Three quick ways to test the strength of the US mar­ket

Trans­port, semi­con­duc­tors and banks are the key sec­tors to watch

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Af­ter a lot of huff­ing and puff­ing to re­cap­ture the ground lost since Jan­uary, Amer­ica’s S&P 500 in­dex is trad­ing at fresh all-time highs and in the process set­ting new records for the long­est bull run in US stocks in his­tory at 3,461 days and count­ing.

The 428% rise since the postLehman bot­tom on 9 March 2009 is not, how­ever, the best ad­vance forged dur­ing a bull run. Be­tween Oc­to­ber 1990 and March 2000, the

S&P 500 romped higher by 518%.

To match that gain, the S&P 500 must there­fore get to 3,505, some 20% higher than where we are now.

One fac­tor in the S&P 500’s rise this year has been very strong earn­ings growth as the US econ­omy has picked up steam, helped by the tax cuts pushed through by the Trump ad­min­is­tra­tion in late 2017.

And with in­ter­est rates slowly ris­ing, and the Fed­eral Re­serve also with­draw­ing quan­ti­ta­tive eas­ing, profit growth will have to re­main strong if stocks are to re­sist the grav­i­ta­tional pull of higher re­turns on cash, which just might one day tempt in­vestors to take on less risk and lessen their port­fo­lio al­lo­ca­tion to eq­ui­ties.

ON­WARD AND UP­WARD

Af­ter 20% year-on-year growth in the first quar­ter of 2018, an­a­lysts went into July look­ing for a 38% surge in the sec­ond quar­ter of the year, buoyed by tax cuts, share buy­backs, ini­tial dol­lar weak­ness and also a strong op­er­a­tional per­for­mance from oil and tech­nol­ogy firms in par­tic­u­lar.

The good news is that cor­po­rate Amer­ica has de­liv­ered in style. With just a hand­ful of S&P 500 mem­bers yet to re­port, earn­ings look set to rise 43% year-onyear, with op­er­at­ing mar­gins and earn­ings per share reach­ing fresh all-time highs, at 11.6% and $38.72 for the quar­ter re­spec­tively.

Bet­ter still, profit growth looks to be ac­cel­er­at­ing.

This helps to ex­plain why US stocks trade at fresh all-time highs of their own, at least us­ing the S&P 500, NAS­DAQ Com­pos­ite and the small-cap Rus­sell 2000 in­dices as bench­marks, with only the share-price weighted Dow Jones In­dus­tri­als let­ting down the side.

But this also im­plies that profit growth forecasts must be met or ex­ceeded and op­er­at­ing mar­gins main­tained or in­creased to help US stocks sus­tain their mo­men­tum.

It will there­fore be in­ter­est­ing to see if any US firms flag any nega­tive im­pact from tar­iffs, costs or the dol­lar. No-one is ex­pect­ing a 2008-09 style mar­gin col­lapse but with US stocks hav­ing done so well any dis­ap­point­ments could be taken badly, since ar­gu­ments that the US mar­ket is still cheap largely rest on the as­sump­tion that profit mar­gins will stay at their new highs for­ever (or go up even more).

THREE AGAINST THE FIELD

Check­ing out some 500 sets of re­sults every three months is a la­bo­ri­ous job that will be be­yond most in­vestors. To cut out of some of the don­key work, in­vestors might like to keep an eye on three sec­tor in­dices to help them take markets’ tem­per­a­ture as the earn­ings num­bers flood in once more.

All three tap into the US econ­omy and tend

to be good in­di­ca­tors of wider stock mar­ket sen­ti­ment. While the past is by no means guar­an­teed to re­peat it­self, the S&P 500 tends to do well when th­ese three sec­tors are do­ing well and not so well when they are do­ing badly.

1. Trans­port. The old the­ory is that if the econ­omy is do­ing well, the trans­port stocks will do well, as goods are be­ing sold and there­fore new sup­plies must be shipped. Bulls will be de­lighted to see that the Dow Jones Trans­porta­tion in­dex is rum­bling higher again af­ter a slight skid in the sum­mer.

2. Semi­con­duc­tors. The Philadel­phia Semi­con­duc­tor in­dex, or SOX, con­tains 30 com­pa­nies in­volved in the de­sign, man­u­fac­ture and sale of sil­i­con chips and it is there­fore a very use­ful guide for in­vestors on two counts.

Th­ese in­te­grated cir­cuits are ev­ery­where, from smart phones to com­put­ers to cars to robots, so they of­fer a great in­sight into end de­mand across a huge range of in­dus­tries and there­fore the global econ­omy.

Chip-mak­ers’ and chip-equip­ment mak­ers’ shares are gen­er­ally seen as mo­men­tum plays, where earn­ings growth is highly prized and val­u­a­tion less of a con­sid­er­a­tion. As such they can be a good guide to broader mar­ket ap­petite for risk.

The SOX is up by 11.5% this year and the S&P 500 by 8.5% so that looks good, although in­vestors need to watch the chip­mak­ers’ in­abil­ity to set new highs. This may re­flect lin­ger­ing con­cerns over trade dis­putes with China in par­tic­u­lar.

3. Banks. Both the econ­omy and the fi­nan­cial markets need healthy banks if they are to thrive so a fee­ble per­for­mance from Philadel­phia Banks in­dex is a con­cern.

Real weak­ness, rather than mere un­der­per­for­mance, could warn of eco­nomic and mar­ket trou­bles ahead since the sec­tor lost mo­men­tum in early 2007, well be­fore the peak in the S&P 500 and be­fore the great fi­nan­cial cri­sis broke.

CON­CLU­SION

His­tory sug­gests bull markets end when in­ter­est rates are ris­ing, val­u­a­tions are stretched and earn­ings dis­ap­point. The first is un­de­ni­able, the sec­ond ar­guable but the third, for now, is not a con­cern, espe­cially with trans­port and chip stocks blow­ing hot, although any fur­ther cool­ing in the banks’ mo­men­tum could yet be an early warn­ing sig­nal.

By Russ Mould, in­vest­ment di­rec­tor, AJ Bell

Source: Thom­son Reuters Datas­tream

Source: Thom­son Reuters Datas­tream

Source: Thom­son Reuters Datas­tream

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