Technical

Key Portfolio Highlights The S&P 500 has started 2019 with a bang as dovish cooing from the Fed has proven a tonic for equities. While we have not entirely retraced the path to the early-autumn highs, our strategy of staying cyclically exposed, based on our view of an absence of a recession in 2019, has proven a profitable one as investor capitulation reached extreme levels (Charts 1 & 2). Chart 1Capitulation Capitulation Capitulation Chart 2Selling Is Exhausted Selling Is Exhausted Selling Is Exhausted Importantly, risk premia have been deflating as the end-of-year spike in volatility has subsided and junk spreads have narrowed from the fear-induced heights in December (Chart 3). Chart 3Risk Premia Renormalization Risk Premia Renormalization Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A continuation of the earnings juggernaut A positive U.S./China trade resolution With respect to the first of these, the S&P 500 convulsed following the December 19 Fed meeting and suffered a cathartic 450 point peak-to-trough fall two months ago. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Charts 4 & 5). Chart 4Powell's Resolve Getting Tested Powell's Resolve Getting Tested Powell's Resolve Getting Tested Chart 5Fed Policy Mistake Fed Policy Mistake Fed Policy Mistake The rising odds of a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome respite for equities. Our second catalyst has been gaining steam through the Q4 earnings season which has seen continuation of the double-digit earnings growth of the prior three quarters. Our earnings model points to a moderation of earnings growth in the year to come, in line with sell-side expectations (Chart 6). Our 2019 year-end target remains 3,000 for the SPX, based on $181 2020 EPS and a 16.5x multiple.1 This represents a 6% EPS CAGR, assuming 2018 EPS ends near $162. Chart 6EPS Growth > 0 EPS Growth > 0 EPS Growth > 0 Chart 7 In Chart 7, we show that financials, health care and industrials are responsible for 61% of the SPX’s expected profit growth in 2019 while technology’s contribution has fallen to a mere 7.2%. While the risk of disappointment encompases financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 8 & 9). Chart 8Earnings Revisions... Earnings Revisions... Earnings Revisions... Chart 9...Really Weigh On Tech ...Really Weigh On Tech ...Really Weigh On Tech Lastly, the negativity surrounding the slowdown in China is likely fully reflected in the market (Chart 10), implying an opportunity for a break out should a positive resolution to the U.S./China trade spat be delivered. China’s reflation efforts suggests that the Chinese authorities remain committed to injecting liquidity into their economy (Chart 11). Chart 10China Slowdown Baked In The Cake China Slowdown Baked In The Cake China Slowdown Baked In The Cake Chart 11Reflating Away Reflating Away Reflating Away Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (Chart 12). All of these underlie our style preferences for cyclicals over defensives2 and international large caps over domestically-geared small caps. Chart 12Heed The PBoC Message Heed The PBoC Message Heed The PBoC Message Chris Bowes, Associate Editor chrisb@bcaresearch.com S&P Financials (Overweight) The divergence between the directions for our CMI and valuation indicator (VI) for S&P financials has reached stunning levels, with the former accelerating into pre-GFC territory and the latter falling to two standard deviations below fair value. Our technical indicator (TI) is sending a relatively neutral message, though this does not diminish the most bullish signal in our cyclical indicator’s history (Chart 13). Chart 13S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) The ongoing strength of the U.S. economy is the driver of such a positive indicator, particularly with respect to the key S&P banks sub index. Our total loans & leases growth model and BCA’s C&I loan growth model (second & bottom panels, Chart 14) are in positive territory. The latter is significant given that C&I loans are the single biggest credit category in bank loan books. Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Further, multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 14). In the context of the generationally high employment rate, the implied lower defaults should drive amplified profit improvement from this credit growth. We reiterate our overweight recommendation. Chart 14Loan Growth Drives Profits Loan Growth Drives Profits Loan Growth Drives Profits S&P Industrials (Overweight) The still-solid domestic footing has maintained our industrials CMI close to its cyclical highs, which are also some of the most bullish in the history of the indicator. However, stock prices have not responded accordingly and our VI has descended mildly from neutral to undervalued. Our TI sends a much more definitive message and stands at a full standard deviation into oversold territory (Chart 15). Chart 1515. S&P Industrials (Overweight) 15. S&P Industrials (Overweight) 15. S&P Industrials (Overweight) While their cyclical peers S&P financials are almost exclusively a domestic play, S&P industrials have been weighed down by trade flare ups for most of the past year (bottom panel, Chart 16). Accordingly, much of the benefit of positive domestic capex indicators and the more tangible capital goods orders maintaining a supportive trajectory has failed to show up in relative EPS growth (second & third panels, Chart 16), though the latter has recently hooked much higher. Chart 16Industrial Earnings Growth Has Recovered Industrial Earnings Growth Has Recovered Industrial Earnings Growth Has Recovered S&P