Here is our monthly view of the financial markets and some of the thoughts that go into our investment decisions.
The stock market is gripped once again by the US-China trade negotiations. The US has upped the ante by increasing tariffs on $200 billion of goods imported from China. President Trump has threatened to expand the list. China has retaliated and could consider other measures. It may well be that the threats and negotiations will go on longer than most have been expecting. At this point, it is unclear what a win looks like to either side. While most believe it is in the best interest of both countries to get a deal done as quickly as possible, the two sides may not be able to deliver. The markets have been down in response to the escalating trade tensions but this is after the market hit fresh highs. It seems that the trade issue will hang over the market, dampening any good news. Earnings for the 1st quarter came in better than most feared. According to FactSet, with 90% of S&P500 companies reporting, 76% of S&P500 firms beat their earnings estimates and 59% reported positive revenue surprises. The markets are a game of expectations. The earnings beats drove stock prices higher but it is important to note that earnings were actually down 0.5% when compared to the same period last year. This is the first decline in earnings since the 2nd quarter of 2016. Analysts forecasted that earnings would be down 4% from a year ago. Being less bad than expected is good. The S&P500 trades at 16.5 times earnings which are about the average for the past five years. The market is not cheap but also is not extremely overvalued, especially considering interest rates are so low. The earnings picture for the second quarter isn’t shaping up to be great. Sixty-five of the 500 companies have offered lower profit guidance versus just 17 companies guiding higher. This makes the trade issue more concerning. It’s one thing to introduce some profit uncertainty when earnings are rising. It’s another when earnings are soft. While 16.5 times earnings are within the market’s recent average, if the earnings component to the calculation declines, the price-to-earnings ratio will increase, adding to the precariousness of the market. I would suggest that investors today need to be more cautious than in the past because computer algorithms can take hold and sell programs can be triggered. As we have seen in today’s market structure, without an uptick rule or market-making specialists, selling can become relentless. This is what happened in the 4th quarter of 2018. With computer-driven trading taking up an ever-larger portion of daily volume, it seems like the markets move around in the short-run irrespective of the fundamentals. Despite the fierce ups and downs, the stock market has not really gone anywhere in 15 months. Investors need a robust portfolio with quality growth, value and cash reserves to withstand the downdrafts, to take advantage of buying opportunities and to participate in the upswings. — Ian Green, Pendragon Capital Management
The stock market put up a tremendous quarter that brought prices within a few percentage points of all-time highs. Once the Fed convinced the markets it was not going to blindly hike rates to send the economy to oblivion, the market stabilized from its 4th quarter swoon and launched higher. The other fears that plagued stocks in December are still floating in the collective market consciousness – an inverted yield curve, slowing corporate profits and tariff wars. I’m not convinced that any of these three worries are about to derail the market. While there is a lot of talk about an inverted yield curve, one has not actually emerged. Yes, the very short-end of the yield curve is inverted. However, from 2 years to 30 years it is not. In fact, the curve recently has steepened a bit. When it comes to skepticism about corporate profits, this is not a new concern. In fact, bears have been talking about a weak economy and earnings for the entire bull market and it hasn’t prevented stocks from grinding higher. The ongoing trade war is the one that concerns me the most. Global trade has proven to be a key ingredient in global growth. The stocks that make up the S&P500 derive about 45% of their revenues from sources outside the US. Supply chains are global and barriers to the free flow of goods can cause disruptions that would drag on profits. Despite the downside, I believe there is a higher probability that the US and China reach some acceptable accord than the probability that a trade war erupts between the two. If a benign deal is announced, the markets will have a reason to rally. The bearish argument is aways the easiest to construct. In 2018 the stock market was down and for about a year and a half stock prices were flat. This is not unlike the 2014-2016 time period where stocks went nowhere and was a frustrating time for investors. The flat market proved to be just a pause in the upward market trend. This time could be similar. If the market manages to make a new high, investors who have been on the sidelines will be drawn in, refreshing the bull market and drive another upward leg in stock prices. First quarter earnings will be released over the next several weeks. Expectations have been lowered so it is possible that we may see profits beating expectations. The expectation game is a typical exercise on Wall Street. The market builds in a conventional consensus to what it thinks revenue and profit will be. Often the analysts tend to have relatively low estimates which helps companies “beat” their forecasts. Most of the time stocks react positively to the “beat”. Why do estimates tend to be lower? There are two possibilities. One is what was mentioned before. The bearish case is the easiest psychologically to build. The second possibility is that the industry prefers to set up a positive market surprise. In either case, the next few weeks will be important for investors. — Ian Green, Pendragon Capital Management