The Market: February 2019

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