Four Sector Plays for a Choppy Market Welcome to Real Vision Trade Ideas. Today, we're sitting down with Art Hogan of National Securities. Great to have you back. Thanks very much for having me. So you've been on twice recently once in January, once in March, bullish on the market, both times and rightly so we've seen a pretty big run up in the market since the beginning of the year. Recently we've had a little bit of headwinds especially with the trade war, we spent a lot of volatility in the market recently. How has that impacted your bullish thesis? That's a great question. So to take a step back, the three reasons the markets really turned this year, I think are in no particular order, I think the Fed has made a pivot, they've become less hawkish and more dovish, and December, they sounded like they were on autopilot and they were going to raise rates agnostic to what was going on in the world. They changed that tune, they changed it in December, changing and it's marked. So I think the earnings season has been much better than we feared that it would be. So coming into the year, we thought we'd have negative earnings growth in the first quarter of anywhere between two and four percent, looks like we're going to be positive by two or three percent, that's great news. The third thing was most of the information we've been getting about the US-China trade talks have been pretty constructive. Every week, or every month, or couple of times a month, you'd hear somebody in the administration come out and say things are going well. We're almost there and we could have a deal with a couple of weeks, and that's all changes over the weekend. So Donald Trump came out and said we're raising tariff, we're escalating, and that's worst-case scenario right now. Then the last thing we want to do is escalate. We want to get to the end of this trade negotiation process because it's slowing the global economy down. If we can get this US-China trade deal done and in the Rearview Mirror, I think that unleashes a lot of economic energy into the global economy. Unfortunately, right now where we thought things were going well, it seems like there's some slippage in that process, and I think that's why markets are taking a bit of a pullback. In terms of having any resolution to this trade war, is that really dependent on what the US does or do you see China potentially coming to the table and taking a hit in some way? That's such a great question. So we look at it like this. First and foremost, both parties feel a little more in Bolden by what's been going on in their counties. So for the Chinese, they've put a massive amount of stimulus and our economy, and their economies actually stabilizing the first quarter of this year, and that's good news. So they feel stronger. Their equity markets actually went down significantly last year 32-34 percent, and they've rallied this year. So they feel like, okay our markets have recovered, our economy stabilizing, we can probably play the long game here. On the other hand, the United States fell the same way. So we just had a three percent GDP print, we get 3.6 percent unemployment. Markets are at all-time highs last week. So we feel empowered or emboldened. So both sides are feeling more confident, which unfortunately means, they're going to work harder for themselves in this deal process, and I think that's exactly what's happening this week. It's almost like when we think about how the Yankees felt in 2004 and the AOCS, they just want three games. It's worth 32 runs and regained 16 or 19 the night before. So going into the game forward, they both felt like indeed the Red Sox need this much more than we do. I think both sides of this argument feel like, the other side needs it more than they do, and that's what slows things down in negotiations. Now, at the same time, both sides need to get this done. They really do. For China, they need to get it done because that's going to help their account. They want to remove most if not all of the tariffs to stimulate economic activity, and I think that they're desperate to get this done, but they don't want to show that. On our side, Donald Trump would love to have this behind him heading into the 2020 election cycle. This is something that will help him. It's also going to help to put this in the Rearview Mirror because he's hurting farmers, and input cost are higher, so builders that need building materials have to pay more. So it's an inflation with no positive benefit to it. So when you have fixed prices, you set that at unnaturally high place and it doesn't help it. There's no economic benefit whatsoever and nobody want trade war. So I think both sides are motivated to get this done. Unfortunately, both sides are feeling confident right now. Do you see China potentially waiting until 2020 until goes to an election and possibly some turnover to actually further the trade war negotiations? Yeah, that's an interesting concept. It's a long time to wait, but China works in long timeframes. They've got a plan that they started 15 years ago that's called China 2025. By then they went to 70 percent of things that they produce Made in China, all of the parts and everything, they want to start selling things. They don't want to be the purveyor of cheap goods to Walmart, they want to be the leader in the economy for things like the Internet of things. So they've got a very long term plan. At the same time, they've got an academy they have to run. So they've got a bit of a tug of war going on. Do they actually want to wait and do they believe Donald Trump won't be around in 2020 and can we play that again? I don't think so. But it's an interesting concept to think about especially when there's a lot of domestic things that are going on that perhaps weaken Donald Trump, and it seems like he's on an upward trajectory. It seems like some of the things that China might have been waiting for domestically to play out have played out, and it's time for them to get to the table and make a deal, I think. How big of an impact do you see this having on the market going forward in terms of other things in the market right now? Because you mentioned the Fed is fairly dovish. Earnings have been decentered better than expected. How big of a headwind is this trade we're going to be? Well, it's the number one headwind that the market space right now. But the thing to think about is as soon as this has gone, a couple of things could happen. We could start a new trade war with Europe, where the Eurozone and the US could start having tariffs on on autos, and I think that would be going from the frying pan into the fire, I think that's the wrong thing to do. I'm hoping, and I'm glad you brought this up, I'm hoping that the administration looks at this and that's something we can put off until after the election cycle, very much like the punted on healthcare and saying okay, we'll deal with that after 2020. I think that any new trade wars would probably get put off until, so that's the good thing. The problem with saying, okay, this headwinds out of the way and it's become a tailwind, what's next is all the things that we've ignored or kept on the back burner come to the fore. So what does that? Venezuela still going on there's a queue there. The people on either side of that disagreement are pretty big nations like the US and Russia, China. So that could heat up and become an issue. Iran, we just deployed a lot of military assets to that region. It wouldn't take much to spark a confrontation. Right now we're not talking about that because we're really hyper-focused on US-China trade war, but you put this behind us and unfortunately, the market have other things to contemplate. But I think it'd be a very good thing. I think getting the trade war accomplished and removed his going to unleash a lot of economic energy in the global economy, I think that helps everybody. Do you see that once that's resolved there potentially being another rally in the markets? Yeah, there's a little bit of a lag time between removing tariff and actually seeing better economic data. It's not going to be immediately. So let's say we get a trade deal them on the first half. We probably start seeing that manifests itself in better economic data in the first half of next year, but that's a good thing. A stronger China economically is better for the Eurozone. This helps everybody, it's very intertwined. Putting this behind us helps business men make decisions about complex supply chains and thinking about where they're going to source things and making decisions, and not having to leave a lot of capital if they've already spent on supply chains out of China and Asia Pacific region in general. So I think it just unleashes a whole lot of economic activity, but there will be a lag, it's a couple of quarters before we say, wow, the global picked up significantly, that's probably the front end of 2020 before that happens. If we do end up getting a trade deal with China, do you see it being a voluntary deal or do you see there being still issues with IP? We've got to that point where the hard part of getting this done is just that, the structural issues. So it's not that we really need China to buy more of our stuff and tighten up that trade imbalance, it's really, we need to have them play fair and by playing we need to have them stop stealing our technology, having forced technology transfer, stealing our intellectual property, forcing companies to join joint ventures when they come into China versus being able to run their businesses. Those are the sticking points. The biggest sticking point is how do we make sure that this is happening? So what's happening right now is at least the hawks that are at the table like light Hauser are making sure that we don't walk away with the deals that doesn't enforce intellectual property theft, forced technology transfer in some way to enforce that. So I don't see a deal happening, I think we'd walk away and have no deal before we'd walk away and say okay, everything's starting to can keep stealing our stuff. Are you concerned at all about near-term earnings, at least earnings through 2019 especially since comms are going to be tough? Comms really difficult, and it's so amazing. I'm glad you raised it like that because we forget that last year was spectacular, nearly 24 percent every quarter and earnings growth a lot of that had to do with a change of corporate tax rate. So that was the reason we heard so much about an earnings recession this year and the problem with that as we tried to extrapolate from estimates. As sad as it is to say, we're really bad at estimates. Every year, every quarter, about 70 percent of companies beat their estimates. We always give conservative estimates and they tend to get beat. So first quarter is going to be positive and second quarter will be positive, not great but a positive. One and a half, two percent, the second half comes into question because if we're still fighting a trade war with China, the numbers for the second half have to come down. I think the second half estimates are predicated on getting this deal done. They certainly are for us, and if this drags out through the summer and into the fall in the third and fourth quarter earnings probably look worse, but still positive, the Comms are really difficult. We're growing but not as rapidly as we could if we weren't fighting a couple of wars. What do you suggest traders do in this environment? Well, it's interesting. So one thing you have to do is try to ignore a lot of the noise, and that's really hard because there was a lot of it. We got it that complacent in the market. So the volatility index, the VIX was pinned for about 90 days at 13. Then also that went up 30 percent in a day, and it's been