Health Care

Special Report

Highlights The odds of universal health care legislation being enacted in the U.S. by 2022 are about 10%-15%. Former Vice President Joe Biden is the most likely Democratic candidate in 2020, but the alternative is most likely a progressive candidate seeking universal health care. Trump is slightly favored to win in 2020, but a Trump loss is likely to translate into full Democratic control of the U.S. government, making ambitious legislation more likely to pass Congress. An overweight portfolio allocation in the S&P health care index is a sensible and defensive move. Fear selling in health care stocks could easily return but would create an exploitable trading opportunity at this late stage of the cycle. We are executing the upgrade of the S&P health care index via an upgrade of the S&P health care equipment index, which has seen a material valuation de-rating at the same time as profits are expanding, to overweight. Feature Will The Democrats Win? Can They Pass Universal Health Care? “Medicare for All,” or government-led universal health care in the United States, is less likely to become the law of the land by 2022 than the market expects. We put the probability at around 10%-15%. Here’s why. The industry faces only two certainties: Americans are getting older and the federal government is increasing its involvement. The former is a secular driver for health care demand. The latter is an inference drawn from the fact that the Republican Party failed to repeal the Affordable Care Act, or Obamacare, even when it had full control of government. It is very unlikely that the Republicans will get another chance at repeal. It is also very unlikely that the public will tolerate the current status quo forever. The result is that the U.S. will eventually end up with a restored Obamacare or an altogether new system with a greater government role. The Republican failure to repeal was not idiosyncratic – it was not based on the fact that the late Senator John McCain, who cast the decisive vote on July 27, 2017, had been diagnosed with brain cancer earlier that year. Rather, it was structural – the repeal failed because (1) it is always extremely difficult to remove an entitlement once it has been given to voters and (2) a slim majority of Americans approved of Obamacare – and still do (Chart 1). Republicans went on to dismantle aspects of Obamacare, including the problematic “individual mandate.” But they did so without replacing it. The result was a severe electoral defeat in the 2018 midterm elections, despite a huge drop in the unemployment rate (Chart 2) – which matters directly in a country where 49% get their health insurance through their employer. Health care was the single most important issue driving people to vote against the ruling party in November 2018, judging by both pre-election polls and exit polls (Charts 3 & 4). Chart 2Low Unemployment Has Not Solved Health Care Woes The need for reform is manifest. It is widely known that the U.S. spends more than other countries on health care (Chart 5) and yet achieves worse results: preventable mortality is higher than in other countries that spend less (Chart 6). Democrats have tried to overhaul the system since 1993. Even President Trump is seeking to cap prescription drug prices and maintain the Obamacare requirement that health care insurers accept customers with “pre-existing conditions.” Uncertainty has risen since the Republicans’ midterm defeat, which increases, or is seen as increasing, the odds of a Democratic victory in 2020. Such a victory would mark the third time in 12 years that American policy would witness a 180-degree reversal – and it would have a major impact on the health sector (Chart 7). Chart 7The Sector's Response To Major Political Events In truth Trump is still favored to win in 2020, on the back of the incumbent advantage – as long as the economy holds up. But with a chronically weak approval rating, and narrow 2016 margins of victory and the aforementioned midterm losses in key swing states, his odds of reelection are probably not much better than 55%. Meanwhile the Democrats are swinging to the left and may not settle simply for restoring Obamacare. Left-wing or “progressive” candidates for the Democratic nomination are polling in line with traditional center-left candidates (Chart 8), which is highly unusual (even compared with the 2007-08 race). Candidates are crowding onto the democratic socialist bandwagon in the wake of Bernie Sanders’s formidable challenge to Hillary Clinton and her subsequent loss to Trump. Could a progressive candidate win the nomination? Certainly. Former Vice President Joe Biden leads the pack at this early stage in the nomination process. He would seek to restore and build upon Obamacare. The second-ranked candidate is Sanders, whose initial proposal to create Medicare for All has transformed the national debate. Following Sanders are Senators Kamala Harris, who co-sponsored the latest version of the bill with Sanders, and Elizabeth Warren, an outspoken progressive who is also in favor of universal health care (Chart 9). Sanders does have a path to winning the nomination, as the leading