Author: Randy Watts

Randy Watts is Chief Investment Strategist for William O’Neil + Company. Mr. Watts manages William O’Neil + Company’s research department and guides the development of the company’s suite of services. He oversees the strategic direction and focus of the company’s research content, and his buy-side experience provides additional insight that allows the company to leverage its experience and expertise to help clients generate alpha. Mr. Watts has more than 25 years of equity asset management experience with specific focus on large- and small-cap growth stocks. He started his professional career as an Equity Analyst at Freedom Capital Management in Boston, MA. He spent nine years at Westfield Capital Management as an Equity Analyst then as a Partner and Portfolio Manager overseeing a $500+ million growth stock portfolio. Mr. Watts served as a Senior Managing Director for small- and mid-cap growth investments at The Boston Company, where he managed $4 billion in both long and long/short equity portfolios. During his tenure at the Boston Company, he hired, trained, and managed a team of investment professionals. Most recently, he ran a long/short equity hedge fund for Folger Hill Asset Management in New York, NY. Mr. Watts graduated from the University of Virginia with a degree in American Studies and is a Chartered Financial Analyst.

Strategy View

Posted on by Randy Watts

While history does not usually repeat itself perfectly, it often rhymes. William O’Neil + Co. likes to study historical examples of the stock market to interpret present market action. Major U.S. indices experienced a 10%+ correction that began on 2/5/18. We shifted the market back into a Confirmed Uptrend on 2/14/18, using our proprietary methodology. In this report, we look at several past examples of markets similarly transitioning from downtrends to uptrends via follow-through days. What is important to note is several times in the following examples there were failed follow-through days where the market generated an upturn signal but then distributed and went to a new low thereafter. As a result, our strategy is to begin to buy stocks slowly in the immediate days following a follow-through day but not put all our equity capital to work immediately. We want to see the market avoid distribution in the near term and leadership stocks break out and move higher to give us conviction that the market has resumed its uptrend. Further, in different market cycles, major indices (S&P 500, Dow Industrials, Nasdaq Composite) sometimes provide signals at varying intervals. We tend to follow the leading index for our general market calls.

*Note: for the periods highlighted, a failed follow-through day is defined as a relative short-order undercut of the lows
from that follow-through day, while a Downtrend resumption does not necessarily undercut follow-through day lows, but
moves further enough off highs for a downgrade in market condition.

Strategy View

Posted on by Randy Watts

The current bull market that began in March 2009 has been one of the longest and steadiest on record with a 311% gain and volatility falling to record lows, as represented by the VIX bottoming at 8.56 on November 24, 2017. In addition, the DJIA went a record 403 days without a 5% pullback, gaining 56% from June 2016 to January 2018. Currently, the U.S. equity markets have entered a corrective phase. Historically, when a part of a longer bull market cycle, corrections average an 8% loss and last 22 trading days.
However, using our disciplined O’Neil Methodology, instead of trying to predict whether the bull market will resume or correct further, we prefer to take our signals from the markets’ technical and quantitative results. Presently, we have the U.S. equity markets rated Downtrend after the S&P 500 violated its 21-DMA on February 2 and its 50-DMA on February 5; the S&P 500, the Nasdaq, and the DJIA are now sitting -10.1%, -9.7%, and -10.4% off all-time highs, respectively. Therefore, the rapid damage done to U.S. markets is already at above average correction levels. If we undercut the 200-DMA on either the S&P 500 (2,538) or Nasdaq (6,553), we will become even more bearish.
With today’s break of Tuesday’s intraday lows, U.S. markets are back in a Downtrend (from Rally Attempt). We now need to see new lows followed by three days off the lows and a follow-through day where the index rises at least +1.7% on volume higher than the prior day to move the market back into a Confirmed Uptrend. We would caution investors that while the U.S. corporate profit cycle is strong aided by an improving global economy, a weak dollar helping exports, and lower corporate tax rates from the recently passed legislation, previous corrective cycles have resolved themselves over weeks not days. As a result, we believe being patient and sticking to our time-tested O’Neil Methodology is the right course of action.
If this is simply a correction within a longer bull market, further gains may be ahead. This was in the case in the 1996 correction of the longest ever 1987–2000 bull market, as demonstrated on pg. 5. That market took over four months to consolidate from February 1996 to August 1996, as seen on pg. 11. After that consolidation, the U.S. equity markets rose until January 2000. Similarities from that period to the current one include record-setting rallies with no 5% correction ( p.4 ), and one-year or longer consolidations within an existing bull, followed by a breakout ( p. 4 ).