Materials (Overweight) Our materials CMI has made a turn, rising off its lowest level in 20 years. This has coincided with our VI bouncing off its cyclical low, though it remains in undervalued territory. The signal is shared by our TI which has only recently recovered from a full standard deviation into the oversold zone, a level that has historically presaged S&P materials rallies (Chart 17). Chart 17S&P Materials (Overweight) S&P Materials (Overweight) S&P Materials (Overweight) When we upgraded the S&P materials sector to overweight earlier this year, we noted that China macro dominates the direction of U.S. materials stocks. On the monetary front, the Chinese monetary easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 18). The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNY/USD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 18). Chart 18Chinese Data Drives Materials Performance Chinese Data Drives Materials Performance Chinese Data Drives Materials Performance S&P Energy (Overweight) Our energy CMI has moved horizontally for the past six quarters, though this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Meanwhile both our VI and TI have descended steeply into buying territory with the former approaching two standard deviations below fair value (Chart 19). Chart 19S&P Energy (Overweight) S&P Energy (Overweight) S&P Energy (Overweight) As with the CMI, the relative share price ratio for the S&P energy index has moved laterally since our mid-summer 2017 upgrade to overweight. Interestingly, the integrated oil & gas energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (top panel, Chart 20). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 2020. The Stage Is Set For A Recovery In Crude Prices 20. The Stage Is Set For A Recovery In Crude Prices 20. The Stage Is Set For A Recovery In Crude Prices Nevertheless, the roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, bottom panel, Chart 20). This echoes BCA’s Commodity & Energy Strategy service, which continues to forecast higher oil prices into 2019, a forecast which should set the stage for a sustainable rebound next year in S&P energy profits, the opposite of what analysts currently expect (Chart 7). S&P Consumer Staples (Overweight) An improving macro environment is reflected in our consumer staples CMI that has vaulted higher in recent months. However, the strong recent relative outperformance has also shown up in our VI which, though still in undervalued territory, has recovered significantly. Our TI has fully recovered and now sends a neutral message (Chart 21). Chart 21S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) The surging S&P household products sector has been carrying the S&P consumer staples index on its back as solid pricing efforts have been dragging results and forward guidance higher. While household product sales have been enjoying a multi-year growth phase (second panel, Chart 22), it has largely been driven by volumes. However, the recent resurgence in pricing power (third panel, Chart 22) has given volume gains an added kick, pushing sales further. Meanwhile, exports have continued their two-year ascent despite the tough currency environment and the upshot is that relative EPS growth will likely remain upbeat (bottom panel, Chart 22). In light of challenged EM consumer spending growth, this signal is very encouraging. Chart 22Household Products Is Carrying Staples Household Products Is Carrying Staples Household Products Is Carrying Staples S&P Health Care (Neutral) Our health care CMI has been treading water recently. Further, a recovery in pharma stocks has taken our VI from undervalued to a neutral position, while our TI sends a distinctly bearish message as health care stocks have been overbought (Chart 23). Chart 23S&P Health Care (Neutral) S&P Health Care (Neutral) S&P Health Care (Neutral) Healthcare stocks have outperformed in the back half of 2018. Recently a merger mania that has swept through the pharma and biotech spaces has underpinned relative share prices. The last three months have seen an explosion of deals, including the largest biopharma deal ever (Bristol-Myers Squibb buying Celgene for approximately $90 billion) with other global deals falling not too far behind (Takeda buying Shire for $62 billion mid-last year). Such exuberance has clearly confirmed that merger premia are alive and well in the S&P pharma index. It is not merely rising premia that have taken pharma higher either. Pricing power has entered the early innings of a recovery (top panel, Chart 24) while the key export channel points to increasingly bright days ahead (second panel, Chart 24). However, the rise of regulatory pressure from the Trump administration may cause better pricing to prove fleeting. Chart 24Merger Mania In Pharma Merger Mania In Pharma Merger Mania In Pharma Further, pharma’s consolidation phase has come at a cost to sector leverage ratios that have dramatically expanded (bottom panel, Chart 24). Such profligacy may come to haunt the sector should the pricing power recovery falter. S&P Technology (Neutral) Our technology CMI has been moving laterally for the better part of the last three years, though the S&P technology index has ignored the macro headwinds and soared higher over that time. Our VI remains on the overvalued side of neutral, despite the recent tech selloff while our TI has been retrenching into oversold territory (Chart 25). Chart 25S&P Technology (Neutral) S&P Technology (Neutral) S&P Technology (Neutral) Until the end of last year, we maintained a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. However, we recently upgraded the niche semi equipment to overweight for three reasons. First, trade policy uncertainty has dealt a blow to this tech subindex. Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Second, emerging market financial indicators are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (second panel, Chart 26). Third, long term semi equipment EPS growth estimates have recently collapsed to a level far below the broad market, indicating that the sell side has thrown in the towel on this niche sector (third panel, Chart 26). Chart 26A Bottom In Semi Equipment A Bottom In Semi Equipment A Bottom In Semi Equipment Overall, and despite our more bullish view on semi equipment, we continue to recommend a neutral weighting in S&P technology. S&P Utilities (Underweight) Our utilities CMI has recovered recently, bouncing off its 25-year low, driven by the modest easing in interest rates, (Chart 27). This has also manifested in a recovery in the S&P utilities index as this fixed income proxy has reacted to the recent fall in Treasury yields (change in yields shown inverted, top panel, Chart 28) and jump in natural gas prices. Further, utilities are typically seen as a domestic defensive play and the recent trade troubles have made utilities soar in a flight to safety. Chart 27S&P Utilities (Underweight) S&P Utilities (Underweight) S&P Utilities (Underweight) We think the tailwinds lifting utilities are transitory and likely to shift to headwinds. First, one of our key themes for the back half of the year is rising interest rates; a move higher in yields will have a predictably negative impact on these high-dividend paying equities. Second, a flight to safety looks fleeting; the ISM manufacturing new orders index usually moves inversely in lock step with utilities and the most recent message is negative for the S&P utilities index (ISM manufacturing new orders index shown inverted, second panel, Chart 28). Meanwhile, S&P utilities earnings estimates have continued to trail the broad market, having taken a significant step down this year (third panel, Chart 28). Chart 28Rising Rates In Late-2019 Will Be A Headwind For Utilities Rising Rates In Late-2019 Will Be A Headwind For Utilities Rising Rates In Late-2019 Will Be A Headwind For Utilities Our VI and TI share this bearish message as the VI is deeply overvalued and the TI is in overbought territory (Chart 27). S&P Real Estate (Underweight) Our real estate CMI has recently started to turn up, though this is off the near decade-low set last year and remains deeply depressed relative to history (Chart 29). This is principally the result of the backup in interest rates since late last year and the lift they have given to the sector, which has been a relative outperformer over the past six months (top panel, Chart 30). Much like the S&P utilities sector in the previous section, and in the context of BCA’s higher interest rate view, we continue to avoid this sector. Chart 29S&P Real Estate (Underweight) S&P Real Estate (Underweight) S&P Real Estate (Underweight) Along with the modest reprieve in borrowing rates, multi family construction continues unabated (second panel, Chart 30), likely driven by all-time highs in CRE prices (third panel, Chart 30). In the absence of an outright contraction in construction, recent weakening in occupancy (bottom panel, Chart 30) will likely prove deflationary to rents, and thus profit prospects. Chart 30Falling Occupancy Will Hurt REIT Profits Falling Occupancy Will Hurt REIT Profits Falling Occupancy Will Hurt REIT Profits Our VI suggests that REITs are modestly overvalued, though the recent outperformance has driven our TI to an overbought condition (Chart 29). S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI has ticked up recently, pushed higher by resiliency in consumer data. However, the S&P consumer discretionary index has clearly responded, pushing against 40-year highs relative to the S&P 500 and taking our VI to two standard deviations above fair value (Chart 31). Much of this should be attributed to Amazon (roughly 30% of the S&P consumer discretionary index) and their exceptional 12% outperformance relative to the broad market over the past year. Chart 31S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) While we have an underweight recommendation on the S&P consumer discretionary index, we have varying intra-segment preferences, highlighted by the recent inception of a pair trade going long homebuilders and short home improvement retailers (HIR). Housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (top & middle panels, Chart 32). Further, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (momentum in lumber prices shown inverted and advanced in bottom panel, Chart 32). Chart 32Long Homebuilders / Short Home Improvement Retailers Long Homebuilders / Short Home Improvement Retailers Long Homebuilders / Short Home Improvement Retailers S&P Communication Services (Underweight) As the newly-minted communication services has little more than four months of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 33 with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Chart 33S&P Communication Services (Underweight) S&P Communication Services (Underweight) S&P Communication Services (Underweight) Rather, we refer readers to our still-fresh initiation of coverage on the sector3 and look forward to being able to deliver something more substantive in the future. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years (Chart 34). Despite the neutral CMI reading, we downgraded small caps in the middle of last year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (bottom panel, Chart 35). This size bias remains a high conviction call for 2019. Chart 34Favor Large Vs. Small Caps Favor Large Vs. Small Caps Favor Large Vs. Small Caps Macro data too has turned against small caps. Recent NFIB surveys have shown that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel, Chart 35). This has coincided with the continued slide of small cap stocks relative to their large cap peers. Chart 35Small Caps Have A Big Balance Sheet Problem Small Caps Have A Big Balance Sheet Problem Small Caps Have A Big Balance Sheet Problem Further, the percentage of small businesses with planned labor compensation increases continues to set new all-time highs and deviates substantially from the national trend (second panel, Chart 35). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel, Chart 35), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of small cap balance sheet discipline during the past five years, ongoing large cap outperformance seems ever more likely. Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “ Catharsis,” dated January 14, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “ Don't Fight The PBoC,” dated February 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Daily Insight, “New Lines Of Communication,” dated October 1, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Daily Insight, “Small Caps Have A Big Balance Sheet Problem,” dated May 10, 2018, available at uses.bcaresearch.com.

Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party The Return Of Vol May Spoil The Party The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Economic Impulse Yellow Flag Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War U.S. Is Winning The Trade War U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand U.S. Has The Upper Hand U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Watch The U.S. Dollar Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Peak Housing Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) Chart 10Financials Are Trailing Rates Financials Are Trailing Rates Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) S&P Industrials (Overweight) S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power Resilient Industrials Pricing Power Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) S&P Energy (Overweight, High-Conviction) S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way Crude Prices Are Still Leading The Way Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback Staples Are Making A Comback Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) S&P Health Care (Neutral) S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care Pharma Strength Is Lifting Health Care Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) S&P Technology (Neutral) S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar Tech Is King But Beware The U.S. Dollar Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) S&P Materials (Neutral) S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved Fundamentals In Chemicals Have Improved Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) S&P Utilities (Underweight) S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided Utilities Should Still Be Avoided Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) S&P Real Estate (Underweight) S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs A Bearish Backdrop For REITs A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary Higher Rates Spell Declines For Consumer Discretionary Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) S&P Communication Services (Underweight) S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Size Indicator (Favor Large Vs. Small Caps) Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps Too Much Debt And High Valuations Should Hurt Small Caps Too Much Debt And High Valuations Should Hurt Small Caps

Dear Client, I had the pleasure of participating in the Affin Hwang Capital conference in Kuala Lumpur on November 8th. In addition to sharing my views on today's macro environment, I discussed BCA's recent successes in developing quant-based solutions for bottom-up stock picking and market timing. I have transcribed my remarks on the latter topic below. Best regards, Peter Berezin, Chief Global Strategist Feature The Arithmetic Of Active Management Every active investor wants to outperform the market. Unfortunately, just like everyone cannot be above-average in height, beauty, or intelligence, not every investor can outperform their benchmark. I think very few people in the audience would dispute this assertion. What could be more surprising to some of you is the following claim, which is that active investors as a group will always underperform the market. I say this not because I have any ill will towards active investors. I'm an active investor myself. I say this simply because it is a mathematical tautology. As Bill Sharpe has emphasized, the market return is simply the weighted average of the returns that passive and active investors earn before fees.1 The passive return must, by definition, equal the market return. This necessarily implies that the average active return must also equal the market return. Since active investors incur higher costs than passive investors, the former group will always underperform the latter group on average. That's the bad news. The good news is that not all active investors are the same. Some are better than others, and while it is not easy, it is possible to isolate certain strategies that active managers employ that help them outperform the market. Before I discuss these strategies, let me make a generic point, which is that most so-called active investors are not particularly active. In fact, according to one academic paper, the fraction of truly active investors - those whose returns deviate significantly from the market benchmark - shrank from 60% in 1980 to less than 20% in 2009 (Chart 1). In contrast to active investors whose portfolio returns broadly mimic the market's, genuinely active investors typically outperform their benchmarks (Chart 2).2 Chart 1How Active Are Active Investors? Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing Chart 2Active Stock Pickers Outperform Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing What are successful active investors doing to beat their benchmark? Well, first of all, let me tell you what they are not doing: They are not taking on more risk. Don't Bet On Beta Chart 3 shows that there is no clear relationship between a stock's beta and its expected return.3 To those familiar with the CAPM model, this may be surprising. The CAPM model predicts that higher-beta stocks will earn superior returns because they are riskier. High-beta stocks outperform the market when the market is going up, but underperform the market when it is going down. Since the market tends to go up more often than it goes down, the expected return to high-beta stocks should exceed the expected return to low-beta stocks. Chart 3Don't Bet On Beta Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing As I will discuss, the reason this theoretical prediction is refuted by the empirical evidence is because the market is rife with inefficiencies. What is more, these inefficiencies reflect pervasive institutional and behavioral biases that are engrained within the market's very own DNA. Active managers who understand these biases can exploit them to outperform their benchmarks. Let me start with the former: institutional biases. The investment industry often encourages a "heads I win, tails you lose" mentality: If a fund manager takes on a lot of risk and gets lucky, he or she will be well remunerated; if the manager is unlucky, he or she may have to look for a new job, but the primary losers will be the clients of the fund. Such an incentive structure encourages managers to take on excessive risk by purchasing, among other things, high-beta stocks. This bids up the price of these stocks to the point where they no longer offer enough additional return to compensate for their higher risk. Size And Value If buying high-beta stocks simply adds more risk without generating more reward, what types of stocks do outperform the market on a risk-adjusted basis? Much of the early academic literature focused on two factors: size and value. Historically, it has been the case that small caps and value stocks have outperformed large caps and growth stocks. Some academics have offered risk-based explanations for the size and value effects. Personally, I find these explanations unconvincing, especially in the case of value stocks. The main problem with risk-based arguments is that they fail to convincingly identify the nature of the risk that investors who purchase value stocks are being compensated for. It is certainly not market risk - value stocks tend to be low beta (Chart 4). Revealingly, companies that do face greater existential risks - those that have high levels of debt relative to equity, for example - tend to underperform the market.4 This is exactly the opposite of what risk-based arguments would predict. Chart 4Value Tends To Outperform Growth When The Stock Market Is Falling Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing The presence of market inefficiencies provides a more compelling explanation for why small caps and value stocks outperform. Consider two companies, identical in every way except that one has a lower market capitalization than the other. Since the only difference between the two companies is the price of their shares, the "cheaper" company will generate higher returns for shareholders over the long haul. The cheaper, smaller capitalization company will also initially trade at a lower price-to-earnings and price-to-book ratio. In other words, it will look more like a small cap value stock. Thus, it is not necessary to invoke complex, risk-based explanations for why small caps and value stock outperform. It is exactly what one would expect if markets are not perfectly efficient. Ignore The Analysts? Of course, some stocks are cheap for a reason. How can we distinguish between hidden gems and fool's gold? Wall Street is populated with thousands of analysts paid to make that determination. But are they any good? For the most part, the answer is no. Chart 5 shows analysts' published earnings forecasts versus realized earnings growth. Analysts have had some success at predicting earnings growth over a one-to-two year horizon, but are almost useless over a five-year horizon.5 In fact, large cap companies favoured by analysts tend to underperform companies that analysts pan. Chart 5A Mug's Game Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing There are two exceptions to this rule. The first applies to small caps. Since many smaller companies are not widely followed, analysts that do follow them often add significant value. Unlike their large cap brethren, small cap stocks with buy recommendations tend to outperform stocks with sell recommendations. Second, changes in analyst recommendations do predict returns. Stocks that have recently been upgraded tend to outperform those that have recently been downgraded.6 Insiders And Short Interest How about insiders? Here, the data suggests that insiders know what they are doing. The shares of