progressive candidate at a time when the party is becoming more progressive. He performs better than Biden in head-to-head polls against Trump in the key battleground states (Chart 10). Strategic voters will have trouble convincing fellow Democrats that they should not vote for him because he is unelectable: he has a clear electoral path to the White House via Michigan, Pennsylvania, and Wisconsin, where he performed well in 2016 and polls well today. If Sanders has a chance, then Medicare for All has a chance. Because it is extremely difficult to unseat an incumbent president, a victory over Trump in 2020 is only likely to occur if there is a surge in voter turnout and Democratic Party support among (1) blue-collar workers who abandoned the Democrats for Trump in 2016, or (2) young voters, women, or minorities. Any such surge would also enable the Democrats to defend their senate seats while picking up Arizona, Colorado, and Maine, which are statewide elections that will be affected by the headline presidential race. And if the Democrats win 50 seats, they would get a majority in the senate, as the vice president would break any tie. With a majority, Senate Democrats could use the “nuclear option” to bypass the filibuster and drive through their priority legislation.1 This would set a new precedent with far-reaching consequences. But recent majority leaders have already begun eroding the filibuster and there is no hard constraint preventing a ruling party from removing it entirely. It is perfectly possible, and all the more likely if the nation sweeps a progressive candidate to power in a wave of enthusiasm for dramatic changes like universal health care. In other words, any victory against Trump is likely to entail full Democratic control of government. In this scenario, Democrats would have a very good chance of passing a major piece of legislation. Hence, if a progressive wins the nomination, and makes Medicare for All the policy priority, there is at least a 50/50 chance it will pass, probably more like 60%. The catch is that a progressive may not win the nomination. There is not decisive evidence that Americans really want Medicare for All. First, Americans tend to view their own health costs as “reasonable” (Chart 11). They are not, as a whole, clamoring for a single-payer system. Second, while Americans say they support Medicare for All, that support evaporates when they learn about the various policies that it would necessitate, such as eliminating private health insurance and raising taxes (Chart 12). Third, most Democrats are closer to Biden’s position than Sanders’s – they want to fix Obamacare rather than revolutionize the system (Chart 13). Fourth, Colorado tried to pass its own version of Medicare for All on the state level in 2016. The bill’s advocates were handed a 79% defeat by voters. Colorado is a swing state so it is not an irrelevant experiment. Fifth, independents are not shifting to the left in a way that would validate the sharp leftward shift within the Democratic Party (Chart 14). Nominating Sanders or another progressive is more likely to lead to a loss in the general election than it is to ensure that universal health care gets passed.   Chart 14Independents Not Swinging Dramatically To The Left A simple back-of-the-envelope exercise suggests that odds of universal health care by 2022 are about 10%-15%. Nevertheless, we attempt a conservative, back-of-the-envelope method for estimating the probability of passage. It runs like this: There is a 50% chance a progressive wins the Democratic nomination. We assume that if Biden wins it is because Democratic voters prefer a restitution of Obamacare. There is a 45% chance that Trump loses the presidential election. We assume that for the Democrats to unseat an incumbent is difficult enough that they will also win the Senate. Under these circumstances, there is a 50%-60% chance that universal health care legislation passes – even though it will be very difficult to get it over the line. (Note that the ACA passed very narrowly at a time when the Democrats had a huge tailwind due to voters’ disenchantment after the global financial crisis). With these assumptions, the conditional probability of passage is around 13.5% (0.5 x 0.45 x 0.6 = 0.135) These odds can be moderated by boosting Trump to a 69% chance of reelection (the historical average for sitting presidents), which brings down the odds of ultimate passage to 9%. Note, however, that the bond market is pricing a 27% probability of a recession 12 months from now (Chart 15). If there is a recession, then President Trump is virtually assured to lose reelection and the Democratic victor will have a strong tailwind of public support. This will increase the chance that universal health care passes to 80%. (We still assume in this case that Biden would stick with Obamacare as he would not be committed to Medicare for All and it is not an economic stimulus package). The conditional probability would become 0.5 x 0.27 x 0.8 = 11%. Chart 15Probability Of Recession Is Rising NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low In other words, whether we upgrade Trump’s chances of winning or we upgrade