Q1 2019 Market & Economic Review

U.S. stocks experienced a strong rally in the first quarter of 2019.  The biggest performance driver came from the Federal Reserve pausing their interest hikes.  Between 2017 and 2018 the Fed raised the Fed Funds rate approximately 8 times and until recently expected to continue raising rates into 2019.  The sell-off in Q4 was largely attributed to the Fed moving too fast with interest rates combined with lofty stock valuations and a mild slowdown in economic activity.  The Fed is also in the process of reducing their balance sheet by selling back the bonds they purchased during their QE program.  They reached a level of $50 billion per month but have since slowed the program dramatically and expect to put it on hold soon.  The Fed actions suggest that while the U.S. economy continues to improve, it remains in a fragile state.

Economically we are experiencing a mild slow-down as reported by Doug Short of Advisor Perspectives in his “The Big Four Economic Indicators”.  For example, January Real Income experienced a sizable decline, but that was after 8 months of growth and followed December’s increase of 1.06%.  Real Sales in February also dipped and 4 out of the last 11 reports have shown declines.  Industrial Production appears to be pausing, with a combination of 2 shallow declines and one small increase during the last three months.  Employment remains the shining star, but February almost reported a decline.  Here’s a look at recent numbers (several reports for March and one for February still need to be updated).

In a report by State Street Global Advisors, they reported confidence of North American investors shows a slight improvement while confidence for European investors declined further.  In the U.S. investors appear skeptical.  In Europe they are faced with BREXIT and a host of other challenges, including violent protest in Paris.

Regarding all the talk about the Yield Curve inversion, we remain in an extremely low interest-rate environment which may reduce the predictability of a future recession a yield curve inversion has had in the past.  The other factor to note is the long lead time between the inversion and the start of a recession (16 months since 1976).

We are at the very beginning of Q1 corporate earnings season.  As of last Friday, 25 companies have already reported quarterly earnings.  Overall the market expects a decline in earnings compared to a year ago.  However, as of April 5th industry analysts project a 8% price increase for the S&P 500 over the next 12 months according to FactSet.  During the last 5 years analysts have overestimated their 1-year price target by 1.5%.  The more constructive takeaway here may be the directional move versus the magnitude of the move, especially give the gains produces in Q1.

There are two developments currently working their way through the political process that could have a positive impact on the market.  A favorable resolution to trade negotiations with China and talk of an infrastructure bill, potentially ready for a vote this summer.  Positive developments in these two areas would go a long way toward helping the economy get back onto a stronger growth trajectory.

Overall, I feel pretty good about the economy and markets.

Should Investors Prepare For More Market Declines?

The stock market experienced swift and deep downward action last week. Part of the market selloff points to typical action by institutional investors and looks very similar to the February decline. This type of trade action includes Option Gamma Hedging strategies, where traders profit from increased sensitivity to an option’s price change measured by gamma. Much of this type of selling is believed to be behind us.

You also have the Trend Following crowd, once indexes made a strong move below the 50-day moving average selling and short exposure increased, which aggravates moves to the downside.

This week Volatility Sensitive Strategies (investment allocations that shift between cash and the S&P 500) and Risk Parity Strategies are expected to be active. Some trading desks suggest there’s around $355Bn allocated to this category of trading. Stock exposure for these strategies is believed to already be down to around 65% from 100%. Another 15% reduction is still expected.

Goldman Sachs reported good flows into their Corporate Buyback desk but as you can see in the chart below (Stockcharts.com & Dightman Capital), it was not enough to establish firm support. Trading volume on Friday was significantly below recovery rallies earlier in the year and selling volume for S&P 500 stocks was significantly higher.

The Tech Premium, the higher cost an investor is willing to pay for tech exposure versus other areas of the stock market has faded a bit and may have further to fall. One area contributing to the compression in tech stocks involves international growth. There is concern international market are going to fall into recession before they kick into a higher growth mode. Rising Costs are also weighing on tech. While top-line growth is steady, margins are being compressed as costs, like wages, are rising.

On the geopolitical front, Trade Talks with China should be quiet (but probably won’t be) leading up to the November G-20 meeting but Saudi trouble and the Price Of Oil is a new issue for the market to digest. Brexit talks are not progressing well with many obstacles remaining so that may be causing traders in Europe to sit on the sidelines.