close yesterday at 19. It's important to remember back in the summer, it was at 36. So we got like this and flatlined and then volatilities picked up. In volatility, there's opportunity, but you have to really watch your position sizes, and I think that's the most important thing. It's like if there's going to be volatile markets, you need to pare back on the size that do make it. If you're making tactical investments, volatility gives you opportunities, but you really have to be careful about your position sizing. Are there any specific sectors that you're looking at or especially since, you're still bullish overall but a little bit hesitant or cautious in the current market situation. What do you suggest investors do in terms of getting cash, bonds, or just stay long the market? All of that is dependent on your investment time horizon, but it doesn't say it's you and I and this is our retirement money and you're going to be retiring in 50 years. So you've got plenty of time to think about that. We wouldn't have you adjust a whole lot. We'd make sure you rebalanced, and that just means if you've got a 70/30 portfolio with 70 percent equities, which is probably the right place for you to be. Make sure you're rebalancing every quarter because as the market does better, your over-allocated equities and probably under allocated at fixed income. I think that makes sense pretty much throughout all of your investment, the time horizon, and that probably doesn't change it a lot. For us, we think our base case is that the S&P 500 can get to 2,900, which we went through. We got as high as 2,945. We didn't change our targets because we were afraid of things like what's happening right now. The two things we thought might happen is either, A, we get a deal done with China and that's already perceived to have been baked into the market, and you get a sell on the news and then have an opportunity to put more money to work. Unfortunately, what happened was, we hit a bump in the road and we still got that sell off. I think that if in fact, we get a deal done and the front half of the year, our estimates are too low for the back half of the year. So our $170 estimate for the S&P 500 probably has to go up using the same multiple, we can probably get to 3,000. We're not doing that yet, but that's the upside risk. The downside risk is this drags on for awhile. Then you're looking at $2,700 target. That's using the same multiple but taking about $10 out of our estimate for this year, and that's just if we fully escalate and put 25 percent tariffs on everything that China exports to us, that's the worst case scenario. That's where we are right now. In terms of sectors, I would say this, when you make that break down, I think that the two sectors that I think look the most attractively valued by financials, they've never really recovered from 2007 and of 11 sectors, and the S&P 500. They're probably trading at the lowest multiple. The other is energy, and it's funny because I think investors have this PTSD with energy. They got so burned in 2015 when the commodity price went from a $100-$30 and the sector just got completely wiped out that they've said I've got other things to do, I'm never getting back in. Quietly, the commodity has moved up some 35 percent on a yearly basis and the sector itself is only at 15 percent. So I think that we'll see some mean reversion. They're trading at less than the multiple of the S&P 500, so I think there's value there. Where I get concerned is where you and I say, well, I'm concerned about volatilities are going to play defensive. Unfortunately, so many people have done that for the last four years, at the multiples on consumer staple stocks are really high, the multiples on utilities are ultra high, and their yields are ultra low for what you should be getting. So in a low interest rate environment people have chased that dividend on trade, I just think it looks expensive right now. What the upside potential do you see for both energy on financials? That's a great question. So when we look at that it's much more of where they trade and compare it to the broader market. So I think that if you've got a market that's trading at 17 times, I think both those groups should certainly trade at that, and they're not. So you have to multiple turns or that's probably about 10 percent upside for both groups this year. I think that's a safe bet, and the same thing is true on the downside. I think if you look at the staples in utilities, couple of multiple turns there, you can go watch out about 10 percent in each group pretty quickly. So if you're looking at a pairing those together, it might be a way to trade that. So you've got the more symmetric risk, but I will tell you the upside and both energy and financials is significant as compared to the broader market. Can you summarize your market outlook for 2019 in thirty-seconds? Yeah, outlook for 2019 is that our base case is that the US and China will come to a deal, probably sometime in the first half. I think the earnings estimates have upside risk to them. We were at a $170 for the S&P 500 for 2019, and we think that that gets you to 2,900 and the upside risks of that would be earnings are probably better or the back half. We could actually get to 3,000 without doing too much math. Great, Art, thank you so much. Thanks for having me. So even though Art is nervous due to the trade war, he is still bullish on the stock market. Specifically, he thinks the financial sector has 10 percent upside potential by the end of the year. In addition, he likes the energy sector, he thinks it also has 10 percent upside by the end of the year. In contrast to his bullish thesis, Art sees 10 percent downside in the staple sector. He also sees 10 percent downside in utilities by the end of the year. That was Art Hogan of National Securities. For Real Vision, I'm Justine Underhill.