Market Recap

Posted on January 17, 2020 by Gemmer Asset

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Housing Fundamentals Improve


There were a few economic reports this week, but the main one concerned home construction, which hit the highest level in 13 years. New housing starts jumped in December to a seasonally adjusted rate of 1.608m, the highest level since December 2006. That was an increase from November’s upwardly-revised 1.375m and cruised past the median forecast among economists for 1.375m.



As you can see above, the hook high in construction is significant, both for single family homes (blue line) and multi-family homes (red line).


The US property market improved last year as the Federal Reserve delivered three interest rate cuts that reduced the federal funds rate by a combined 0.75%. By September, the 30-year mortgage rate hit its lowest since late 2016. Even today mortgage rates remain low, as you can see below.



Two other factors are helping housing, and should lead to a decent market in 2020. First, the employment market is solid and wage growth is picking up. Secondly, inventory levels nationwide are low. As you can see below, the inventory of new and existing homes is close to the lowest levels we’ve seen since 1985.



All this means is that housing should continue to be a tailwind for both consumer spending and the economy in the months to come.


A Trade Truce For Now


The other major (not unexpected news) was the signing of the Phase 1 trade agreement with China. Key provisions include:


1) An increase in US merchandise exports to China of $200bn vs the 2017 baseline over the next two years.


2) In return, the U.S. will halve tariffs, to 7.5%, on the $120bn tranche in Chinese imports and suspend any further tariff hikes.


3) Increased Chinese penalties on intellectual property infringement and trademark violations.


4) General language restricting forced technology transfer as a condition of market access.


5) Broad reductions of Chinese import restrictions on US agricultural goods.


The additional purchases are split as follows across four sectors



It’s hard not to be skeptical this will achieve much at all. Michael Cembalest at J.P. Morgan notes the following:


– “How can China import more US manufactured goods at the same time that the US is imposing greater sanctions on Huawei, which is a large customer of US technology firms? In addition to direct sanctions on Huawei, the US is also considering new rules that would bar third party countries from selling US chips to Huawei if the designs originally came from US firms, or if chips were supplied by US companies.


– Won’t problems at Boeing be another obstacle for the China manufactured goods target, given their recent decision to switch from Boeing to Airbus?


– How good could the deal have been if existing tariffs mostly stayed in place?


– China has made promises before regarding intellectual property protection which never satisfied the US, so why should now be any different?


– The deal includes the phrase “according to market conditions” with respect to Chinese imports of US agricultural goods, which could mean different things to different people


– Shifting the burden of proof to the accused on intellectual property cases and moving them to criminal rather than civil courts could help, but legal system changes in China are very slow, and China’s legal system is not known for its openness, transparency or fairness (see our Holiday piece of 2019)


– Phase Two talks won’t yield any results since it covers China’s domestic subsidies/loans which they will be reluctant to reduce”


But Cembalest ends on a more positive note:


“Even so, worst-case trade war outcomes look like they are off the table, the Chinese purchase commitments are substantial indications of a willingness to compromise if they’re not reached in full, and some capital spending plans will now be restarted, which is what equity markets are responding positively to.”


The $1 trillion Club


When Google (now Alphabet) was founded in September 1998, few would have thought the company would grow to be worth $1 trillion a little more than 21 year later. Even in August 2004 when the company went public at a valuation of more than $20bn, the prospect seemed remote. But here we are. This week Google became just the fourth U.S. firm to hit the $1tn threshold.



Apple and Amazon (briefly) hit the number in the summer of 2018 while Microsoft crossed the threshold in April 2019. Here’s where the big four stand on January 16th:



As it turns out, Apple is getting so big it is surpassing entire country market capitalizations. Just this week Apple’s market cap is close to topping the entire Australian stock markets.



How much of this has to do with the rise of indexing? After all, assets managed by global index funds hit $10 trillion last year, up from $2.3 trillion ten years ago, as you can see below.



And as the FT notes:


“Even this figure may understate the extent to which index investing has caught on. Many big pension funds, endowments and sovereign wealth funds have set up internal strategies that mimic markets without having to pay an asset manager. Data on this is sparse, but BlackRock estimated in 2017 that such activity could amount to an additional $6.8tn.”


If you are buying the index fund or ETF you obviously are buying all the underlying stocks. The highest weighted market-cap stocks receive the bulk of the flows. For example, iShares Core S&P 500 ETF has close to $208bn in assets. Top holdings are as follows:



To the extent money flows into indexes it is clearly bidding up the high market cap companies. As it turns out, the top five market-cap companies today make up a larger share of the S&P than at any time in history, even at the tech bubble peak in 1999.



What’s different this time around (dangerous words!!) is that the valuation backdrop is far different. Four of the five top companies today trade at less than 30 times earnings, and Amazon’s PE of 69 is arguably distorted due to high capital expenditures (they’ve had a high PE forever). The valuation of the ‘fab five’ really isn’t out of line with the broad market.


By contrast, in 1999 valuations were at nosebleed levels.



GE at 50 times earnings? Today it sports a market cap of just $103bn. Will Exxon even be around 10 years from now?


What does this mean for the future? To the extent the shift to indexing persists in the months and quarters to come nothing will change. If anything, the concentration will get worse. But looking out over the next decade I can’t help but look at the table below. Very rarely does a company stand at or near the top over time (albeit Microsoft is a remarkable exception to the rule).



Have a good weekend.





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