Homebuilding

Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Indurated Indurated Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Trade “Tax” A Drop In The Bucket Trade “Tax” A Drop In The Bucket Chart 3Sequence Of Macro Events Matters Sequence Of Macro Events Matters Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Homeownership Still Well Within Reach Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics Positive Housing Demand/Supply Dynamics Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Homebuilders Rest On Solid Foundations Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief Lumber Input Cost Relief Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Price Hikes Should Stick Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Big Gaps Set To Narrow Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Two Risks: Interest Rates & Wages Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Too Much Euphoria Too Much Euphoria Chart 12Timberrrr! Timberrrr! Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Operational Trouble Brewing… Operational Trouble Brewing… Chart 14...But Offsets... …But Offsets… …But Offsets… Chart 15...Exist …Exist …Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The opposing sides of our market- and industry-neutral trade going long the S&P homebuilding index/short the S&P REITs index1 have both been on the receiving end of negative data in the last month. With respect to homebuilders, housing permits, a leading indicator of future starts, fell well short of expectations this week and took the S&P homebuilding index down with it. Meanwhile rising UST yields have been weighing heavily on REIT stocks. The end result is that our trade has given up its early gains. The macro environment tells us that it is too early to throw in the towel on this trade. We continue to believe prices in the residential real estate sector have the upper hand over their commercial real estate (CRE) peers. Existing home inventories have tightened and remain at historically low levels, which should support pricing. On the flip side, our CRE occupancy rate composite is still contracting, warning that already-slowing pricing has further to fall. The divergence in pricing should support homebuilders' returns at the expense of REITs. Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. Stick With Homebuilders Over REITs Stick With Homebuilders Over REITs

Neutral Despite rising rates, homebuilders remain highly optimistic about the prospects for the domestic housing market, with the homebuilder survey persistently pushing near decade-highs (second panel). The message from Q2 earnings calls echoed this positivity, with the public homebuilders indicating demand was resilient even in a rising price environment. Still, the niche S&P homebuilding index has been moving sideways since our late-May upgrade to neutral. The cue from lumber prices is equally mixed; while the fall from the stratospheric levels of late-2017 is certainly a boon to profits, such a fall may be indicative of declining demand (third panel). At the same time, the tight labor market has seen wages in construction accelerating at the fastest rate since the rebound coming out of the financial crisis (bottom panel). The margin implication is thus unclear; we remain comfortable on the fence and reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Mixed Signals In Homebuilding Mixed Signals In Homebuilding

The long S&P homebuilding/short S&P REITs pair trade is off to a flying start. Already, this market- and industry-neutral trade has generated alpha for our portfolio to the tune of 7% since the early-July inception.1 There is a long runway ahead for additional gains in this pair trade. Importantly, the recent slew of bank earnings releases had a common thread: across the board, banks are pulling in their horns with regard to extending commercial real estate (CRE) loans. This represents a bearish backdrop for the overextended CRE sector (second panel). As the Fed continues to tighten the monetary screws, delinquency rates have nowhere to go but up, especially in CRE that currently enjoys an ultra-low starting point (fourth panel). Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. Through The Roof Through The Roof

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Anastasios Avgeriou, Vice President U.S. Equity Strategy An exploitable market- and industry-neutral opportunity has surfaced to generate alpha by going long the S&P homebuilding index/short the S&P REITs index. This ratio has only recently reclaimed its upward sloping long-term time trend, leaving ample room for additional gains as the business cycle is long in the tooth (Chart 1). Chart 1Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Four key pillars form the thesis for this intra-real estate pair trade: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. Of Prices, Credit And Rates... Commercial real estate (CRE) is in a slightly different stage of the real estate cycle than its brethren, the residential real estate sector. Chart 2 shows that real CRE prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. This makes the CRE sector extremely vulnerable, as there is no cushion for any potential mishap. Importantly, our CRE occupancy rate composite has peaked for the cycle and is actually contracting, warning that CRE prices will likely suffer the same fate (bottom panel, Chart 