This week, we reintroduce our volatility charts and here we highlight the inverse correlation between volatility and valuation. We also touch on GE and the fresh, old claims around its accounting.
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The risks remain in the distributor channel with inventory trends at cycle peaks - electrical, chemical, MRO and Big Box stand out to us. Manufacturers remain in better shape, although A&D, Auto, Chemicals and Semi sectors are carrying excess inventory. Generally, we see channel burn as a risk to short cycle demand into 1Q20, compounded by increasing sell-out weakness. EE/MI stocks with greatest leverage to external channels are 3M, SWK, ROK, RBC, HUBB and ITW; GE and UTX are least exposed.
Folks – I wanted to send you a complete and up to date compilation of our models post-2Q19 results. Our Model Book also includes cheat sheets and bull/bear target price spreads for each company.
We are in the middle of the Atlantic hurricane season, and we can't help but draw a parallel with the economic slowdown and associated China trade conflict that is buffeting industrial demand. Capital spending has flattened out for FY19, and the outlook for the US over the next 6-12 months has significantly deteriorated. Global capex spending remains relatively depressed vs. history, which likely limits 2020 downside risk, and offers continued hope of recovery in a more stable macro backdrop.
GE has been a significant laggard since reporting earnings on July 31 - the stock has declined 12% and was a notable under-performer on Friday (8/9/19) following a Barron’s article that argued GE’s underlying 1H19 free cash flow has significantly deteriorated. This is not true: GE’s $2.2bn of headline negative free cash flow during 1H19 compares to $1.4bn outflow in prior year, primarily due to a $0.5bn heavier working headwind and this is primarily due to the MAX grounding ($0.6bn). It is worth noting that GE’s FY19 guidance is pointing to $4.5bn of adverse free cash flow vs. FY18, so there is nothing here that is controversial, surprising or even new.
Folks, we have updated our GE Deck for 2Q19 results and the latest McCoy Power market data.
We are turning more bearish and so look at the quantitative attributes that tend to drive relative performance during EE/MI corrections. The good news is that we think we are well positioned to outperform through a choppy macro. We note that JCI, ITW and PH are outperforming relative to our expectations, while FTV, DOV and UTX are lagging – these are the three stocks where we see best potential for new money flows post-earnings.
2Q19 played out pretty perfectly on the fundamentals, but positioning was so important this quarter. We believe it is too early for a pro-cyclical trade and we remain significantly below FY20 consensus for ROK, MMM, PH, FAST, GWW and WCC. We see fresh money for DOV, UTX and HUBB out of EPS season.
This feels like a very different environment. Global PMIs are sub-50 – a bullish indicator for Cap Goods stocks – yet trade tensions are ratcheting substantially higher, valuations are too rich and we have yet to see a negative EPS revision cycle in the US. This all argues for a more defensive profile.
WR CGMI declined 2.7ppts M/M to 44.9 in July, on weakness in China and ROW regions. This confirms the negative trend that has been in place since May, immediately after trade talks first broke down. Since cap goods momentum has been so sensitive to trade, the announcement of List 4 tariffs is a troubling development. Further negative momentum would be bearish for the EE/MI group and this endorses a more defensive and less pro-cyclical bias to portfolio positioning.
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