The Market: April 2018

Corporate earnings season is under-way.

Expectations for the 1st quarter are high as analysts look to new lower corporate tax rates and a fairly strong economy to deliver good results. The US dollar has been declining against other major currencies which also should provide a tailwind for companies that have significant overseas revenues.

As I have written, over time, profits drive stock prices. Unfortunately, investors need to get through the short and intermediate-term before they arrive at the long-run.

Markets anticipate and price-in expectations

While earnings may indeed come in strong, there are forces at work that may mitigate the positive impact. The first is the phenomenon that markets anticipate and price-in expectations.

It has been conventional wisdom since Donald Trump won the Presidency in November 2016 that there would be tax cuts and deregulation that would push corporate profits higher. After Election Day, stocks soared and continued to rise steadily throughout 2017 and through to the March correction.

How much of the upswing in stock prices has already discounted the positive news of higher profits? If it already has, then stocks might not move up that much now that the profits related to policy changes are actually coming in.

A return to rising interest rates and inflation

The second force that could lean on stock prices is a return to rising interest rates and inflation.

After all, it was concerns about rising rates and inflation that may have knocked stocks into the March correction in the first place and there are no signs that either is heading lower.

  • The rate on the 10-year Treasury note hit 2.92% on February 22nd and is at 2.87% now – almost the same.
  • The rate on the 2-year Treasury note was at 2.25% on February 22nd and now is higher at 2.43%.

On the inflation front, oil prices have found a bid and at almost $69 a barrel is already beyond what many pundits said oil could ever get to.

Industrial metals, principally copper, nickel, and zinc, are also strong.

Will higher input prices dampen the benefits of lower taxes on profits?

Signs that risks are growing

Whether stocks can continue to rise in the short-run remains an open question.  The correction that began in Mid-March is not over yet.  The S&P500 sits at 2,709.  Not until a new high is made at 2,873 can we say the correction is over and that the bull market is still intact.

I suspect the bull market continues but there are signs that risks are growing.

In addition to interest rates and inflation there were two recent weak economic reports from Europe that surprised the markets given that the narrative has been that, for the first time since the 2008 financial crisis, there is across the board global economic growth.

These reports may turn out to be outliers but nevertheless merit attention. Again, I think stocks will make new highs.

The new tax code will allow companies to increase dividends and stock buy-backs.  Corporate buying has been a powerful source of demand for equities.

As the market recovers, a prudent approach is warranted, and slowly building cash might also be a good idea.

— Ian Green, Pendragon Capital Management

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Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.