, there is broad-based skepticism on the industry’s profit growth recovery prospects both on a cyclical and structural time horizon. The middle panel of Chart 13 highlights that over the past two decades every time sell-side extreme pessimism reigned supreme, it was a good contrary signal. More precisely, when relative 12-month profit growth expectations sink to negative double digits, a reflex rebound typically ensues. We doubt this time will prove different. Chart 12Follow The Margin Debt In sum, a resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal and election uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P AMCB index. Chart 13Lean Against Extreme Analyst Pessimism Bottom Line: We continue to recommend an above benchmark allocation in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT – BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

The market has rallied roughly 10% this month, and while we remain cyclically and structurally bullish, a short-term consolidation period is likely in the cards. As Chart 1 highlights below, extremely easy financial conditions along with a near halving in implied volatility – which have been key rally drivers since the March lows as we pointed out numerous times in our research – are nearly perfectly priced in the SPX. The implication is that if a meaningful rally is to resume, further easing is required.  Another factor underpinning the market’s recent advance is the drop in the CBOE’s implied correlation index (pair wise correlation of S&P500 constituents, shown inverted, Chart 2). However, correlations have collapsed and are near levels that have marked prior temporary peaks in the SPX. Bottom Line: A short-term consolidation phase is likely in the cards  

The vaccine announcement this week accelerated the unwinding of the long tech short everything else pandemic trade. While such a rotation is augmenting our portfolio via an explicit long “Back To Work”/short “COVID-19 Winners” trade, as we highlighted in yesterday’s Daily US Sector Insight, our small cap size bias is another prime beneficiary. Specifically, small caps outshined large caps by nearly 4% this week. One of the key drivers behind such a quick move is the delta in sector composition between the small and large cap indexes. The relative gap in deep cyclicals alone is 13% as we highlighted in recent research. The implication is that as manufacturing rebounds, so will the relative performance of small caps (top panel). Moreover, easy fiscal policy is a tonic to the small/large share price ratio. As a flood of money enters the economy with a slight lag, small caps will continue to make up ground lost during the early stages of the pandemic (fiscal balance shown inverted, bottom panel). Bottom Line: We reiterate our recent small cap bias.

Yesterday’s vaccine news reawakened investors to the reality that the world might be going back to normality much sooner than previously anticipated unleashing a violent equity rotation. Perhaps one of the most illustrative examples is the one-day percentage change in our “Back To Work” and “COVID-19 Winners” baskets. The top and middle panels of the chart on the right highlight the point: 7/14 stocks in the “Back To Work” basket experienced more than a 10% increase with AXP leading the pack with a mighty 21% rise. On the other side, pandemic beneficiaries got clobbered with ZM losing 17% of its value.  As a reminder, we have been recommending being long our “Back To Work” basket at the expense of the “COVID-19 Winners” basket since early September, and this trade is currently up 15% since inception. Importantly, the economic normalization process has just begun and according to the ISM manufacturing PMI new orders sub-category there is likely a long runway ahead for this pair trade (bottom panel). Bottom Line: Stick with the long “Back To Work” basket / short “COVID-19 Winners” basket, but recent market action is enticing us to put a trailing stop at the 10% return mark in order to protect profits. ​​​​​​​

In this Monday’s Special Report we introduced our 2021 SPX target of approximately 4,000 and also updated our EPS forecast from $162 to $168. We arrived at these targets by applying our three-scenario approach that we first implemented in our research methodology early in the year. Specifically, our worst-case scenario (with the lowest probability of occurrence) is a recessionary relapse (double-dip recession) in 2021. Our base- and best-case scenarios incorporate bullish recovery dynamics that we forecasted in our Special Report and that Table 1 below also summarizes. Bottom Line: We remain cyclically and structurally bullish on the US equity market with the current end-2021 SPX target of 4,000 and EPS of $168. Table 1

