Thursday, August 18, 2016  |   Email   Print


The S&P 500, Dow Jones Industrials, and other major indexes have recently
broken out to new highs. But this commentary is not about the breakouts in those
indexes (check out for more on those). Nor is this commentary
about the classic video game called Breakout that debuted in the mid-1970s, which
some of us more seasoned investment professionals recall. And it’s definitely not
about the 2008 Miley Cyrus album by that name (even though the authors of this
report have six daughters between the two of them). In this week’s commentary,
we look at some interesting, under-the-radar breakouts in the economy and markets.

Breakout #1: Economic Suprises 

Many wonder how the stock market can do so well when S&P 500 earnings
have not produced any gains since the second quarter of 2015, and even then
earnings grew by a meager 1.3%. Valuations have risen, which has been helpful
(more on that below). Central banks have also helped, which could explain why 
the VIX measure of stock market volatility is sitting near post-financial 
crisis lows and about 7 points (or 35%) below its 25-year average. But another
reason that few would cite is that economic data have been increasingly beating
expectations—our first featured breakout.
The Citigroup Economic Surprise Index, or CESI, tracks how economic data are 
faring relative to expectations. The index rises when economic data exceed 
economists’ consensus estimates and falls when data come in below estimates. 
After an 18-month stay in negative territory, the July 8, 2016 reading put the 
index above zero [Figure 1]. 
Economic growth has not picked up during this time period but the data have been 
better than expected, supporting stocks during their recent ascent—including the 
month since the Brexit vote in the U.K.—highlighted by the June Institute for Supply 
Management (ISM) Purchasing Managers’ Index (53.2 versus 51.4 expected) and the June 
Employment Situation report (287,000 net new jobs versus 175,000 expected).
More data beats than misses is an encouraging sign for stocks. Over the past 10 years,
when the CESI breaks above zero (14 instances), the S&P 500 was higher over the 
subsequent 6 months 79% of the time with a median gain of 5.2% (the average is lower, 
dragged down by a 35% drop in 2008). Excluding the Great Recession, stocks rose in 11 of
12 instances with a median gain of 6.3% (and an average of 6.9%) over the subsequent 6 
months. We have also observed better performance from the more economically sensitive 
sectors in these scenarios. Both good signs.
The second quarter 2016 gross domestic product (GDP) report will be released this Friday, 
July 29, which may deliver another surprise. GDP is expected to pick up strongly from the 
tepid 1.1% annualized growth rate posted in the first quarter of 2016. The Bloomberg 
consensus forecast for the second quarter is 2.6%.
Something else that is poised for a breakout after an extended stay below zero is earnings 
growth. After what will likely make four consecutive quarters of earnings declines in the 
second quarter of 2016, consensus estimates are calling for a modest low-single-digit 
gain in the third quarter. More on earnings in the coming weeks.

Breakout #2: Valuations

Our next breakout is not as upbeat, and that is valuations. Based on the trailing 12 
months priceto-earnings ratio (PE), one of our preferred valuation measures, stock 
valuations have broken out to a new post-financial crisis high. In fact, you have to go
back more than 11 years—to November 2004—to find a higher PE than the current 18.3 
[Figure 2].
These lofty valuations are understandably concerning to many. Most bull markets since
WWII have ended at similar PEs to where we are today (the 1990s bull market ended at 
a much higher valuation of near a 30 PE). These multiples are now above long-term 
averages. Stock market corrections tend to be more painful when they come at higher 
Even more worrisome, some other valuation measures look even more stretched than this 
one. Professor Robert Shiller’s Cyclically Adjusted PE ratio (or CAPE), which uses 
10-year average S&P 500 earnings, is over 26, versus a long-term average at 17. The 
median PE for stocks in the S&P 500 is 23, compared with an average of 17. And the S&P
500 PE based on GAAP, or as reported accounting earnings, is 21, above its average at 
18. These are all valid concerns and certainly play into our cautious second half outlook 
for stocks. 
Two things keep us from getting overly worried about this breakout. One, valuations have
not historically been good market timing tools (Shiller publicly admits this about his 
own valuation metric). From year to year, it is random whether higher or lower valuations 
will lead to better returns. And second, inflation and interest rates are low. Lower 
interest rates and less inflation make future earnings more valuable and make bonds a 
less attractive opportunity than stocks. We continue to watch for downside catalysts 
that may suggest valuations will become problematic.

Breakout #3: Emerging Markets

Emerging markets (EM) is another group that is on the verge of a potential breakout. 
EM has been a major underperformer relative to U.S. equities over the past five years, 
mainly due to a combination of earnings weakness, commodity declines, political strife, 
and U.S. dollar strength. With commodities performing well so far this year and earnings
and currency stabilizing, EM has finally begun to
reverse the tide. 
EM is not near a breakout on an absolute basis like the S&P 500—the MSCI Emerging Markets 
Index is still more than 30% below its all-time high set back in October 2007. But on a 
relative basis versus developed foreign markets, EM has broken above a two-year downtrend 
line [Figure 3]
After numerous head fakes in recent years, it may be a good time to accumulate this beaten 
down group from a technical perspective. 
In next week’s Weekly Market Commentary, we will continue the breakout theme and discuss some
sentiment indicators that could be considered breakout candidates and potential contrarian
bearish indicators.


The breakouts for the S&P 500 and the Dow Jones Industrials are getting the most attention, 
but they are not the only ones. The breakout in economic surprises is a positive sign for 
the stock market and cyclical sectors, though the breakout in valuations suggests only 
potential moderate gains for stocks in the near term. Finally, the breakout in emerging
markets, coupled with improving fundamentals and attractive valuations, suggests strong 
recent performance for that group may continue. 

Important Disclosures


The opinions voiced in this material are for general information only and are not intended to 
provide specific advice or recommendations for any individual. To determine which investment(s) 
may be appropriate for you, consult your financial advisor prior to investing. All performance 
referenced is historical and is no guarantee of future results.
The economic forecasts set forth in the presentation may not develop as predicted and there can 
be no guarantee that strategies promoted will be successful. Investing in stock includes numerous 
specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity 
of the investment in a falling market. Investing in foreign and emerging markets securities involves 
special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, 
and risk associated with varying accounting standards. Investing in emerging markets may accentuate 
these risks. The fast price swings in commodities and currencies will result in significant volatility 
in an investor’s holdings. All investing involves risk including loss of principal.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure 
performance of the broad domestic economy through changes in the aggregate market value of 500 stocks 
representing all major industries.
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries 
and widely held by individuals and institutional investors. The Institute for Supply Management (ISM) 
Index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. 
The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier 
deliveries. A composite diffusion index is created that monitors conditions in national manufacturing 
based on the data from these surveys.
The MSCI Emerging Markets Index captures large and mid cap representation across 23 emerging markets (EM) 
countries. With 822 constituents, the index covers approximately 85% of the free float-adjusted market 
capitalization in each country.
The MSCI EAFE Index is a free float-adjusted, market-capitalization index that is designed to measure 
the equity market performance of developed markets, excluding the United States and Canada.


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