Strategy View

Posted on by Randy Watts

S&P 500 Companies
Two groups of stocks:
1. Those having reported Q4 2017 earnings: Large upward revisions to consensus EPS estimates for 2018.
2. Those not yet reported Q4 2017 earnings: Slight upward revisions to consensus EPS estimates for 2018 since mid-November.
As we projected in our Q4 Earnings Preview dated January 11, Q4 2017 earnings season has started off strong. Through January 23, 51 companies in the S&P 500 have reported. As expected, 2018 EPS revisions have been very strong. Before earnings season began, analysts were predicting only 10% earnings growth for the full S&P 500 for 2018. After reporting began, 2018 EPS growth estimates have risen to 23% for the 51 companies that have reported. While this is a small sample, we expect this pronounced improvement to continue for U.S. public companies as we move through the Q4 2017 earnings season. The median upward revision for companies not yet reported is only 2% over the past
60 days.

Besides company-specific factors, we believe strong U.S. and global economies are driving some of the improvement in 2018 EPS estimates. We believe another significant factor in these revisions is the lower 2018 corporate tax rate that U.S. companies will face due to the recently passed U.S. tax legislation. Bloomberg estimates that the median effective U.S. tax rate for the S&P 500 in 2017 was 26%, which is close to 2016’s median rate of 27% for companies yet to report Q4 results. This rate is expected to fall below 21% in 2018 due to the new tax laws. As a result, and as mentioned in our piece on Corporate Tax Reform dated December 6, 2017, we believe that S&P 500 2018 earnings estimates will still be
revised meaningfully higher.

Upward 2018 EPS revisions translate into lower projected 2018 P/E ratios than currently estimated. In fact, the 51 companies in the S&P 500 that have reported currently carry a median 2018 P/E of 14x on their revised earnings estimates.

Strategy View

Posted on by Randy Watts

Given U.S. dollar weakness (-13% in 2017, down ~2% in 2018), continue to favor companies with high revenue exposure to Europe.

S&P 500 companies with 10-30% or more of revenues from Europe reported better median Q3 sales/EPS growth, more sales/EPS surprises, and         better Q4 sales/EPS growth.

Top Focus List picks with high revenue exposure to Europe include ATVI, ALGN, FB, MCHP, ILMN, WP, FLIR, VRTX, CRM, PYPL, NVDA, GOOGL, AMAT.

Given U.S. dollar weakness, commodity sector outperformance is not abnormal. Historically, Energy and Materials are by far the most negatively correlated with the U.S. dollar.

The last time U.S. dollar weakness persisted for this long (2006-2008), commodities had a period of wide outperformance versus all other sectors, stretching months past an eventual October 2007 market top.

Combining the two themes, S&P 500 Energy and Material names with high revenue exposure to Europe include XOM, CVX, COP, PSX, FCX, LYB, IP, ARNC, PPG, DWDP.

Strategy View

Posted on by Randy Watts

Q4 2017 Earnings Preview

Similar sales and EPS growth expected in Q4 versus Q3 for the S&P 500 and most sectors. But, consistent upside EPS surprises over six years are likely to continue. Assuming normal beats (+3%), about 11-12% EPS growth expected, versus 9% in Q3.

Energy, Materials, Tech, and Retail have best sales/EPS growth estimates.

Jan/Q1 Market Seasonality

Typical January pause or weakness following strong prior year has been absent thus far. Tax reform is likely offsetting this historical pattern, p.6

Overall, Q1 is usually good following a strong prior year, but investors should note that the first quarter of the second year of a presidential cycle normally has muted returns.

2018 Outlook, YTD Performance/Current Trend

From 2010–2018, Energy and Materials have drastically underperformed versus their own longer-term averages and versus all other sectors. We think this has a good chance to change in 2018, especially given the positive earnings outlook for the two sectors and recent relative price improvement.

Our picks from the two sectors are FANG, CDEV, JAG, COG, NBLX, NEP, EXP, USCR.

All major indices are at 52-week and/or all-time highs. The Nasdaq has resumed outperformance. On a style basis, large growth has also resumed outperformance.

There has been a sharp increase in the number of actionable names on our U.S. Focus List in the first two weeks of 2018. Buyable names include ATVI, PYPL, NFLX, CDEV, RNG, VRTX, ZION, WAL, BABA.

U.S. Focus List Earnings

Financials will kick off earnings season next week (MS, SCHW, GPN). The heaviest earnings weeks are the second and third weeks in February.

Especially favorable companies on our list are those that expect sales/EPS growth acceleration. These include NFLX, EXP, SIVB, ILMN, AMZN, TYL, GRUB, NBLX, AMAT, PRAH, COG, RP, USCR, AVGO, RHT, JAG.

 

Strategy View

Posted on by Randy Watts

Low distribution across the major indices and strong price action in both indices and growth stocks means we are still bullish.