Q3 Earnings ramp up this week, so we will know more about the health of corporate finance throughout the week. Disappointing results or poor guidance could send stocks lower.

A scenario is developing which could push stocks further into the red in the coming days and weeks, or at least mute any recovery.  More downside for the stock market would provide cover for The Fed to become more dovish and slow interest rate hikes. This would likely be a welcome development for stock investors but in the meantime, we may see a bit more pressure on stock prices. From a longer-term perspective this looks like it may end-up being a buying opportunity on the strength of the U.S. economy, a renaissance in innovation and low interest rates globally.

 

Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

Are Tech Stocks Going On Sale?

The U.S. stock market has come under pressure despite good Q2 earnings and the continuation of strong economic numbers.  The price declines are especially prevalent in tech industries while other sectors of the stock market have held up over the last week.  What is the market telling us?

In simple terms, technology stocks may be going on sale.

It is clear Facebook and Twitter face unique and systemic business challenges, but the massive declines they have experienced in the last few days seem to be taking down other tech related stocks.  The software industry, for example, is down nearly 5% from highs reached just 5 days ago.  More specifically, Cyber Security is down nearly 6% from highs it reached on July 18th.  Biotech is another example, down 6% since July 12th.

Company valuations are also a concern.  Technology stocks have become expensive and those companies with strong growth fundamentals, primarily sales and earnings growth, generally trade at a premium to the market, during rising markets.  There’s little evidence business conditions for tech companies are contracting so the decline in price appears to be a typical correction bringing tech valuations closer to the broad market.

Other sectors of the stock market do not appear to be impacted by the tech selling, at least so far.  How can we tell?  For one thing, other stock market sectors have been able to avoid the selling:  Materials (XLB), Industrial (XLI), Consumer Staples (XLP), Energy (XLE), Healthcare (XLV) Utilities (XLU), Financial (XLF) have all generated positive returns over the last 5 trading days.  7 out of 11 sectors delivering positive returns.  These are not just defensive sectors either.  The Financial Sector participation is a bonus, suggesting these financial companies have not been impacted significantly by problems in the tech space and valuations in this sector are actually quite reasonable.

Other groups have also been able to side-step the selling over the last 5 days.  Transportation, Healthcare, and Consumer Staples, just to name a few.

Below is a look at the price performance over the last two months of the 11 SPDR Sectors, considered a good proxy for the entire U.S. stock market.  Recent selling appears to be focused on technology related companies;  However, talk of a government shutdown has the potential to aggravate the situation; it would be wise to proceed cautiously with any new investment.

(NOTE: The recently introduced eleventh “Communications Services Sector” (XLC), has an 18.5% allocation to Facebook, and 26% to Google.  The largest traditional “Telecommunications” holding is Verizon, which only represents 4.8% of the sector ETF.  A good example of why it is important to know the actual holdings of any mutual or exchange traded fund.)

As of July 30, 2018. StockCharts.com

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

The Stock Market Prepares for Higher Interest Rates

U.S. stocks have been stuck in a trading range since the middle of July. Q3 earnings and central bank policy are likely to be the factors driving near-term market direction but any number of wildcard events could derail a rally attempt. The market is currently priced for perfection but that does not mean it can’t go higher. In 10 years is it likely to be significantly higher.

SPY4mD101116

Q3 earnings expectations are not very high. Market consensus currently suggest this will be the sixth straight quarter of earnings declines. An earnings contraction of this duration has never happened before without a market correction. It is possible the two swift stock market sell-offs and recoveries over the last 12 months were all that was needed but the earnings picture has not improved suggesting a repeat is likely.

Talk of a Fed rate hike later this year (after the election) has pressured bond prices as well as gold. After a very strong rally earlier this year gold has corrected over 8%. Real estate and utilities have also been hit by potential rate hikes.

European stocks are starting to waver again but Asia and Latin America regions have been able to maintain the uptrends they started around the start of the year.

On the bond side of the market, the biggest surprise might be how well corporate junk bonds have held up. The recovery in crude oil prices appears to have taken some of the pressure off the highly leveraged energy market.

We have definitely seen a change in market character as we transitioned from summer to fall. To give you an idea here is how some asset classes have performed over the last 90 days.

90dayAssetClassPerf

The market appears to be telling us interest rates are going to adjust up which has caused most bonds, gold and real estate to fall after being darlings earlier this year, especially gold and real estate.