3). The residential occupancy rate is the mirror image of the CRE one. Not only are new plus existing home inventories extremely tight by historical standards in the housing market, but the ultra-low vacancy rate is also a harbinger of additional house price gains in the coming months (top two panels, Chart 3). Chart 2Trade Opportunity In Diverging... Trade Opportunity In Diverging... Trade Opportunity In Diverging... Chart 3...Real Estate Markets ...Real Estate Markets ...Real Estate Markets As with every bubble, ultra-cheap credit has fueled the excesses in the CRE sector. Total CRE credit outstanding has ballooned to over $2.1tn, and comprises more than half of the commercial banks' overall real estate loan portfolios (Chart 4). While CRE loan growth is no longer galloping north of 10%/annum, it is still expanding. The stock of residential real estate loans on U.S. commercial bank's balance sheets also hit fresh all-time highs recently, but CRE dwarfs its residential cousin both in growth and level terms. Real estate investors know all too well that, ultimately, rising interest rates prick bubbles and the specter of tightening monetary policy concentrates minds. While both sectors will suffer from rising interest rates, given that the excesses this cycle are concentrated in CRE, in a relative sense, residential real estate is more insulated from a hawkish Fed (Chart 5). Keep in mind that housing was at the epicenter of the Great Recession, a once in a life time crisis, whose ramifications are still reverberating across the financial system one decade later. We doubt another big bust looms large in the residential real estate market. Chart 5 also shows that relative share prices are not only positively correlated with the fed funds rate, but also with the 10-year Treasury yield. True, rising 10-year interest rates filter right through to 30-year fixed mortgages denting housing affordability, but homebuilders are less sensitive to interest rates than REITs. Thus, a rising interest rate backdrop, which remains one of BCA's key themes for the year, is not detrimental to the relative share price ratio, but conducive to relative gains. In more detail, rising interest rates are likely to cause more pain in CRE than in the residential market, given the different starting points for delinquencies. Chart 6 shows a steep divergence between the two real estate sectors in their respective delinquency rates. In fact, since data is available, the CRE delinquency rate has never been lower than its current 0.75%. The Fed continues to raise interest rates, but some CRE borrowers are having trouble serviving this debt as rental income growth (for more details refer to the supply section below) is under pressure. Thus, delinquency rates, charge-offs and foreclosures will shoot higher. Chart 4CRE Excesses This Cycle CRE Excesses This Cycle CRE Excesses This Cycle Chart 5Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Chart 6Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies What About Relative Demand... On the demand front, our comparative demand proxy also corroborates the positive correlation of relative share prices with interest rates. Rising interest rates deal a blow to refinancing mortgage applications, but do not prohibit first-time homebuyers from making one of the largest purchase decisions of their lives (Chart 7). Moreover, there is a preference switch that is gaining steam on the horizon. The own versus rent dilemma has likely hit a multi-decade nadir. Rising job certainty and wages at a time when the economy is at full employment argue for a switch out of rent and into home ownership. Already, the ratio of home owners to renters has gone from 1.7 to 1.8 in the past 18 months; yet, it is still hovering near a generationally low level. Put differently, only 64.2% of the housing stock are owners and 35.8% are renters. This differential remains depressed and if there is a modest renormalization toward the historical mean, the ratio would have to revert closer to 1.9, and thus further lift relative share prices (Chart 8). Chart 7Relative ##br##Demand... Relative Demand... Relative Demand... Chart 8...Gauges Favor Residential Vs.##br## Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...And Supply Backdrops? The relative supply backdrop also favors homebuilders versus REITs. Multi-family housing starts have been running near previous cyclical peak levels and 33% above the historical mean for the better part of the past five years adding roughly 2mn apartment units in aggregate. In contrast, single family home construction has been in recovery mode and continues to trail its historical average, with single family housing starts also adding a similar amount of units since 2013. To put this number in perspective, on average single family home construction should be triple multi-family starts (Chart 9). This construction backdrop does not bode well for CRE prices relative to residential real estate prices. Another related source of CRE pricing pressures are CRE rents. Rental income is in danger of stalling from this massive multi-family supply overhang and so is REITs cash flow growth. The opposite is happening in residential housing. Household formation is still running higher than housing starts, underscoring that recent house price inflation rests on a solid foundation. Chart 9Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Chart 