Here is our monthly view of the financial markets and some of the thoughts that go into our investment decisions.
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
The stock market has sharply moved higher, erasing about 60% of the September 20 to December 24 decline. While investors are breathing a bit easier, the mood on Wall Street is far from euphoric. There is a general feeling that the economy in 2019 will slow and corporate profits will decline. The conventional wisdom says that the impact of tax cuts that boosted 2018 profits will fade as we move into 2019. Wall Street estimates for earnings per share (EPS) growth have declined from a 10% increase to a 6 or 7% increase. Given the formula of EPS multiplied by the price-to-earnings (P/E) ratio equals the stock price, if EPS is going to rise less than previously forecast, unless the P/E ratio increases, stock prices will fall. Declining EPS estimates, however, are not new to this bull market. In fact, it has been more of the rule rather than the exception. From 2011 to 2016, analysts forecasted steady declines, each year, in earnings growth. As a result of the new tax law that lowered the corporate tax rate, in both 2017 and 2018, analysts forecasted accelerating earnings growth rates. Important to note, the earnings growth forecasts from 2011 to 2018 were not predictive indicators of future stock market returns. In 2011 the market was flat. From 2012 through 2014 it was up. Flat in 2015. The market returns for 2016 and 2017 were positive and despite rising growth expectations, returns were negative in 2018. With these figures in mind, we should hold the negative sentiment with some suspicion. What no doubt will influence the market in the first half of this year will be the resolution, if any, of the US trade negotiations with China and Brexit. The US has threatened to place a 25% tariff on Chinese imports if China does not come to a satisfactory agreement by March 1st. Raising tariffs to 25%, in my opinion, would be a disaster for global stocks. It would signal a new escalation in the trade war and thoroughly disrupt global supply chains. While the probability of a policy mistake is significant, my sense is that both sides are unlikely to want to risk their economies. As a result, I believe that some small agreement will be reached or there will be a delay in any action and negotiations will continue beyond the March 1st deadline. The impact on the US stock market of Great Britain crashing out of the European Union is harder to determine and will likely be less direct. A hard Brexit will be tough on UK-EU trade and markets but I’m not sure how much of an impact it will have on the US. Having said this, a bad Brexit outcome will no doubt place a drag on global GDP. The global bond markets are expressing some concern over Chinese trade and Brexit. There has been buying of sovereign bonds as a defensive play. US Treasury bonds have rallied and interest rates remain stubbornly low. Demand for German bonds has been strong as well. Despite the Bard’s warning, “Beware the Ides of March”, I’m cautious but hopeful. — Ian Green, Pendragon Capital Management