Money is still being put to work in high-growth stocks and markets which explains why the Nasdaq 100 and most emerging markets are outperforming developed market large-cap stocks. Also, in Europe and Japan central bank policy remains more active (although Japan has stepped back a bit), where stocks are still responding favorably.

What we are experiencing is a classic adjustment period where markets are taking into consideration the impact of higher interest rates on the short end of the yield curve and the potential impact to longer bond maturities.

Exposure to high-growth mid-large cap U.S. and emerging markets stocks has helped maintain portfolio value over the last few months. So far shorter maturity bonds have only experienced small declines but further weakness might indicate a market that expects the economic recovery to accelerate with more rate hikes to follow. Don’t count on it, there is sparse data suggesting anything of the sort.

As I have said before, margin debt is the one area where higher rates could aggravate stocks. Margin debt peaked 18 months ago so it is entirely possible the next ramp up on stock prices will be a function of levering up again assuming the costs are not prohibitive – we are likely a long way from that problem. Who really thinks 3-month T-bill rates will normalize at 2.6% anytime soon?

There are plenty of strategies for positioning your retirement assets in this market for long-term growth or a margin of safety. Let me know if this is a subject you would like to discuss in more detail.

The Stock Market After Brexit

Last week’s Brexit vote has cast a cloud of uncertainty over global markets.  The decisions direct impact is largely a regional one but as new information arrives we are learning the outcome calls into question the entire European Union concept and that has rattled markets globally.

It is unfortunate timing.  Stocks were starting to show some resilience after two brutal market declines in the last year, the IPO market was starting to warm again and international stocks rallied strongly into the vote.  The vote may also turn out to be just what is needed to bring back vibrant economic growth.

The challenge for European Union members is the ability to sustain rich social programs in the face of stagnating incomes and productivity.  We face similar problems here in the U.S. from local government pensions all the way up to Medicare and Social Security.

UKBrexitCentral banks have been in the driver’s seat since 2008 and their policies have pushed asset prices to levels where fundamentals are stretched.  Economic stimulus efforts to date have fallen short.  New programs designed to inject liquidity directly into consumers’ pockets are likely under active discussion although Europe may find it difficult to implement new policy at a time when many factions have proposed new agendas.  Central bankers no doubt have their work cut out.

At present the overall stock market environment contains far more negatives than positives.  Technical characteristics of the market have deteriorated significantly and now suggests more declines may follow.  It could also get worse if economic growth slows.  There has been little evidence that U.S. corporate sales and earnings have started a recovery after one of the longest periods of contraction on record without a recession.  Banks in Europe remain undercapitalized and slowing growth in China remains a concern.

Innovation and market expansion is alive and well and we can expect a more robust economic environment to return eventually.  The task at hand is to determine how much of an interruption to the global economy the Brexit saga likely to cause before we finally exit the malaise affecting this market.

Investment management has become more complex in the era of hyper-policy action lowering confidence intervals for decisions.  We have had a long market run, a mediocre economic recovery and a very long list of problems yet to be solved.  The likelihood of the market taking matters into its own hand and again serving up a steep correction has risen significantly.

A couple years from now we may look back on this event as a small blip in market history.  The innovation and market expansion on the horizon may need to take a pause as excesses are removed and reforms implemented.  While investing is a long-term pursuit there may be times where playing some defense pays off. This may be one of those times.

BREXIT UPDATE – Q&A

Is BREXIT Europe’s “Lehman” event?

Britain’s vote to leave the European Union is nowhere near the impact of the Lehman Brothers bankruptcy back in 2008.  The BREXIT situation at this point is not a financial disaster.  How market respond going to forward will tell us more about the impact this development is going to have than today’s reaction.  Over the weekend policy makers will be busy working on responses; programs put in place between banks (from the 2008 Credit Crisis) appear to have provided some stabilization, especially in currency markets where price swings were abnormal.

How much will BREXIT impact the U.S.?

This is a Britain/Europe development and has very little to do with the U.S.  Thankfully the U.S. won’t be on the hook for a bailout (at least so far).

How much will BREXIT impact the U.K.?

It is impossible to know how this will impact the UK and we won’t know for some time.  Like most outcomes there will be some positives and some negatives for the country as a whole and for its citizens.  We will have to wait to see where the balance falls.  Nothing has changed in the immediate future.  The exit will take years.

Brexit2Is there a risk of other countries “exiting”?

