the new S&P 500 sector arrangement

Keeping Score tomorrow

a new S&P 500 sector breakout

Announced last November, a new S&P sector arrangement went into effect last Friday.

Telecom, with only three constituents and about a 2% market weighting, disappeared and was replaced by the new Communication Services sector.

The latter contains former telecom names + enough heavyweights from IT (e.g., Facebook, Alphabet, Activision, Electronic Arts) and Consumer discretionary (e.g., Disney, 21st Century Fox, Comcast, Netflix) to give the new sector a total of 26 constituents and about a 10% market weighting–clipping a total of eight percentage points from IT + Consumer discretionary.

 

revised overall sector weightings:

IT .    21%

Healthcare .    15%

Financials .         13.3%

Consumer discretionary .         10.3%

Communication services .         10%

Industrials .         9.7%

Staples .         6.7%

Energy          6.0%

Utilities .         2.8%

Real estate .         2.7%

Materials .         2.4%.

 

my thoughts

–Telecom was a mature sector–if sector is the right word for three stocks–with large, high-dividend companies in it.  So it had defensive characteristics.  Not Communication, though, which contains a bunch of high-multiple, low/no yield components.

–The old Wall Street saw is that any sector is in for big trouble when it breaches 25% of the S&P 500’s weight.  That’s no longer the case with IT, but the change is obviously artificial.

–Splitting the index  sectors into highly cyclical, somewhat cyclical and defensive comes out like this:

Highly:  Materials, Industrials .  ~12% of the S&P

Defensive:  Real Estate, Utilities, Staples .   ~12% of the S&P

Somewhat cyclical:  everything else.      ~76% of the S&P.

Nothing has really changed, but parsing it out like that makes the index look like it has almost no defensive characteristics.  The lower weight for IT makes the index look less risky: this does the opposite–if only by about 2 percentage points.

–There’ll be new passive ways to bet on the Communication sector

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tariffs and the stock market

The Trump administration has just triggered the latest round of tit-for-tat tariffs with China, declaring 10% duties on $200 billion of imports (the rate to be raised to 25% after the holiday shopping season).  China has responded with tariffs on $60 billion of its imports from the US.  Domestic firms affected by the Trump tariffs are already announcing price increases intended to pass on to consumers all of the new government levy.

It isn’t necessarily that simple, though.  The open question is about market power. Theory–and practical experience–show that if a manufacturer/supplier has all the market power, then it can pass along the entire cost increase.  To the degree that the customer has muscles to flex, however, the manufacturer will find it hard to increase prices without a significant loss of sales.  If so (and this is the usual case), the company will be forced to absorb some of the tariff cost, lowering profits.

From an analyst’s point of view, the worst case is the one where a company’s customers are especially price-sensitive and where substitutes are readily available–or where postponing a purchase is a realistic option.

 

Looking at the US stock market in general, as I see it, investors factored into stock prices in a substantial way last year the corporate tax cut that came into effect in January.  They seem to me to be discounting this development again (very unusual) as strong, tax reduction-fueled earnings are reported this year.  However, the tax cut is going to be “anniversaried” in short order–meaning that reported earnings gains in 2019 are likely going to be far smaller than this year’s.  The Fed will also presumably be continuing to raise short-term interest rates.  Tariffs will be at least another tap on the brakes, perhaps more than that.

Because of this, I find it hard to imagine big gains for the S&P 500 next year.  In fact, I’m imagining the market as kind of flattish.  Globally-oriented firms that deal in services rather than goods will be the most insulated from potential harm.  There will also be beneficiaries of Washington’s tariff actions, although the overall effect of the levies will doubtless be negative.  For suppliers to China or users of imported Chinese components, the key issues will be the extent of Chinese exposure and the market power they wield.

PS   Hong Kong-based China stocks have sold off very sharply over the past few months.  I’m beginning to make small buys.

 

 

thinking about Walmart (WMT)

On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details).  Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.

Maybe that’s right.  But I think there’s a simpler, and likely more correct, interpretation.

WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000.  It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however.  And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.

This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000.   My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.

 

This interpretation has three consequences:  although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest.  Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting.  Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.

Trump on trade

so far:

intellectual property…

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it.  His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table.  In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think:  US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers;  certainly there will be fewer affordable choices

–overall economic growth slows.  The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way.  In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US.  This is a much bigger deal than what he has done to date.   How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing.  So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex:  many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China.  Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold.  It will send cars from Japan instead.  [Q: Who is the largest exporter of US-made cars to China?  A:  BMW  –illustrating the potential for unintended effects with automotive tariffs.]

 

More significant for the long term, the world is in a gradual transition toward electric vehicles.  They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader.  Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s.  The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency.  The relative market position of the Big Three deteriorated a lot.  During that decade alone, GM lost a quarter of its market share, mostly to foreign brands.  Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles.  GM has been the poster child for this.  It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy.  I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit.  So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways.  They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500.  Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products.  My guess is that if auto tariffs are put in place, this trend will intensify.  Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

 

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut.   This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

 

 

Trumponomics to date

a plan?

It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to).  I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill.  It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average).  This should have two beneficial effects:  it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time.  Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus.  Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing,  It ups the chances of overheating.  We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels.  More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates.  Oddly–and worryingly,  Mr. Trump has begun to jawbone the Fed not to do so.  That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this.  Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage  …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government.  One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened.  Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak.  Therefore, every trade action is a case of national security.  In other words, this emergency power gives the president complete control over all trade matters.  What’s odd about this state of affairs is that so far Congress hasn’t complained.

 

More tomorrow.