the chances of a recession that kicks him out of office, the odds are roughly the same at 9%-11%. And they could be a bit higher at 14%. Medicare for All has a chance of becoming law, although it is not all that great. Bottom Line: With fairly conservative assumptions the odds range from 10%-15%. that the U.S. could legislate a sweeping overhaul of the health care system and new social entitlement by 2022. This is a serious risk to the industry. Health care equities have recovered the losses suffered since Sanders’s latest push for Medicare for All, which means that it is not pricing in a high probability of passage at present. Additional policy-related selloffs are likely between now and the spring of 2020, if and when the odds increase of Sanders (or another progressive) winning the Democratic nomination. Buy Into Health Care Weakness Regardless of the likelihood of passage, the faintest hint of the winds of change has brought about significant price changes in the relevant equities. In the lead up to the 2016 U.S. presidential election, Hillary Clinton, a health care reformer (though importantly NOT a Medicare for All advocate) was polling well ahead of Donald Trump. Health care stocks underperformed the broad market in anticipation of potential reforms resulting from a Clinton win (Chart 16). Two years after Donald Trump’s election, both S&P health care equipment and S&P managed health care have significantly outperformed with the effect most dramatic in the former. Chart 17 shows the reverse picture: a “blue wave” in the 2018 midterm elections was swiftly followed by the zenith for health care stocks as the market digested the implications of a Democratic House and the resulting higher probability of a similar sweep in 2020 in the Senate and executive branch. Chart 16Election Fear Creates Buying Opportunities... Chart 17...And History Appears To Be Repeating Itself Furthermore, our prior research shows that S&P health care has been the top performer in the last equity market surge to take place between the peak of the ISM manufacturing composite index and the beginning of the subsequent recession.2 This research was confirmed in a report last month analyzing sector returns after a Fed loosening cycle begins. The S&P health care index has historically outperformed from six months before a rate cut all the way to two years after easing policy.3#fn_3 As a reminder, the market has now priced in two rate cuts over the next year. We recommend an overweight position for the broad S&P 500 health care index as well as for health care equipment. BCA’s U.S. Equity Strategy has already moved to an overweight recommendation on the S&P managed health care index, a move that has netted our portfolio 12.4% of alpha. Today U.S. Equity Strategy is raising our recommendations on both the S&P health care equipment and, more importantly, the broad S&P health care index from neutral to overweight. Further, considering U.S. Equity Strategy’s recent portfolio changes, namely moving the S&P materials index to neutral, this upgrade of S&P health care to overweight moves our cyclicals vs. defensives style preference from overweight cyclicals to neutral. This move to the sidelines on the cyclical/defensive portfolio bent has netted modest gains of 2% since its October 2, 2017 inception. Equipping The World’s Hospitals Our upgrade of S&P health care equipment to overweight is not contingent upon earnings outperformance. Rather, it is a combination of overwrought investors having created a buying opportunity, combined with health care’s historic outperformance at the end of the business cycle. Nevertheless, an examination of the sector’s macro environment is revealing. The health care equipment index has recently completed an inventory clear-out cycle, as evidenced both by a slingshot rebound in the shipments-to-inventories ratio (second panel, Chart 18) and a recovery in industry pricing power (bottom panel, Chart 18). This is remarkable in the context of the deceleration in equipment fixed-investment growth that the industry has faced since reaching decade-highs in 2017 (third panel, Chart 18). The upshot is that steady pricing and resilient volume growth should deliver positive top-line growth. The margin picture has also dramatically improved: industrial production has been surging for the past year while hours worked have remained tepid (second and third panels, Chart 19). The combination has driven our productivity proxy to a multi-year high where it has recently diverged from the relative stock price (bottom panel, Chart 19). Chart 18Inventories Have Cleared Chart 19Productivity Is Soaring This underpins our thesis that health care stocks in general and health care equipment stocks in particular have recently suffered based on fear, not fundamentals, amidst a stable domestic demand environment and rosy profit picture. The export channel is at least as important to the S&P health care equipment index as the domestic demand environment. In fact, roughly 60% of sector revenues are generated outside the United States. The news on this front is encouraging. Europe, the other key market for domestically-manufactured health care equipment, has