June 5, 2017

Despite a weaker than expected employment report, stocks held close to the flat line on Friday closing out two weeks of net gains.  Fundamentals still rule even if the U.S. economic fundamentals remain rather weak.

What is unusual in today’s market is that earnings are moving higher at a solid clip while economic activity overall remains in a funk with growth closer to 1% than 2%, much less than the 3%+ promised by Trump and Republicans after the election.  There are no key legislative initiatives set to move forward.  This week, the White House is expected to pivot to infrastructure spending in an effort to stir the animal spirits in Washington and around the nation.  Today, Mr. Trump is expected to call for privatization of the air traffic control system.  Before week’s end, he is going to call for an overall program that would spend $1 trillion on infrastructure.  But, as has been the case with so many showcase speeches and Executive Orders to date, details of how such a program gets done will be missing.  In short, the White House is still on the campaign trail; the reality of converting promises to reality remains elusive.

None of this has been lost on markets.  Growth, as mentioned earlier, remains anemic.  To be sure, growth does continue without threat of recession, and there are some signs that growth will accelerate slightly in the months ahead from the very slow first quarter pace.  Growth internationally shows more distinct signs of improvement.  Worldwide growth in 2017 should return to a 3%+ pace.  That will be both a driver of accelerated worldwide earnings growth and a weaker dollar.  Money flows to strength.  With growth in the U.S. decelerating ever so slightly while growth elsewhere is increasing, the dollar slides.

If one looks at indicators like Treasury yields, the shape of the yield curve, commodity prices, and currency values, clearly the market is stating that the U.S. is the growth laggard, that inflation remains well contained, and that absent real fiscal action in Washington, one can expect more of the same. The unemployment rate is down to a post-recessionary low of 4.3% without  putting undue upward pressure on wages.  That suggests either we are farther from full employment than conventional wisdom suggests, or inflation remains low enough that workers are content with wage increases of 1-2% annually.  I suspect the former to be true more than the latter.

With the monthly employment report now behind us, we go into a period between now and the beginning of July where the corporate and economic news calendars are relatively skimpy.  In the absence of news, stock prices should logically drift higher.  But within a news void, small stories can take on outsized importance.  I am not talking about terror attacks like we saw in London over the weekend.  As bad as they are, they no longer surprise us and don’t move the economic needle.  Rather, I am talking of what today is an unseen event that could spook investors.  For instance, a few years ago earthquakes and tsunamis in Japan rattled markets during a period void of other major news stories,.  A sudden move in the price of oil could do the same thing.  By their very nature, such events are unpredictable.  They don’t always happen and as long as they don’t, markets tend to drift along on low volume.

Lately, a lot has been said about this market being driven by just a handful of high profile names like Amazon, Apple# and Tesla.  That is not completely true.  There are clear pockets of strength in the market.  Names like Johnson & Johnson# and Unilever# set new all-time highs last week.  These aren’t tech high flyers, and they aren’t alone.  Names like 3M#, Marriott, and even a handful of REITs were setting highs.  Is there a common thread?  There are several:

  1. Tech is rising because of major sea changes such as the evolution of cloud computing, the emergence of smarter automobiles, the ongoing move toward greater mobility, and new ways to deliver entertainment.
  2. As mentioned previously, earnings growth overseas is faster than here at home and the dollar is falling. That favors multinationals with a high percentage of earnings overseas as well as international companies whose functional currency is showing strength against the dollar.
  3. Millennials are choosing experiences over hard assets. They are spending less on clothes and more on dining. They want to travel more and consume less.  As boomers age and retire, they follow similar patterns, shopping their closets and traveling more.
  4. While there is pressure on drug prices, demographics still point to health care as a growth sector.
  5. Millennials are getting jobs, leaving home, and living on their own, finally. That means good news for companies in the housing industry.