What to Buy Now: Activision Blizzard (

), Broadcom (

), Diamondback Energy (

), Eagle Materials (

), Estee Lauder (

), Facebook (

), Fidelity Natl Info Svcs (

), Jagged Peak Energy (

 

), Global Payments (

), Illumina (

), Nextera Energy Partners (

),

Semiconductor (

), RingCentral (

), Servicenow (

), Texas Capital Bancshares (

), Tyler Technologies (

), Vantiv (

), Western Alliance Bancorp (

), Zayo Group (

), Zions Bancorp (ZI

)
Most Recent Focus List Addition: Jagged Peak Energy (

‘>

 

)

1.  Moving into 2018, risks to be aware of include:
Higher interest rates
Historically high market valuation
Extended period with no market correction
Extreme lows in volatility
Extreme highs in investors advisor and retail investor sentiment
High hedge fund leverage

Investment Strategy: Winners from Tax Overhaul

Posted on by Randy Watts

Key points:

  • We do not think the potential positive boost to earnings from the lower corporate tax rates from the tax overhaul are fully discounted in the U.S. equity markets.
  • Companies with businesses that are primarily domestic focused tend to have higher tax rates on average. Similarly, small cap stocks, which are generally more U.S. centric, could see strong earnings revisions if the Tax Bill passes.
  • Energy currently has the highest corporate tax rate and would see major relief. Technology, on the other hand, has the second lowest and would not have as large earnings revisions.
  • If the Tax Bill passes in its current form, Wall Street consensus is that S&P 500 earnings estimates may rise by as much as $10. That would take 2018 EPS from roughly $146 per share to $156 (+19% y/y).

Strategy View

Posted on by Randy Watts

Q1 2018 Market Preview
As an investment year, 2017 is ending with a continuation of the strength it showed earlier. As of November 28, the DJIA is +19.67%, the S&P 500 is
+16.41%, and the NASDAQ Composite is +27.85%. Clearly this has been an excellent performance year for the major averages. With this in mind, we will examine the implications of this strong performance historically for the upcoming Q1 and all of 2018.
Since 1970, Q1 market averages have been second best among the four quarters across the three major U.S. indices, trailing only Q4. However, in the second year of a presidency, averages are only about half as good. Of note, Energy and Technology are the only two sectors to post negative returns during the 1970- 2017 time period. Given the strong performance both sectors have had recently, a counter-trend move may be possible in Q1 2018. In addition, Consumer Cyclical and Retail, two groups that have lagged YTD but have shown some strength in Q4, tend to perform well in the first quarter of the second year of a
presidency.

Strategy View

Posted on by Randy Watts

Some highlights from the report:

  • With 90% of S&P 500 companies having reported Q3 earnings, median sales growth of 6% is in line with Q2, while median EPS growth of 9% decelerated a bit from 11% in Q2.

o   Health Care and Retail are the two sectors that showed median acceleration in both sales and EPS growth. Financial showed slight sales growth acceleration but slight EPS growth deceleration.

o   Tech had another great quarter, with the second-best median sales growth (7%) and tied-for-best median EPS growth (13%).

  • EPS surprises: As expected, the median surprise was about 3%, in line with the last six years. Energy (+9%) and Tech (+6%) had the best median surprises.
  • Day-of Reactions: Reactions to earnings were not great, about flat across all companies. Despite growth acceleration, Health Care and Retail had the worst reactions. Cyclicals and Energy had the best reactions, possibly attributed to outsized EPS beats.
  • Looking at our U.S. Focus List, companies that reported sales/EPS growth acceleration, sales/EPS beats, and reacted positively on the day of earnings include: WING, CDEV, OLED, EL, SIVB, GOOGL, ALGN, MPWR, ABMD, RHT, PYPL, PRAH, NOW. Those highlighted in green remain buyable.
  • Other actionable names include BABA, AMZN, ADSK, AVGO, COG, SCHW, COR, ESNT, FB, FIVE, FLT, GPN, ILMN, MB, MS, NFLX, QTWO, RP, SKX, SWKS, TNET, WB, WAL.

Strategy View

Posted on by Randy Watts

Remain bullish and be prepared to be quick.

U.S. equity markets’ current rally is reaching historic levels. Presently, we remain bullish given that we follow a discipline based on quantitative and technical measures. While the bull market may be starting to get long in the tooth, the final phase may produce strong gains that we want to capture. Furthermore, we believe our method of identifying stock market distribution and technical failure will allow us to exit positions before pullbacks from the peak are too great. As of November 3, the S&P 500 has only one distribution day and the NASDAQ has only three. Generally, if the major U.S. indices were to experience distribution day counts greater than seven, especially if this occurred over a period of 25 trading days or fewer, then we would likely become more cautious. It is important to remember that distribution can occur in a rising market if money flows are to the downside. However, for now, investors should stay positively inclined and invested.

Slow and Steady Wins the Race

In terms of performance, the current bull market (defining -25% from highs as the end of a bull market) is the fifth-best on record since 1903, rising 263%. This gain has occurred over 451 weeks, the third-longest stretch ever. This is atypical versus the average bull market length of 199 weeks and is now the longest rally since 1900 without a 5% correction in the DJIA.