It is a European problem if other countries push for an exit.  Greece did not leave partially because they were the recipient of aid.  Germany is now the sole country with any real economic strength in the union.  Germany now decides if the European Union survives.  Who knows, fewer regulations and a more sovereign identity in the region might provide needed stimulus.

Why did stocks react so poorly?

Stocks fell because of a sudden economic change they did not expect.  Once the details are better understood the manner in which stocks behave will tell us more about the near-term direction for the market.

Is there a risk this could push the global economy into a recession?

There is always a possibility global economic activity will slow in response to a significant economic development.  The global economy is in a fragile state with corporate earnings and sales here in the U.S. already in decline.  Again, how stocks respond over the coming days and weeks will indicate the markets view of this development going forward.  Up to this point central banks have been very successful at supporting asset prices.

Is there a silver lining?

U.S. companies could ultimately benefit from the disruption created by British companies renegotiating new trade deals.

What should I do this weekend?

Relax with friends and family.  Have some fun.  Monday will be here soon enough.

To Raise Or Not To Raise, That Is The Question

The on again of again posture of The Federal Reserve is apparently back “on” again regarding an interest rate hike in June.  At least that is what they are signaling this week.  Apparently they are seeing enough strength in the U.S. economy to feel confident another small increase from already very low rates should not derail the economy; they are probably right.  Another reason they may be focused on normalizing rates is so they have the ability to lower rates during the next recession.  The one thing they cannot risk is a slowdown in real estate activity.  If higher rates cause a slowdown in construction, remodeling, refi and resale activity, one of the few areas of strength at present, that could be problematic for the broader economy.  Rates are probably low enough that another rate hike or two is not going to crush real estate but if it turns out the reason they are raising is to normalize rates versus respond to economic growth they may create a problem as the perception of a less accommodative environment causes a slowdown in real estate activity.  At present the futures market does not believe a rate hike is going to happen in June but that does not mean that it won’t.  There is plenty of time between now and the next meeting for data to impact the decision.

The last time The Fed raise rates back in December stocks corrected briefly.  That was the second correction.  Stocks also sold off last summer when The Fed started discussing the idea.  Late winter and into the spring stocks staged a strong rally with the S&P 500 touching on all-time highs.  Stocks have pulled back during Q1 earnings season, which is coming to a close, where results have been mixed but not a disaster.  With two recent corrections and a generally improving economy it is remarkable stocks have held up which is reason to believe there won’t be another steep correction.

If the U.S. economy has more strength than is currently realized, small rate hikes at current low levels should have little impact on economic activity.  Therefore, we would expect a recovery in earnings to materialize which should lead to higher stock prices.

The other factor that makes this particular round of market analysis more difficult than the environment that led up to the 2008 bear market is there is no obvious market threat the way the subprime market was a potential problem back then.  Sure, there are lots of possible culprits but no one central market risk that could send stocks into a bear market at least here in the U.S.  There are some who suggest the next market collapse will be sparked in Japan, China or a coffee shop in Venezuela.  It is true, most of the rest of the world is a mess.

It is interesting that Walmart reported earning this morning and the stock was up 8.6% as I wrote this note.  If the price holds it will be their best one-day gain since 2008.

Pro Forma & Reported Earnings Spread

The Wall Street Journal recently published an article suggesting earnings are far worse than reported based on a widening gap between Pro Forma and Reported (GAAP) earnings.  Pro Forma earnings exclude certain items like restructuring charges and stock based compensation and shows U.S. companies earning 0.4% more in 2015 then 2014 – the weakest growth since 2009.  When you look at earnings based on GAAP reporting EPS actually fell by 12.7%, the sharpest decline since 2008.

There is also concern about “one-time events” taking place every quarter.  One-time events allow a company to clean up their books by writing off bad investments, accounting for the cost of a layoff or other infrequent business expenses.  It sounds like bad things are happening in corporate America on a more frequent basis.

Investors continue to plug their nose in hopes this is a short-term development with sales and profits to recover later in the year.  It could happen, often during a earnings decline the market will anticipate the earnings recovery sending stocks higher.  This late in the credit cycle risks are higher earnings will contracting further before making a recovery.

Q1 earnings have been adjusted down by analysis, probably too low, which allows companies to “beat” their estimates sending the stock higher.  Just another reason for investors to be very selective and careful regarding their exposure to stock investments.

4.5.16 Q1 Earnings Growth