Transportation

Overweight The Cass Freight Expenditures Index, a barometer of the total amount spent on freight, recorded an all-time high reading in the latest monthly report, rising by an astonishing 17.3% year-over-year on already firm comparable numbers (second panel). While this is partly a function of much improved volumes, the explosion in expenditures is largely due to higher prices. In fact, the Cass Freight Index Report noted that "demand is exceeding capacity in most modes of transportation by a significant amount. In turn, pricing power has erupted in those modes to levels that continue to spark overall inflationary concerns in the broader economy." This is well reflected in railroad operating metrics. Shipments have been steadily improving but pricing power has been enjoying multiple years of above-inflation growth, driven by tight capacity and accelerating demand (third panel). Our rails profit margin proxy (pricing power versus employment additions) echoes this positive earnings backdrop, pointing to margin improvements in this year and beyond (bottom panel). Though inflation represents a longer term risk to rails and the broad S&P transportation index, near-term earnings growth should be well beyond trend. Accordingly, we reiterate our overweight recommendation for the S&P railroads index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Prices Will Push Rail Margins Higher Prices Will Push Rail Margins Higher

Overweight (High Conviction) The S&P air freight index has been on a tear in recent months, after putting in a bottom earlier this year. It appears the market is valuing rising global trade driving a surge in revenues over a run up in fuel costs that will be a headwind for margins. We would concur. Domestic business conditions are nearly as good as they get, which has historically coincided with rising global air freight volumes (second panel). This rising demand, combined with relatively flat capacity growth, puts pricing power squarely in the hands of the logistics providers (third panel). We think the necessary conditions are in place to improve profit despite rising input costs. While the performance of the S&P air freight index has been solid recently, the growth in forward EPS estimates has been stronger, meaning valuations have barely budged from their steep discount to both normal and the market (bottom panel). We expect this situation is unlikely to persist with the most likely scenario being strong stock price performance, particularly if input costs begin to recede. Accordingly, we reiterate our high conviction overweight recommendation on the air freight index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Global Trade Is LIfting Air Freight Global Trade Is LIfting Air Freight

Underweight (Upgrade Alert) It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus, it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (fuel prices shown inverted in top panel). Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations (bottom panel). We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Could Jet Fuel Be The Tailwind Airlines Need? Could Jet Fuel Be The Tailwind Airlines Need?

Highlights Portfolio Strategy A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Unwavering Unwavering Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Too Soon To Bail Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Steadfast SPX Steadfast SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Buy The Breakout Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Pristine Balance Sheet Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Mind The Gap Mind The Gap Chart 11Acute Margin Trouble... Acute Margin Trouble... Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... ...But Demand is Firming... ...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight As recently as three months ago, the U.S. legacy air carriers were being feted for not diving headfirst into fuel hedges, as they had done in earlier cycles to mixed results. Now, with jet fuel prices hitting 3 year highs, the shine has come off the market (top panel). AAL, who saw spectacular benefits as the price of fuel was falling, reduced their full year earnings guidance by 10% yesterday as pricing has failed to keep pace with the rising costs. Even LUV, who still maintain a modest hedge portfolio, lowered expectations, though they have some fairly specific challenges following a fatal engine incident. Rising jet fuel prices are coming at an inopportune time; the industry is binging on new capacity which has spurred a price war. Predictably, such a strategy has been stretching balance sheets (second panel). At a time when valuations have appeared to turn a corner (bottom panel), we think an excellent selling opportunity has emerged. We reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Please Look For Your Nearest Exit Please Look For Your Nearest Exit

Overweight CSX Corp led off the S&P railroads index in reporting results for the first quarter of 2018 yesterday; the markets were not disappointed and the stock jumped substantially higher. Most notably, the company's operating ratio (the ratio of operating expenses to revenues and a standard measure of industry profitability) leaped down by nearly 10% from 73.2% to 63.7% (lower means better profitability) year-over-year. Further, the company was able to increase prices in the key intermodal segment without impacting volumes; the resilience of the current business cycle should support more of the same for the rest of the year (second panel). Unsurprisingly, there is a tight correlation between the S&P railroads index relative performance and the industry’s operating ratio (operating ratio shown inverted in top panel). We expect ongoing efficiency gains and exceptionally strong demand to keep the latter suppressed (possibly delivering the most profitable year in railroad history), implying outsized EPS gains. With a valuation only slightly above the 16-year average and in line with the market multiple (bottom panel), such EPS strength should point to stock price outperformance; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stoking The Boiler For 2018 Stoking The Boiler For 2018

Overweight (High Conviction) U.S. manufacturers are rarely so excited about exports; the latest ISM manufacturing export subcomponent recently hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel). Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (bottom panel). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list; please see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Air Freight and Logistics - Prepare For Takeoff Air Freight and Logistics - Prepare For Takeoff

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

Underweight U.S. airline stocks hit a patch of turbulence this week when Southwest, usually known for being the price disrupter amongst airline peers, dropped their Q1 revenue guidance "primarily due to the competitive fare environment". We have been flagging a looming price war since United Airlines announced a significant and prolonged capacity expansion plan earlier this year, underpinning our preference to avoid the S&P airlines index. In fact, airfares have been losing share of the customer's wallet for more than a year now and the downtrend is accelerating (second panel). This is further evidenced by airlines' eroded ability to pass through higher jet fuel prices, which have historically been the marginal price setter (third panel). The upshot of declining revenues and rising costs is stalling margins (bottom panel); investors would be wise to skip this flight and stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Price War Is A Downdraft To Airline Earnings Price War Is A Downdraft To Airline Earnings

Overweight Railroad stocks have recently seen a spike in forward EPS which has eliminated the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (second panel). The track is now clear and more gains are in store for relative share prices in the coming quarters. Industry operating metrics point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (third panel). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (bottom panel), particularly the ever-important coal and intermodal segments. Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index; please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stay On Board The Rails Stay On Board The Rails