lately seen a pickup in new orders and coupled with the loss of momentum in the trade-weighted U.S. dollar signal that future export growth will remain upbeat (trade-weighted U.S. dollar shown inverted and advanced, bottom panel, Chart 20). The global PMI has historically led exports. While this series has turned down, it has been diverging from export growth for the past year. We believe this is a function of the early stages of a secular trend in health care equipment: the expansion of the EM safety net with health care at its core. The same demographic trend that has been driving the explosion of health care spending in the DM for the last 20 years is rapidly impacting the EM, namely an aging population. The UN projects that the share of the population aged 65 and older in the EMs will rise from roughly 7% this year to 16% in 2060, while population growth slows to below the replacement rate, a tectonic shift in the demographic landscape (Chart 21). Meanwhile, according to IMF data, EM health care spending is approximately 5% of GDP. By contrast, the DMs stand in excess of 14%. Chart 20The Export Valve Is Wide Open A catch-up phase looms, driven by both demographics and an overall global harmonization of standard of care, resulting in a secular outperformance of internationally geared health care equipment manufacturers’ earnings. This bodes well for U.S. health care equipment providers who are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Notwithstanding the bright outlook, fear selling in the S&P health care equipment index has driven a reversal in the two-year valuation rerating that the index has undergone (bottom panel, Chart 22). With the valuation retreating back to its historical range, our main concern that the index is too expensive has eroded. Further, the valuation decline is coming at a time when forward earnings growth has come out of hiding and is now slated to materially outgrow the broad market (middle panel, Chart 22). Chart 22Valuations Have Returned To Earth Bottom Line: Something has to give in this equation and macro tailwinds suggest that a valuation re-rating phase looms. Accordingly, we are moving to an overweight recommendation on the S&P health care equipment index. This move pushes our S&P health care index to an above benchmark allocation and also moves our cyclical vs. defensive preference back to neutral. The ticker symbols for the stocks in the S&P health care equipment index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR. BCA’s Geopolitical Strategy echoes the tenor of these recommendations and is going long the S&P 500 health care index and the health care equipment index versus the broad market. A Word On Pharma Between 1980 and 2000, pharma earnings expanded at a record clip, taking sector share prices into the stratosphere (top panel, Chart 23). Since the zenith in the early 2000’s, margins have been continually under pressure as R&D costs have outpaced volume gains (second panel, Chart 23). However, earnings growth has continued mostly uninterrupted as the industry has raised drug prices. Since 2015, however, price increases have flat lined and now they move at the same pace as overall inflation, though the current convoluted system keeps pricing mostly opaque (bottom panel, Chart 23). We think this is the new normal. The thesis of this report revolves upon a blue vs. red probability outcome. However, as noted, both parties seem united in the fight against high drug costs and Republicans under President Trump are not averse to government intervention to drive down prices. As such, we expect the pharma pricing headwinds to remain a secular trend, driven by outrage from both sides of the aisle and even universal coverage is not enough to bear the pressure. Accordingly, we reiterate our underweight recommendation. Chart 23Pharma Remains Underweight Conclusion Universal health care will be negative for the U.S. budget deficit but positive for economic growth. As for the macroeconomic impact of universal health care, it is complex to assess because much would depend on the extent of any reduction in private health-related sectors. Almost certainly, the U.S. would adopt a parallel system where private health care remains available, but there inevitably would be some job losses in the insurance sector. And drug companies would face downward pressure on pricing. On the other hand, the marked increase in government spending would be stimulative. And we do not see future American administrations exercising a heretofore unknown fiscal discipline once such a new entitlement is established. Many families would enjoy a reduction in health care costs. Overall, it should be positive for economic growth.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy ChrisB@bcaresearch.com Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      The filibuster is a means of prolonging debate and obstructing a vote. It can be defeated if 60/100 senators vote to move to end debate (“cloture”). It effectively ensures that the three-fifths majority is the standard majority needed to pass legislation in the senate. However, it is possible for the senate majority leader, backed with a simple majority, to alter the senate rules and remove the filibuster, so legislation can be passed with a simple majority. But it would be an aggressive move and a historic precedent. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap” dated May 6, 2019, available at uses.bcaresearch.com.   Current Recommendations