But given that overall growth is still under 2%, the winners above mean there have to be losers.  And there are:

  1. No group is getting beaten up more than the department stores. They have been slow to embrace new technology and offer merchandise aimed at an aging population.  Retail is a difficult business and we all can name dozens of old favorites that have long disappeared.  That trend, if anything, is going to accelerate over the next decade.
  2. We are driving less and sharing transportation alternatives more. That doesn’t bode well for the auto industry.
  3. Credit card default rates are returning to normal. The fear, probably justified, is that before long we will once again as a nation collectively start to live beyond our means. While the lessons of 2008 aren’t lost completely and no one, including me, expects a repeat of that financial collapse, the trends in place today suggest a slower expansion of consumer credit ahead.  Millennials want to move out on their own and live in their own homes, owned or rented.  They also still have student debt to pay off.  They aren’t avoiding the stores because they hate clothes; they are staying away because the piggy bank is running low.
  4. Boomers, wanting to retire, are finding it hard to live off accumulated savings in a world that pays 2% or less. So they work longer, and spend less, as they seek to boost their retirement pots.  Many are finding that plans to sell their homes and move to Florida are on hold because they can’t afford to move.  Homes they want to sell aren’t providing enough to buy the dream house.  As a result, many are staying put.  That means less inventory of existing homes for sale which, in turn, slows down the housing industry overall.  New homes are very attractive as a result, but market pressures limit the ability of homebuilders to increase prices to offset rising costs of labor and lumber.
  5. As consumers become more responsible for more of their own health care costs, via high deductibles and co-pays, they put downward pressure on health care prices. Nowhere is that more evident today than in the generic drug industry.  Expect that pricing pressure to expand to ethical drugs and hospitals.
  6. 50% of every barrel of oil goes to make gasoline or diesel fuel. With the auto industry cresting and cars becoming increasingly more efficient, demand for oil is less than previously predicted.  At the same time, technology has lowered the cost of production.  Lower costs and lower prices amid lower demand don’t make a good formula for a robust oil industry.  Indeed, it is the worst performing S&P sector year-to-date.  Normally, oil prices peak seasonally right about now at the beginning of summer driving season.  Don’t look for any rebound in oil prices over the coming months.   If there is a surprise, it may be that oil prices over the next several months could challenge the $40 level and dip below.

Thus, you can see that, within a 1-2% growth economy, there are haves and have-nots.  We are no longer in that phase of an economic cycle where rising tides lift all boats.  The tide today is barely moving.  Successful companies have to do it themselves.  Every dollar spent on Amazon is a dollar that is not spent elsewhere.  A hamburger eaten at McDonald’s# is a meal not eaten elsewhere.  We are dealing with choices, as always, but new technology is changing the choices we make.  We call the new companies that catch the wave, disruptors, but old companies can disrupt as well. Look at how well McDonald’s is doing as some of its pretenders, like Shake Shack, lose some of their initial energy.

Nowhere is change more evident than how we watch and consume entertainment.  The new buzzword is unbundling.  But I suspect that a decade from now, we aren’t going to live in a home where we buy 4 or 5 different services and bundles and then use technology to string them together on our living room set. To be sure, gaming is likely to replace watching “Cheers” or “Seinfeld” on some sets.  But whether Netflix offers movies, TV reruns or original programming, the product is really just the old stuff with a new wrapper.  Sports isn’t going away.  Yes, I know you can now go to arenas and watch participants compete in virtual electronic sports, but it is hard for me to believe that is about to replace the real thing.  Sure, the economics of producing and delivering entertainment will evolve and there will be winners and losers.  But in the end, the more things change, the more they stay the same.  This business is like everything else.  Winners will evolve and those that don’t change will die.  But I suspect a decade from now the water cooler conversation will still be about your favorite sports teams, or show you watched on TV.  It may be a YouTube stream instead of a traditional sitcom, but we can all adjust to that.

Today, Mark Wahlberg is 46. Kenny G is 61.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request.  This report is not a complete analysis of every material fact representing company, industry or security mentioned herein.  This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned.  This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities.  The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed.  This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report.  Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized.  Opinions are subject to change without notice.

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