10Alluring Entry Point Alluring Entry Point Alluring Entry Point Compelling Entry Point One final reason why we are warming up to this pair trade is valuations and technicals. Relative value has been restored with our Valuation Indicator correcting to one standard deviation below the historical mean, offering investors a great reward/risk tradeoff. Similarly, technicals are no longer waving a red flag; our Technical Indicator has also unwound extremely overbought conditions and recently sunk below the neutral line (Chart 10). Risks To Monitor Chart 11Monitor This Risk Monitor This Risk Monitor This Risk Nevertheless, there are two key risks that can put our thesis, and thus the relative share price ratio, offside. While both sectors are 100% domestically geared and appear insulated from all the trade war / protectionism risks, homebuilders have to contend with rising input costs both in terms of building materials (lumber in particular, as well as concrete and steel), but also with rising construction-related wage inflation. REITs, in contrast, are free of both such risks. Most importantly, the Fed's Senior Loan Officer Survey is waving yellow flags. Both in terms of demand for respective loans and bankers' willingness to extend credit, CRE has the upper hand. While loan officers are tightening standards in CRE and mortgage loans, they are more prudent with credit origination in residential housing than in CRE. Similarly in a relative sense, bankers are reporting a steeper decline in demand for residential mortgages than for CRE loans (Chart 11). Adding it up, four key drivers - favorable macro tailwinds for residential versus commercial real estate on the price, credit and interest rate fronts, firming relative demand dynamics, supportive relative supply backdrop and appealing relative valuations and technicals - argue for opening a long S&P homebuilders/short S&P REITs pair trade. Bottom Line: Initiate a long S&P homebuilding/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com

Neutral In yesterday's Weekly Report, we pulled the trigger on our upgrade watch for the niche S&P homebuilding index,1 monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather, 2. Housing fundamentals remain robust and 3. Compelling valuations reflect most, if not all, of the bad news. With respect to the first of these, BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased. This should support continued gains in the MBA's mortgage purchase index, which has climbed to a fresh cycle high (top panel). Housing fundamentals have proven resilient; new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (second panel). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel). Bottom Line: We are acting on our upgrade alert in the S&P homebuilding index and lifting exposure to neutral. Please see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Enough Is Enough - Upgrade Homebuilders To Neutral Enough Is Enough - Upgrade Homebuilders To Neutral

Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Seeing The Light Seeing The Light Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Saddled With Debt... Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction ...But Ratings Migration Moving In The Right Direction ...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Money Flowing Into Government Coffers Takes A Real Time Pulse Of Corporate Profits Money Flowing Into Government Coffers Takes A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Q2 Profits Will Likely Surprise To The Upside... Q2 Profits Will Likely Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk ...But A U.S. Dollar Spike Is A Risk ...But A U.S. Dollar Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Housing Fundamentals... Housing Fundamentals... Chart 7...Remain On A Solid Footing ...Remain On A Solid Footing ...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Firming Top And Bottom Line Growth Prospects Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Surging Building Supply Costs Are A Big Risk Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs Rising Relative Health Care Outlays Weigh On HMOs Rising Relative Health Care Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Early Signs Of... Early Signs Of... Chart 12...Margin Pressures ...Margin Pressures ...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations M&A Frenzy Fully Priced Into Expensive Valuations M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight - Upgrade Alert Homebuilders took another beating this week, and it seems as if they cannot catch a break. While the latest NAHB sentiment survey reflected homebuilder optimism, survey participants acknowledged that spiking building material costs are now hurting profitability (lumber prices shown inverted, middle panel). Tack on the recent jump in the 10-year Treasury yield that also pushed the 30-year fixed mortgage rate significantly higher and first time home buyers are, at the margin, getting priced out of the new home market (interest rates shown inverted, top panel). When we recently put the S&P homebuilding index on upgrade alert, we thought most of the bad news was already priced into deflated prices and valuations. However, persistent input cost inflation pressures coupled with additional interest rate increases suggest that patience is warranted before crystalizing relative gains to the tune of 25% since our late-November inception. Worrisomely, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel). We would lean against such exuberance and wait for another breakdown in relative share prices before acting on our upgrade alert. Bottom Line: Shy away from homebuilders for now, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Hamstrung Hamstrung