​​​​​​​In our recent Weekly Report, we initiated a pair trade, going long S&P managed health care/short S&P semiconductors. Given the trade’s extreme volatility, we initiated this trade with a stop loss at the -7% mark. However, this market-neutral trade has outperformed beyond our expectations, currently up 14% since its inception at the beginning of last week. Accordingly, and in order to protect these outsized gains, we are moving the goalposts and taking the stop to the 10% mark. From a macro perspective, nothing has changed to shake our conviction. Job openings, the ultimate driver of managed health care enrollments, are upbeat compared with declining global semi revenues (second panel). Further, on the relative pricing power gauge front, overall wage inflation is continuing to outpace DRAM prices (bottom panel). The combination implies more gains in store for the pair trade, despite our risk management change. Bottom Line: We reiterate our long S&P managed health care/short S&P semis pair trade and change our -7% stop loss recommendation to a 10% stop. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively.

While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date. This is an exploitable gap and on Monday, we suggested a new pair trade: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. The chart at the side shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings (second panel). The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues (third panel). Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices (bottom panel). Bottom Line: We initiated a long S&P managed health care/short S&P semis pair trade on Monday with a stop loss at the -7% mark; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively.

Highlights Portfolio Strategy Firming relative demand and input cost dynamics, the Medicare For All (MFA)-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short home improvement retail pair trade is in the early innings. Recent Changes Initiate a long S&P managed health care/short S&P semiconductors trade today, with a tight stop loss at -7%. Table 1 Feature Equities hit a speed bump last week, as President Trump’s trade related tweets instilled some fear back into the markets. Investor complacency reigned supreme and, given the liquidity crunch, risk premia exploded higher with the VIX more than doubling from the recent lows. Historically, a parabolic rise in policy uncertainty is synonymous with an equity market selloff and a widening in risk premia; last week was no different (economic policy uncertainty shown inverted, second panel, Chart 1). Adding insult to injury, given that the forward P/E multiple expansion explained all of the equity market’s advance year-to-date as we highlighted three weeks ago, the trade-related melt up in policy uncertainty caused a mini meltdown in the forward multiple as financial conditions tightened (financial conditions shown inverted, third panel, Chart 1). The implication is that short-term equity market caution is still warranted as we have been writing over the past few weeks, at least until the U.S./China trade dispute dust settles. Chart 1Caution Still Warranted Chart 2Tenuous Trio The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap (Chart 2). One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year. Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. Importantly, the 12-month forward EPS number is artificially rising. Chart 3 shows that calendar 2019 and 2020 EPS estimates continue to build a base, but the 12-month forward number has been rising since early-February. What explains the increase in the 12-month forward estimate is arithmetic. In other words, despite a multi-month downgrading of calendar 2019 and 2020 EPS, the first two quarters of next year are forecast to come in significantly higher than 2019’s first six months. As the latter roll off and the former get added to the 12-month forward EPS number, a deceiving jump occurs. For next year, we continue to expect $181 EPS, and we would lean against the double-digit EPS growth in 2020 that the sell-side currently forecasts. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth (Chart 4).   