companies with a lot of insider buying tend to rise more than those that have experienced insider selling. Short interest also predicts returns. Heavily-shorted companies tend to underperform companies that have attracted few short sellers. Combining data on insider activity and short interest can help supercharge returns. Chart 6 shows the highest returns are earned when insiders are buying and short interest is decreasing.7 The worst-performing stocks end up belonging to companies where insiders are heavy sellers and short interest has risen over the prior 12 months. Chart 6Prefer Stocks Where Insiders Are Buying And Short Interest Is Falling Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing Mo' Money What about technical analysis? The academic literature on this topic is a mixed bag, with some studies deeming it useless and others suggesting it can be useful in certain situations. For most technical indicators, the noise-to-signal ratio is very high. Nevertheless, some technical indicators are worth following. Momentum is one of them (Chart 7). Over short-term horizons of about one month, mean reversion prevails - stocks that did well over the prior month tend to do poorly during the subsequent month. In contrast, over medium-term horizons of about 12 months, return continuation is the name of the game - stocks that have done well over the last 12 months tend to do well during the subsequent month. Interestingly, at very long time horizons of three-to-five years, mean reversion takes over again: Stocks that have done well over the last five years tend to do poorly over the subsequent month. The implication is that the best stocks are those that have underperformed the market over the past one month and over the past three years, but have outperformed the market over the past 12 months. Chart 7The Three Phases Of Momentum The Three Phases Of Momentum The Three Phases Of Momentum Putting aside the short-term reversal effect which, in practice, is hard to exploit due to trading costs, what are the drivers of the medium-term return continuation effect and the longer-term return reversal effect? I think three factors explain the medium-term return continuation effect. The first is institutional inertia. A large money manager cannot instantly jump in and out of a position. It may take many months to build a position to its desired size and just as much time to liquidate it. Persistent buying and selling generates momentum in equity returns. The second factor is imperfect information. A lot of the return continuation effect occurs around the time of earnings reports. If a company reports better-than-expected earnings, its stock goes up. As others hear about and process the good news, the stock usually continues to advance over the subsequent days. The third factor is behavioral biases. People tend to be quite eager to lock in gains but are usually reluctant to realize losses. When a company reports good news, investors are too quick to sell. This premature selling prevents the stock price from rising to its fair value instantaneously. During the time it takes the stock to reach fair value, the share price displays upward momentum. Conversely, when the company reports bad news, investors avoid taking losses, hoping instead that some miracle will bail them out. The lack of willing sellers prevents the stock from falling to its fair value immediately. In the time it takes investors to come to terms with the fact that a miracle is not forthcoming, the share price displays downward momentum. What about the longer-term return-reversal effect? Ironically, it is probably a function of the medium-term return continuation effect. Upward momentum attracts interest from trend-following investors. People who sold too early or never got in from the beginning kick themselves and look for the slightest dip to buy. All this buying interest eventually pushes the stock price above its fair value, setting the stage for a prolonged period of subpar returns. Anomalies Abound Let me briefly mention a few other factors that predict equity returns. Share turnover is one of them. Investors often presume that high turnover is intrinsically a good thing. Terms such as "healthy volume" abound. The truth is that companies with low rates of share turnover actually outperform the market, all things equal.8 Part of this outperformance reflects a liquidity premium. Part of it may also simply reflect the fact that undervalued companies often hide in the shadows of the market, away from the spotlight. There are also balance sheet and earnings quality factors that are worth highlighting. I already mentioned that companies with high debt-to-equity ratios tend to underperform the market on a risk-adjusted basis. It is also true that companies with high accruals - firms that fail to convert most of their earnings into cash flow - underperform the market. More surprisingly, companies whose assets have been growing very quickly also tend to underperform the market. Such asset growth often ends up reflecting empire building rather than prudent corporate management. Relatedly, a significant dispersion in analyst earnings estimates is often a red flag.9 Companies with something good to say usually say it. Companies that do not have much good to say often clam up, leading to greater uncertainty about their earnings prospects. When analysts have little visibility on what earnings a company is poised to deliver, be careful. Picking Stocks With ETS I have discussed a variety of factors that help predict the performance of individual stocks. There are dozens of others that I could have mentioned but did not. Clearly, successful bottom-up investing requires that one sort through a lot of information. What one would like is a system that distills all this information into a single score that ranks stocks from best to worst. The ideal system should dynamically adjust factor weightings to account for the fact that there is momentum in factor returns. For example, if value stocks have recently been doing well, they are likely to continue to do well. At BCA Research, we have constructed our Equity Trading Strategy (ETS) to do just that.10 Chart 8 shows the backtested returns of the ETS model. As you can see, they are quite impressive. Chart 8ETS Model Back Tested Performance To Date Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing I have been personally trading a variant of the ETS model for the past 18 years and once wrote a blog chronicling the journey.11 I have added a line in the chart that shows my own personal performance on a pre-tax basis inclusive of brokerage commissions and other trading costs. I typically hold about 30 to 50 stocks. Except in very rare cases, I don't let any single stock exceed five percent of my portfolio. I normally hold a cash cushion of about 10%-to-15%, although occasionally, as in late 2008/early 2009, I have bought stocks on margin. I have lost a lot of money shorting stocks, so I rarely do it. I am not sure how lucky I have been over the years or how scalable my results are - I generally invest only in small cap companies that most money managers would not touch. But it does give you a sense of what is possible with this system. Market Timing With MacroQuant Of course, stock selection is only one half of a successful investment formula. The other half is market-timing - knowing when to scale back or increase exposure to the stock market. That's where our soon-to-be-released MacroQuant model comes in. The model uses over 100 variables on the economy, financial and monetary conditions, sentiment, and valuations to predict the direction of the stock market. Chart 9 shows the back-tested performance of the model. Chart 9MacroQuant* Model Suggests Caution Is Warranted Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing What is MacroQuant saying today? The signal from the model moved into bearish territory in the lead up to October's correction and continues to flag downside risks to stocks. This is mainly because the leading economic data has softened outside the United States, and more recently, in the U.S. itself. Financial conditions have also tightened on the back of rising bond yields, wider credit spreads, and a stronger dollar. Sentiment enters our model in both level and directional terms. We have found that the best configuration for stocks is when sentiment is bearish but improving while the worst configuration is when sentiment is bullish but deteriorating. Going into October, sentiment began to slip from very bullish levels, which was a warning sign for stocks. Valuations have improved over the past month, but still remain somewhat stretched by historic standards. We do not believe that we are at the beginning of a bear market in stocks. However, our model does suggest that the correction may have further to run. With that, let me conclude my formal remarks, and open it up to questions. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 William F. Sharpe, "The Arithmetic of Active Management," The Financial Analysts Journal 47:1 (January/February 1991): 7-9. 2 Antti Petajisto, "Active Share And Mutual Fund Performance," Financial Analysts Journal 69:4 (July/August 2013): 73-93. 3 Andrea Frazzini And Lasse Heje Pedersen, "Betting Against Beta," Journal Of Financial Economics 111:1 (January 2014): 1-25. 4 John Y. Campbell, Jens Hilscher, and Jan Szilagy, "In Search Of Distress Risk," The Journal of Finance 63:6, (December 2008): 2899-2939. 5 Louis K. C. Chan, Jason Karceski, And Josef Lakonishok, "The Level And Persistence Of Growth Rates," The Journal Of Finance, Vol. 58, No. 2 (2003): 643-684. 6 Ireneus Stanislawek, "Are Stock Recomemndations Useful?"1741 Asset Management Ltd Research Note Series, (IV 2012). 7 Amiyatosh K. Purnanandam, And H. Nejat Seyhun, "Do Short Sellers Trade On Private Information Or False Information?"Journal of Financial and Quantitative Analysis, Vol.53, 3 (2018): 997-1023. 8 Vinay T. Datar, Naik Y. Narayan, and Robert Radcliffe, "Liquidity And Stock Returns: An Alternative Test," Journal of Financial Markets 1:2, (1998): pp. 203-219; and Charles M.C. Lee and Bhaskaran Swaminathan, "Price Momentum And Trading Volume," The Journal of Finance 55:5, (October 2000): 2017-2069. 9 David Veenman and Patrick Verwijmeren, "Earnings Expectations And The Dispersion Anomaly," (January 2015). 10 Please see Global Investment Strategy and Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach To Bottom-Up Stock Picking," dated December 3, 2015. 11 My now-defunct blog, stockcoach.blogspot.com, discussed my real-time trading progress between 2004 and 2007. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 Critical Reset Critical Reset FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid VIX The Comeback Kid VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Economic Impulse Yellow Flag Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Economic Growth Trouble Economic Growth Trouble Chart 5Watch Credit Quality Watch Credit Quality Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought Overvalued And Overbought Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Capex Blues Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Warning Signals... Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... ...Abound... ...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... ...Even In Intermodel... ...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets ...But There Are Offsets ...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Too Good To Be True Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion No Valuation Cushion No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... Mixed Signals... Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads ...On Crack Spreads ...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