Highlights Portfolio Strategy The reward/risk profile of air freight & logistics is extremely attractive. Synchronized global growth, the capex upcycle, a falling dollar and secular advance in e-commerce compel us to add this unloved transportation sub-index to our high-conviction overweight list. Prepare to lock in gains in managed health care. The positive demand and pricing backdrops are already reflected in perky valuations. While homebuilders still have to contend with rising lumber prices and interest rates and the partial elimination of mortgage interest deductibility, the near 20% peak-to-trough drawdown suggests that all of the bad news is baked in relative share prices, warranting an upgrade alert. Recent Changes Add the S&P air freight & logistics index to the high-conviction overweight list. Put the S&P managed care index on downgrade alert. Set an upgrade alert on the S&P homebuilding index. Table 1 Bumpier Ride Bumpier Ride Feature Equities lost ground last week and flirted with the bottom part of the trading range established during the past two months, but held the 200-day moving average. Our view remains that the SPX is digesting the early-February swoon, and the buy-the-dip strategy is still appropriate for capital with a cyclical (9-12 month) time horizon as the probability of a recession this year is close to nil. Nevertheless, the recent doubling in the TED spread and simultaneous spike in financials investment grade bond spreads is slightly unnerving (second panel, Chart 1). Junk spreads also widened as investors sought the safety of the risk-free asset. What is behind this fear flare up propagating in risk sensitive assets? First, the Fed continued its tightening cycle last week, raising the fed funds rate another 25bps. As we have been writing in recent research Weekly Reports, rising interest rates go hand-in-hand with increasing volatility (please see Chart 1 from the March 5th Special Report on banks). Thus, as the Fed tightens monetary policy and continues to unwind its balance sheet, the return of volatility will become a key market theme (bottom panel, Chart 1). The implication is that a bumpier ride looms for equities, and the smooth and nearly uninterrupted rise that market participants have been conditioned to expect is now a thing of the past. With regard to the composition of equity returns in the coming year, rising interest rates and volatility signal that the forward P/E multiple has likely crested for the cycle, leaving profits to do all the heavy lifting (Chart 2). Second, rising policy uncertainty (trade and Administration personnel related, please see Chart 1 from last week's publication) is muddying the short-term equity market outlook at the current juncture, and fueling the risk-off phase. However, synchronized global growth, a muted U.S. dollar and easy fiscal policy are a boon to EPS and signal that profit growth will reclaim the driver's seat in coming weeks. Stocks and EPS are joined at the hip and there are good odds that equities will vault to fresh all-time highs on the back of earnings validation as the year unfolds (Chart 3). Chart 1Closely Monitor These Spreads Closely Monitor These Spreads Closely Monitor These Spreads Chart 2EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting Chart 3Profits And Cash Flow Underpin Stocks Profits And Cash Flow Underpin Stocks Profits And Cash Flow Underpin Stocks Importantly, comparing net profit growth to cash flow growth rates is instructive, as SPX EBITDA is not affected by the new tax law. While EPS are slated to grow close to 20% in calendar 2018, the respective forward SPX EBITDA growth rate (based on IBES data) sports a more muted 10% per annum rate (second panel, Chart 4). Similarly, sell side analysts pencil in a visible jump in forward net profit margins, whereas the forward EBITDA margin estimate is stable (middle panel, Chart 4). The recent tax-related benefit is a one-time dividend to profits that will not repeat in 2019. Thus, the market will likely look through this one time effect and start to focus on the calendar 2019 EPS growth number that is a more reasonable 10%, and also similar to next year's EBITDA growth rate. Our sense is that this transition will also be prone to turbulence. Our EPS growth model corroborates this profit euphoria and is topping out near the 20% growth rate (Chart 5). While it will most likely decelerate in the back half of the year, as long as there is no relapse near the contraction zone à la late-2015/early 2016, the equity bull market will remain intact. Chart 4Investors Will See Through The Tax Cut Investors Will See Through The Tax Cut Investors Will See Through The Tax Cut Chart 5EPS Model Flashing Green EPS Model Flashing Green EPS Model Flashing Green As we showcased in the early February Weekly Report, four key macro variables are behaving as they have in four prior 20% EPS growth phases since the 1980s excluding the post-recession recoveries (please see the Appendix of the February 5th "Acrophobia" Weekly Report). Therefore, if history at least rhymes, the equity