Chart 3Artificial EPS Rise Chart 4SPX Macro EPS Model Forecasts Softness Finally, one of the tech sector’s invincible subgroups is cracking with the S&P semis relative performance hitting a wall both versus the broad market ex-TMT and versus the NASDAQ 100. This is significant not only from a sentiment perspective, but also because semis have high international sales exposure in general and China in particular (Chart 5). Chart 5Vertigo Warning This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. New High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date (Chart 6). This is an exploitable gap and today we suggest a new pair trade: long S&P managed health care/short S&P semiconductors. Chart 6Exploitable Reversal Looms Bernie Sanders’ revamped MFA bill sent the managed health care group to the ER. While there is heightened uncertainty surrounding MFA and we are working on a joint Special Report with our sister Geopolitical Strategy service due on June 3rd, this is likely a 2022 story. Not only will Sanders have to win the Democratic candidacy and subsequently the Presidential election, but also the GOP would have to lose the Senate. This is an extremely low probability event that has dealt a massive blow to HMO stocks. On the flip side, semis are priced for perfection. The recent catalyst for this group’s stratospheric rise was Apple’s patent settlement with Qualcomm that set in motion a 5G-related euphoria. Again 5G is a late-2021 story and a lot of good news is already priced in to semis stocks. Moreover, historically, semi cycles last four-to-five quarters and investors’ neglect of the semi downcycle is puzzling as we have recently concluded just two down quarters. Explicitly, what is truly baffling is that 12-month forward EPS are slated to contract in absolute terms and forward sales are hovering near the zero line, yet the Philly SOX index recently vaulted to all-time highs. Taken together, we would lean toward health care insurers at the expense of semiconductor stocks. Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. Chart 7 shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings. The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues. Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices. On all three fronts, the message is to expect a mean reversion higher in the relative share price ratio. Chart 7Buy Managed Health Care… Chart 8…At The Expense… Input cost/inventory dynamics suggest that HMOs also have the advantage. The health care insurance employment cost index is growing on a par with inflation, but semi industry employment is climbing at a rate over 5%/annum (bottom panel, Chart 8). Taking stock of medical cost inflation, costs are still melting, however global semi inventories are expanding. The upshot is that relative share prices have ample upside (middle panel, Chart 8). Finally, the previous relative valuation overshoot has returned to the neutral zone and, encouragingly, relative technicals are probing multi-year lows near one standard deviation below the historical mean. Importantly, over the past two decades every time our Technical Indicator has hit such a depressed level, a playable rebound in relative share prices has ensued (bottom panel, Chart 9). Chart 9…Of… Chart 10…Semis Nevertheless, this highly volatile market-neutral trade faces one big risk we previously alluded to: relative profit expectations are extended. In other words, the bombed out S&P semiconductor forward EPS and revenue projections are masking the relative profit and revenue backdrop (Chart 10). Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Bottom Line: Initiate a long S&P managed health care/short S&P semis pair trade today with a stop loss at the -7% mark. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively. Homebuilding/Home Improvement Retail Pair Trade Update In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 7% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel, Chart 11). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel, Chart 11). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel, Chart 11). Chart 11Still In Early Innings In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Importantly, the new/existing home sales–to-inventory ratio is an excellent leading indicator of relative share prices and is currently emitting an unambiguously bullish signal for homebuilders at the expense of HIR (Chart 12). Chart 12Supply/Demand Backdrop Says Stick With This Pair Trade Chart 13Relative Sales ##br##Expectations… Examining the relative demand backdrop reveals that homebuilders will continue to outshine HIR. Current readings in the NAHB home sales survey versus the remodeling survey and future expectations both point to more gains in the relative share price ratio (Chart 13). The felling in lumber prices also represents a benefit to homebuilders to the detriment of HIR. Lumber is a key building input cost in new home construction so any price liquidation is a boon for homebuilding margins. In contrast, HIR makes a set margin on lumber sales, therefore deflating lumber prices cut HIR profits (Chart 14). Chart 14…Felling Lumber Prices And … Chart 15…Bombed Out Valuations Signal More Relative Share Price Gains Finally, on the relative valuation and technical fronts, there is anything but froth. In fact, the relative price to book ratio is perched near an all-time low and relative momentum has only recently troughed and has yet to reach the neutral zone (Chart 15). In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings.       Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data.   Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week).  Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9Short China Vs. Japan   The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.     Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations