Summer 2018 Market Perspectives

Ryan Hanna

Ryan Hanna

July 30, 2018

Market Perspectives

As the current economic expansion passes its 108th month and now represents the second longest expansion since 1900 (second only to the 120-month period from 1991 through 2001), it is reasonable to wonder if the best days of the stock market rally may already be behind us. Risks facing our economy, including concerns around global trade, tightening monetary policy, higher interest rates, and an increasing budget deficit are greater today than in recent memory and could potentially cap market gains for the remainder of 2018.


Equities

As this market cycle ages, on the margin we have begun making some necessary adjustments within portfolios. During the first half of 2018, we added or increased our exposure to some of the more traditional “value-oriented” sectors, industries, and stocks, such as integrated energy, financials, and telecommunications. We eliminated some growth-oriented holdings that met our price target and reduced others that had appreciated significantly or had an unfavorable risk-versus-reward ratio. Despite the fact that growth stocks continue to work, and the information technology sector continues to represent leadership in the market, we are mindful of valuations, high correlation among these “winners,” and avoiding the herd mentality. Even core positions should be pruned from time to time. These types of modest changes can help us to reduce some of the risk within our equity portfolio incrementally and add an element of defensiveness within the strategy.

In the first quarter of 2018, corporate earnings for companies in the S&P 500 Index increased over 25% compared to the same quarter last year. While almost two-thirds of that increase was the result of higher profit margins driven by lower corporate tax rates, 9% came from higher revenue and another 1% came from share buybacks.

Earnings for the recently completed second quarter are forecasted to grow by more than 20% compared to the second quarter of 2017. Additionally, S&P 500 dividends increased 8.1% versus 2017 to $52.63, reflecting strong earnings, tax cuts, record corporate cash, and strong business confidence.

As a result of 20+% earnings growth and only modest increases in stock prices thus far in 2018, the P/E ratio for the S&P 500 has compressed by almost 15% and is trading at only 16.1x current earnings as of June 30. In fact, across most style or capitalization segments, aside from small cap growth and core, valuations are within 2%–3% of the 20-year average (plus or minus). The 20-year average P/E ratio for the market is 16x, so valuations are right in line with the 20-year average, partially dispelling the notion that the markets are “overvalued.”


Economy

It's hard to question the strength of the US economy right now. Currently, the unemployment rate is hovering around 4%, with the most recent data indicating an increase in the labor participation rate, combined with roughly 200,000 new jobs. Given the tight labor market, we are seeing some signs of a pickup in wages, which is good for employees and, at this point, can be digested by corporations via the positive impact from corporate tax reform, without much of a margin impact.

Capital spending is trending higher. Manufacturing momentum remains robust. Inflation, minus food and energy, remains subdued. Despite the increase in home prices, housing affordability remains at very attractive levels given low mortgage rates (albeit off the bottom). Housing starts are trending higher. Vehicle sales remain firm at around 17 million SAAR (seasonally adjusted annual rate) as of June. Importantly, the balance sheet of many consumers remains healthy. Across the US, the household debt service ratio, which measures debt payments as a percentage of disposable income, is below levels last seen in the early 1980s. Household net worth is at an all-time high, driven by the combination of home price increases, savings, and retirement assets. Finally, small business optimism is at record levels.


Other Key Issues

Despite the plethora of positive economic data, all is not great. Offsetting the solid fundamental data are three high profile issues that will likely loom large for the remainder of 2018. The three most pressing issues investors are faced with today are a flattening yield curve and widening credit spreads, peak corporate earnings, and foreign trade policies.
 