overshoot phase will resume. This week we add a neglected transportation group to the high-conviction overweight list, put a defensive index on the downgrade watch list and set an upgrade alert on a niche early cyclical group. Air Freight & Logistics: Prepare For Takeoff Last week we reiterated our overweight stance in the broad transportation space and today we are compelled to add the undervalued and unloved S&P air freight & logistics index to the high-conviction overweight list. Air freight services are levered to global growth. Currently, synchronized global growth remains the dominant macro theme. Firming export expectations suggest that global trade volumes will get a bump in the coming months (second panel, Chart 6). Importantly, U.S. manufacturers are also excited about exports; the latest ISM manufacturing export subcomponent hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel, Chart 7). Chart 6Heed The Signals From Global Growth,##br## Capex And The Greenback Heed The Signals From Global Growth, Capex And The Greenback Heed The Signals From Global Growth, Capex And The Greenback Chart 7Domestic Demand##br## Is Also Firm Domestic Demand Is Also Firm Domestic Demand Is Also Firm Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel, Chart 6). Chart 8Mistakenly Unloved And Undervalued Mistakenly Unloved And Undervalued Mistakenly Unloved And Undervalued Tack on the near uninterrupted depreciation of the trade-weighted U.S. dollar and factors are falling into place for a relative EPS overshoot, given the large foreign sales component of this key transportation sub-group (bottom panel, Chart 6). Not only are air freight stocks' fortunes tied to the state of global trade, but this industry is also sensitive to capital outlays. A synchronized global capex cycle is one of the key themes we are exploring in 2018. The third panel of Chart 7 shows that our capex indicator points to a reacceleration in the corporate sales-to-inventories ratio. This virtuous capital spending upcycle, that would get a further lift were an infrastructure bill to be signed into law, is a boon to air cargo services. In addition, as the secular advance in e-commerce continues to make inroads in the bricks-and-mortar share of total retail dollars spent, demand for delivery services will continue to grow smartly, underpinning industry selling prices (bottom panel, Chart 7). As a result, we would look through recent softness in industry pricing power that has weighed on relative performance. Indeed, transportation & warehousing hours worked have recently spiked, corroborating the message from global revenue ton miles (not shown), rekindling industry net earnings revisions (second panel, Chart 8). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (third panel, Chart 8). Similarly, the index is trading at a 10% discount to the broad market's forward P/E multiple or the lowest level since the turn of the century (not shown). Finally, technical conditions are washed out offering a compelling entry point for fresh capital (bottom panel, Chart 8). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Downgrade Alert: Managed Health Care Managed health care stocks have been stellar outperformers not only versus the overall market, but also compared with the broad S&P health care sector. Since the April 2016 inception of our overweight recommendation, they have added considerable alpha to our portfolio to the tune of 21 percentage points above and beyond the SPX's rise (Chart 9). While most of the factors underpinning our sanguine view for health insurers remain intact, from a risk management perspective we are compelled to put them on downgrade alert. Most of the good news is likely baked into relative prices and valuations (bottom panel, Chart 9). In the coming weeks, we will be on the lookout for an opportunity to pull the trigger and crystalize gains and downgrade to a benchmark allocation, especially if defensive equities catch a bid on the back of the current mini risk off phase. Namely, recent inter-industry M&A euphoria is a key catalyst to lighten up on this health care services sub-sector (Chart 10). While regulators have disallowed intra-industry consolidation over the past few years, the M&A premia remained and now the proposed CVS/AET and CI/EXPR deals could be a harbinger of petering out relative valuations and share prices. Chart 9Prepare To Book Gains Prepare To Book Gains Prepare To Book Gains Chart 10M&A Frenzy M&A Frenzy M&A Frenzy True, melting health care inflation is likely a secular theme that is in the processes of reversing three decades worth of health care industry, in general and pharma in particular, pricing power gains. While this is a dire backdrop for drug manufacturers - which remains a high-conviction underweight - it is a clear benefit to HMOs (Chart 11). Health insurance labor costs are also well contained: the employment cost index for this industry is probing multi-year lows (bottom panel, Chart 12). The upshot is that profit margins are on a solid footing. Chart 11Operating Metrics Suggest... Operating Metrics Suggest… Operating Metrics Suggest… Chart 12...To Stay Overweight A While Longer …To Stay Overweight A While Longer …To Stay Overweight A While Longer Meanwhile, the overall U.S. labor market is on fire. Last month NFPs registered a month-over-month increase of 300K for the first time in four years and unemployment insurance