As promised in early September, this is the third installment of our four part Indicators series. In this Special Report, we follow a similar script to Part II but instead of sectors, we now cover the S&P 500, non-financial equities, cyclicals/defensives, small/large and growth/value, and document the most important Indicators in the same four broad categories (where applicable): earnings, financial statement reported data, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators we deem significant in aiding us in our decision making process of setting/changing a view on the overall market, cyclicals/defensives portfolio bent, and size and style preference. As a reminder, the charts in this Special Report are also available through BCA's Analytics platform for seamless continual updates. Finally, we are still aiming before the end of 2018, to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the eleven GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com S&P 500 Chart 1S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 2S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 3S&P 500: ROE And Its Components S&P 500: ROE And Its Components S&P 500: ROE And Its Components Chart 4S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 5S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 6S&P 500: Valuation Indicators S&P 500: Valuation Indicators S&P 500: Valuation Indicators Chart 7S&P 500: Technical Indicators S&P 500: Technical Indicators S&P 500: Technical Indicators Non-Financial Broad Market Chart 8U.S. Non-Financial Broad Market: ROE And Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components Chart 9U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 10U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 11U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators Chart 12U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators S&P Cyclicals Vs. Defensives Chart 13Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 14Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 15Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Chart 16Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 17Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 18Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Chart 19Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators S&P 600 Vs. S&P 500 Chart 20S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 21S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 22S&P 600 Vs.S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators Chart 23S&P 600 Vs.S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 500 Growth Vs. Value Chart 24S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 25S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 26S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators Chart 27S&P 500 Growth Vs.Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators Table 1S&P 500 Growth/S&P 500 Value Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III) Table 2S&P 600/S&P 500 Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III)

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? Can Policy Be Truly 'Tight' With Negative Real Rates? Can Policy Be Truly 'Tight' With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal A Pause In The Rising Yield Trend, Not A Reversal A Pause In The Rising Yield Trend, Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Slowing Growth In China... Slowing Growth In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability ...But Not Yet Enough To Threaten Global Financial Stability ...But Not Yet Enough To Threaten Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? A Turn In European Yields On The Horizon? A Turn In European Yields On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences Wide UST-Bund Spread Reflects Monetary Policy Divergences Wide UST-Bund Spread Reflects Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals UST-Bund Spread Overshooting Fundamentals UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model UST-Bund Spread Looks Wide On Our Model UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Relative Data Surprises No Longer Support A Wider UST-Bund Spread Relative Data Surprises No Longer Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes UST-Bund Spread Momentum Got To Stretched Extremes UST-Bund Spread Momentum Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... UST-Bund Spread Narrowing Will Be Limited By Faster U.S. Growth... UST-Bund Spread Narrowing Will Be Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy ...The Result Of Looser U.S. Fiscal Policy ...The Result Of Looser U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now UST Technical Indicators Are More Mixed Now UST Technical Indicators Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market The Bond Bear Market Is Not Over The Bond Bear Market Is Not Over Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Bear Market Is Not Over The Bond Bear Market Is Not Over Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

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