Americas CIO View

Halloween's blue moon: Light in the night or just ominous?

Winter chills ahead spooked investors, despite receiving pictures of summer fun

The S&P 500 fell 5.6% last week, its worst week since March as cooler weather infections hit Europe and the United States. Also, a longer wait for additional stimulus became evident with the U.S. elections now knocking. Investors are contemplating how a Democratic sweep could raise policy and profit uncertainty. The dip occurred despite strong third-quarter gross domestic product (GDP) and earnings reports all week that confirmed a leap forward this summer on the recovery path. But with eerie days ahead, third-quarter reports were received like a summer memories photo album.

Third-quarter S&P 500 EPS (week 3): Bottom-up is now 37.50 dollars, most reliable firms deliver again

Last week was the heaviest reporting week of the season with more than 180 companies or 42% of S&P 500 index earnings reporting. Now, 315 S&P 500 companies or 78% of index earnings have reported. Health care and technology delivered again and continue to post the strongest year-over-year (y/y) earnings-per-share (EPS) growth of 7% and 5%, respectively. Some cyclical sectors, particularly industrials and materials, also beat very low expectations (by 46% and 29%, respectively), but despite big bounces still have EPS well below last year (-49% and -4% y/y, respectively). Consumer discretionary also delivered big beats so far, but retailers have yet to report. Aggregate consumer discretionary bottom-up third-quarter EPS growth is -14% y/y. Despite banks arguably under provisioning, annualized S&P 500 EPS is now about 150 dollars.

U.S. GDP bounces strongly on consumption, but capex stays weak outside of tech

GDP bounced sharply after the sharpest fall in post war history, led by a rebound in consumption / production of both services and goods as well as a large inventory rebuild. Service consumption remains below normal, but goods consumption has fully recovered. Despite third quarter's bounce, investment spending remains quite depressed, especially outside of spending on information technology and single family home construction. This is because many consumer goods in demand are imported, but more because demand and production of capital goods is weak. U.S. industrial production as of September end remains at levels below that of seven years ago and U.S. manufacturing within it more depressed, despite the rebound at cars. Some were encouraged by the September durable-goods report, but new orders still remain well below shipments, which historically suggests that shipments have further to fall. Inside, we dive deeper into the data to distinguish conditions between strength in consumer goods demand / production vs. weakness at industrial capital goods.

U.S. manufacturing is a bifurcated situation of consumer goods vs. industrial goods

There is strength in manufacturing of computers and technology, where both consumer and business spending is good, and also consumer durable goods, particularly of cars and homes. But machinery demand is weak, which is likely related to weak private non-residential construction, weak aircraft and energy equipment demand. Auto units manufactured rebounded to trend in the third quarter, but the trend here still appears downward. U.S. housing starts are up sharply for single family, but down sharply at multifamily / apartments. Many industrial capital goods are long cycle businesses still with soft outlooks. We think many industrials stocks are dependent on infrastructure stimulus, we prefer utilities.

Fair P/E for energy? Beware risk of a shift from perpetuity to annuity valuation

The energy sector has been clobbered by excess supply and Covid-19 demand destruction. The elections could bring policies that accelerate transitions to clean energy and electric vehicles. This would require reexamining the likely level and longevity of recovery earnings at energy. Most investors would then probably find it too risky to capitalize such earnings in perpetuity, as they might fade rapidly or require much higher maintenance capital expenditures (capex) than depreciation to sustain. If the fair price-to-earnings ratio (P/E) construct on recovery EPS moves from 1/real cost of equity (CoE) (6%+) to a 20-40 year annuity valuation, then the fair P/E on recovery EPS drops from about 16x to 12-15x. Without a large allocation of earnings to profit replacement projects, we think sector profits could disappear in 20 years under accelerated transitions. Whether recovery profits last just 20 years or require a 25% retention for profit replacement projects to be sustained (instead of fueling real profit growth as normal), then the fair P/E on recovery EPS is about 12.5x. The sector's current 550 billion dollars market cap is about 12x our estimate of normalized profits of about 45 billion dollars assuming normal oil prices of about 55 dollars per barrel. If transition policies accelerate post-election, we think the sector's valuation is no better than fair.

Last minute portfolio tweaks before the election? Protection is not cheap

We see the volatility index (Vix) as too high and Treasury yields as too low to offer much protection to a contested election. We think Asia, including Japan, may be a viable protection play while being a solid add even if not needed. Energy likely benefits most on a Trump victory surprise.

Appendix: Performance over the past 5 years (12-Month Periods)

 

10/15 - 10/16

10/16 - 10/17

10/17 - 10/18

10/18 - 10/19

10/19 - 10/20

S&P 500

4.5%

23.6%

7.3%

14.3%

9.7%

U.S. Treasuries (10-year)

4.6%

-1.8%

-3.2%

14.6%

8.5%

Past performance is not indicative of future returns.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 11/2/20

 

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