claims are perched near five decade lows. This represents an enticing demand backdrop for managed health care companies, especially when the economy is at full employment and the government is easing fiscal policy (bottom panel, Chart 11). Despite the still appealing demand and pricing backdrop, the flurry of M&A deals will likely serve as a catalyst to lock in gains and move to a benchmark allocation in the coming weeks as this health care sub-index is priced for perfection. Bottom Line: Stay overweight the S&P managed health care index, but it is now on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Upgrade Alert: Homebuilders Showing Resiliency In late-November 2017 when we launched our 2018 high-conviction call list, we downgraded the niche S&P homebuilding index to underweight (Chart 13). Our thesis was that the trifecta of rising lumber prices, mortgage interest deductibility blues and rising interest rate backdrop, a key 2018 BCA theme, would weigh on profit margins and, thus, profits would underwhelm. Since then we have monetized gains of 10% versus the SPX and removed this early-cyclical index from the high-conviction underweight list.1 Today we are putting it on upgrade alert. As a reminder, this was not a call based on a souring residential housing view. In fact, we remain housing bulls and expect more gains for the still recovering residential housing market that moves in steady prolonged multi-year cycles (Chart 14). Keep in mind that housing starts are still running below household formation and the job market is heating up. The implication is that the U.S. housing market rests on solid foundations. Chart 13Bounced Off Support Line Bounced Off Support Line Bounced Off Support Line Chart 14Housing Fundamentals Are Upbeat Housing Fundamentals Are Upbeat Housing Fundamentals Are Upbeat While interest rates and rising house prices are denting affordability (second and fourth panels, Chart 15), homebuilders share prices have been resilient recently and have smartly bounced off their upward sloping support trend line (Chart 13). Indeed, interest rates may continue to rise from current levels, but as we have highlighted in recent research, there is a self-limiting aspect to the year-over-year rise in the 10-year yield near the 100bps mark. Put differently, any rise above 3.05% on the 10-year Treasury yield in a short time frame would likely prove restrictive for the U.S. economy.2 Encouragingly, the mortgage application purchase index has well absorbed the selloff in the bond market, unlike its sibling mortgage application refinance index, signaling that there is pent up housing demand (second panel, Chart 16). New home sales are expanding anew as price concessions have likely been sufficient to compete with existing homes for sale (top panel, Chart 16). Chart 15Get Ready To Upgrade... Get Ready To Upgrade… Get Ready To Upgrade… Chart 16...Given Receding Profit Margin Risks …Given Receding Profit Margin Risks …Given Receding Profit Margin Risks On the lumber front, prices have gone parabolic year-to-date courtesy of trade war talk and a softening U.S. dollar. However, lumber inflation cannot continue at a 50%/annum pace indefinitely (third panel, Chart 16). While higher lumber prices are a de facto negative for homebuilding profit margins, we deem they are now well reflected in compelling relative valuations (bottom panel, Chart 15). In addition, if we are correct in assessing that housing demand remains upbeat, this will give some breathing room to homebuilders to partly pass on some of this input cost inflation to the consumer. Bottom Line: The S&P homebuilding index remains an underweight, but it is now on our upgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Risk management is important in tumultuous times. Our long held strategy of how to navigate choppy waters during a tactical correction has been to book gains in pair trades and thus de-risk the portfolio, and institute trailing stops to the high-flyers in our high-conviction call list. Two additional high-conviction underweight calls got stopped out recently with hefty gains for our portfolio: 10% for our underweight call on homebuilders and 20% for our underweight call in semi equipment stocks. We are obeying both stops and taking profits by removing them from the high-conviction underweight list. Nevertheless, the spiking lumber prices, surging interest rates and tax reform trifecta is still, at the margin, weighing on homebuilders. Therefore, we continue to recommend an underweight stance in this niche consumer discretionary industry. Similarly, while our underweight conviction level is not as high for semiconductor equipment stocks as on November 27, 2017, we continue to recommend a below benchmark allocation to this highly cyclical industry. Rising interest rates, a key BCA theme for 2018 is working against last year's stellar performers with growth stocks (semi equipment equities included) suffering a valuation derating. Bottom Line: Crystalize profits of 20% and 10% in chip equipment and homebuilding stocks, respectively, and remove from the high-conviction underweight list. We continue to recommend a below benchmark allocation in both indexes. The ticker symbols for the stocks in the S&P semi equipment and S&P homebuilders indexes are: AMAT, LRCX, KLAC, and LEN, DHI, PHM, respectively. Housekeeping In Turbulent Times Housekeeping In Turbulent Times