  1. Yield Curve and Credit Spreads

    While high yield and investment grade bond spreads remain tight relative to historical norms, we have started to see some widening in credit spreads over the past several months. The yield curve has been flattening for quite some time, and the spread between two-year and ten-year US Treasuries is less than 30 basis points (0.30%). With the Federal Reserve on tap to potentially increase rates two more times in 2018, or 50 basis points, we could be looking at an inverted yield curve by winter. That would be an ominous sign indicating a heightened chance of a recession. Notably, during the period of 1994–1999, the yield curve remained in a trading range of about zero to 50 basis points, similar to where we are today, so there is some precedent for a relatively “flat” yield curve for an extended period of time. But this bears watching.
  2. Corporate Earnings

    Having received a major shot-in-the-arm from corporate tax reform, earnings are forecasted to report accelerated levels of growth this year, which is not likely to repeat in 2019 or 2020. So while 2018 will be strong on an absolute and year-over-year basis, it is likely to represent a high watermark in terms of earnings growth and corporate margins for this cycle. As prognosticators begin looking forward to next year and beyond, earnings are likely to decelerate, stoking fears of decelerating growth and peak earnings for the cycle.
  3. Trade War

    The most impactful issue is likely the heightened rhetoric surrounding a growing trade war. There are unlikely to be any winners if the trade war intensifies, as prices for a broad basket of goods and services will likely rise, increasing fears of an unexpected surge in inflation and subsequently higher interest rates.While the concerns over the theft of intellectual property rights by China and fair trade policies may be justifiable, the methodology around how to deal with these issues remains highly questionable. Jason DeSena Trennart, Chief Investment Strategist at Strategas, estimates the negative impact of tariffs to be roughly $120 billion in calendar year 2018. While this $120 billion trade “headwind” is consequential, his argument is it pales in comparison to the fiscal stimulus measures implemented in 2018, which total closer to $800 billion ($200 billion in tax cuts, $100 billion in spending, and $500 billion in foreign repatriation). This positive spin on the fiscal stimulus may help explain why the US stock market is up, when most other foreign markets caught in the crosshairs of this trade war have declined.

Conclusions

There hasn’t been much to the current economic cycle that has been “normal.” What started with a financial crisis of historic proportions has morphed into the second longest expansion since 1900, fueled by cheap money. While this economic cycle has been long, it has also been somewhat underwhelming compared to previous recoveries and has been below average in terms of cumulative GDP over the past nine-plus years. The economic impacts of the financial crisis in 2008 were devastating, and the actions taken following the crisis were unprecedented. Ten years later, these actions (Quantitative Easing and the expansion of the Federal Reserve’s balance sheet) are still being unwound and, arguably, our economy has yet to fully recover, despite the gains seen in equity markets.

Also, valuations are not unreasonable; unlike the recession that started in early 2000, the market is trading at 16x earnings, not 24x earnings. While it is uncommon at this point in the cycle to get such massive fiscal stimulus, especially at a time when it could be viewed as unnecessary, the playing field now appears much more level in terms of a more comparable corporate income tax rate compared to many foreign nations.

It is also conceivable that the easy money policies of the past ten years pulled forward equity returns (18.5% annualized compounded equity returns, with dividends reinvested, since March 9, 2009, compared to historical levels for stocks at closer to 11%). and Returns from domestic equities over the next decade could be below the long-term average for stock returns. However, following a 37-year bull market in fixed income (interest rates peaked in 1981), with interest rates on the cusp of moving higher after decades of declines and credit spreads already very tight, fixed-income returns will likely be equally (if not more) challenged.

Finally, from an asset allocation standpoint, we are mindful of the growing risks in our economy, despite the ongoing strength of the fundamental data. Accordingly, we have started to gradually and incrementally reduce our equity weighting in portfolios toward neutral from overweight, while increasing our cash positions. We are also starting to modestly shift our growth bias and technology overweight toward a more core blend of growth and value, with more defensiveness to the strategy. With money market funds now yielding over 1.7% on an annual basis, we feel that holding a bit more cash in portfolios is prudent and will serve as dry powder to redeploy should we experience a pullback in stocks.

This article is for informational purposes only and should not be construed as investment or legal advice.