Special Report

Feature In April we first published our view that S&P 500 EPS would return to trend level of $162 in calendar 2021. At the time, it seemed unrealistic as heightened uncertainty was cloaking over 2020 let alone 2021. But fast-forward to today, and analysts have already eclipsed our stale $162 estimate according to I/B/E/S data. In this Special Report, we update our very well-received three SPX EPS scenario analysis that we highlighted in January, validate whether the $162 estimate is still reasonable, and finally introduce our 2021 SPX target. Importantly, our four-factor macro S&P 500 earnings model ticked up recently following a better-than-expected ISM manufacturing release. The profit model’s current projection calls for roughly 20% year-over-year (yoy) growth for the first quarter of 2021 (Chart 1). Understandably, such a bullish outlook might raise some eyebrows. However keep in mind that 20% yoy growth from a recessionary trough is by no means an overly bullish estimate as we have shown in recent research owing largely to base effects. The next step is to put some science behind our forecast and arrive at a robust and quantifiable EPS forecast. Thus, we deconstruct our SPX profit growth model into its components and trace their likely paths over the next 8 months. Our model has four inputs: ISM manufacturing PMI, the greenback, interest rates and house prices. The first three components are responsible for the lion’s share of explanatory power; hence this is where we focus most of our attention. Chart 1One-Way Road To 2021   Extending The Model: ISM Manufacturing PMI To plot the likely path of PMI data, we introduce US Equity Strategy's FutureCast Indicator, which is based on Michael Howell’s of CrossBoarder Capital D-star (duration*) measure.1 As a brief explanation, D-star measures duration at which curvature of the US Treasury curve is maximized. The interpretation of D-star is that it is a duration boundary after which, economic conditions become uncertain. Consequently, the further away that boundary is, the longer the sanguine macro environment is expected to last. Similarly, as D-star takes smaller values, it signifies that the boundary is getting closer to the present, meaning that the length of the sanguine macro window is contracting. For more details on the D-star measure, please refer to Michael Howell’s original publication.2 While our FutureCast indicator is a slightly modified version of the original D-star measure, it still preserves all of the properties including a lead on the ISM manufacturing PMI data by 15 months (Chart 2). The current message is also enticing: over the course of 2021 the ISM manufacturing PMI will stay perched in the mid-to-high 50s on a three-month moving average basis while dipping into the low-to-mid 50s in 2022. Chart 2Introducing FutureCast Indicator The next series that will help us gauge the ISM’s future path is the BCA US Liquidity Indicator (USLI), which is a blend of six variables including credit conditions and “excess money” calculations that quantify how much extra money is available to the financial economy after the real economy takes its share adjusted for inflation. Similar to our FutureCast Indicator, the USLI used to lead the PMI by approximately 18 months prior to the dot-com bubble, but since then the lead has changed to 30 months (Chart 3). This extension likely reflects the growing dependence of the US economy on the financial sector. Chart 3Everyone Gets Liquidity! We have entered a brand-new liquidity cycle as the USLI is printing nearly all-time high readings. The reason behind such an aggressive rise is a number of exogenous shocks that were hounding the market over the past several years. Not only was liquidity already contracting in 2018, but the trade war with China exacerbated the manufacturing downturn capping new inflows. As a result, by the time the virus hit, US liquidity canisters were running dry, and policy makers had to open the liquidity spigots in order to belatedly cushion the blow from the trade war and combat this year’s COVID-19 related lockdown. The net result is that today abundant liquidity is sustaining the budding recovery, which will be reflected in upbeat PMI prints going forward. Extending The Model: The US Dollar The US dollar is the second major input in our earnings model as the S&P 500 derives 43% of its sales outside US boarders. Table 1 also highlights that deep cyclical sectors source most of their revenues internationally, further underscoring greenback’s importance. Currently, the US dollar remains range bound likely taking a breather before resuming its downtrend as ours and BCA’s working view remains for a cyclical depreciation in the currency. The bearish USD thesis is multifaceted. Starting from a structural (5-10 years) time horizon, swelling twin deficits as far as the eye can see emit a bearish US dollar signal; in more detail, prior to the pandemic, the US twin deficits were estimated to gradually rise toward the 7.5% mark, but COVID-19 related fiscal largess has pushed the twin deficits into the stratosphere (top panel, Chart 4). Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* Switching gears from a structural to a medium-term horizon (2-3 years), BCA’s four-factor macro model, is also sending an unambiguous bearish message for the greenback (middle panel, Chart 4). Finally, on a short-term time frame, the USD is lagging the money multiplier by approximately 3 months, and the nosedive in the latter cements the US dollar bearish thesis (bottom panel, Chart 4). Chart 4Bearish Across All Timeframes Since S&P 500 sales and the greenback are inversely correlated, and as the dollar bearish view unfolds, it will serve as a tonic to top- and bottom-line growth. Extending The Model: US 10-Year Treasury Yield Now onto the final piece of the puzzle – the 10-year US Treasury yield. Up until recently, the bond market was dormant refusing to price in the recovery. While the selloff in bonds that commenced in early August took a breather on the back of the GOP retaining the Senate, i.e. implying a smaller than previously expected fiscal stimulus package, the path of least resistance remains higher for yields. As the economy continues to reopen in 2021, a new bear market in bonds is likely. US yields are tightly correlated with the ebbs and flows of global growth, especially G7 industrial production (IP) growth. Global IP is set to recover from the depths of the COVID-19 recession paving the way for higher 10-year US Treasury yields. In fact, our excess demand for goods indicator, which gauges the difference between the total number of goods produced versus consumed, leads industrial production data by 12 months and currently predicts a long overdue V-shaped recovery in global IP (Chart 5). In summary, it is only a question of time until the ten-year catches up with “soft” data and the bullish economic signal from the equity market, both of which have already discounted a V-shaped recovery. The US 10-year Treasury yield has a positive coefficient in our SPX EPS growth regression model, implying that rising yields that reflect an economic rebound boost EPS and vice versa. Chart 5Yields Will Rise Tying It All Together Adding all the pieces of the puzzle reveals that our previous $162 estimate is slightly pessimistic for calendar 2021. We arrived to this conclusion by applying our three-scenario approach that we first implemented in our research methodology early in the year. Specifically, our worst-case scenario (with the lowest probability of occurrence) is a recessionary relapse (double-dip recession) in 2021. Our base- and best-case scenarios incorporate bullish dynamics that we outlined earlier in the report and we quantify below to arrive at our new probability-weighted $168 EPS estimate. We then deduce our 2021 SPX target through a five-step process outlined in Table 2. Table 2Three Scenarios Step 1: We plug into the model our base, worse and best case estimates of the four macro variables into mid-2021, and we get as output the model’s estimate of EPS growth for end-2021 with a range of -3.6% to 36.2% (one important assumption is that the historical correlation of the movement of these variables holds steady). Step 2: Then, we apply these growth rates to the expected IBES 2020 EPS forecast of $136/share and arrive at our end-2021 three scenarios EPS level estimates with a range of $131/share to $185/share. Step 3: We then assign probabilities to those three outcomes resulting in our new 2021 EPS forecast of $168/share. Step 4: In order to get an SPX expected value we need to apply a forward P/E multiple to our EPS estimate. Thus, we introduce our base-, worse- and best- case forward P/Es and multiply them with our $168/share weighted EPS forecast in order to arrive at the SPX 3,940 expected value for end-2021. Concluding Thoughts So what does it all mean? At the onset of the report we mentioned an eyebrow-raising 20% EPS growth estimate. However as it turns out, if we take into account the long overdue economic recovery that started in early-2020, but got short-circuited due to the COVID-19 outbreak, there are reasonable scenarios that can overwhelm our previous $162 2021 EPS target. Moreover, if the looming stimulus lands sometime in early Q1/2021, our best-case scenario may come to fruition. Under such a backdrop the SPX is likely to gallop even higher than our roughly SPX 4,000 target by the end of 2021. Finally, last week Wall Street analysts upgraded their calendar 2021 EPS estimate to $168 following news that the GOP would retain the Senate, which will prevent Biden’s tax increase should he be the winner of the 2020 election. If everything goes according to plan, then there are high odds that sell-side analysts will eventually catch up to our best-case scenario. But by then the market will have likely already discounted such a rosy backdrop, calling for a brand-new earnings analysis. Stay tuned.   Arseniy Urazov Research Associate Arseniyu@bcaresearch.com     Footnotes 1     Howell, Michael J. 2017. Further Investigations into the Term Structure of Interest Rates. London: University of London. 2     Ibid.