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The stock market ended the quarter much different than it began. Stocks roared in January with the S&P500 jumping more than 5% to set repeated records; until January 26th. Then, it’s as though the electrician changed the direction of the wall switch. As we wrote in our March commentary, “Agitation Overdone”, the current pullback is the first drawdown exceeding -5% since February 2016 (almost 2 years), or 404 trading days. The February drawdown took 10 days to erase -10%, wherein 83% of stocks declined -10% or more and the average stock gave up -14%. March vibrated back and forth, retesting the February lows. Corrections (-10% decline or more) are never comfortable, but most evolve into new rallies. The evolution process typically involves 3 components – price, time, and emotion. Price action can be quick, while emotional change takes time before playing out. It seems probable that additional time and the evaporation of bullish emotion (sentiment) are needed before the Bull run continues. An important part of any corrective process is converting optimism to pessimism. Today, we are closer than at the early-February lows, which were retested in late March/April – now almost 30% of stocks are down 20% from their highs.
For 1Q2018, the S&P500 fell -0.8 for its first quarterly loss since 2015. Most every index lost ground during the quarter. It always seems inappropriate to get too caught in daily market movements, but as I write today (first trading day of 2Q), the stock market is very unsettled. Investor confidence is getting wacked (which is a good contrarian indicator), and this is necessary to ultimately achieve a corrective low. Further, tech stocks are taking the brunt of the hit; again, this is okay as the “best performers go down last.” The hit to Big Tech suggests the market’s corrective process is moving forward.
So, what is your emotional “heart rate” doing – racing ahead, or beating normally? Do you need an emotional “pulse check?”
Client portfolios performed better than the markets during 1Q for several reasons. First, no client portfolio is only the stock market. A typical portfolio owns bonds and stocks. Stock exposure is diversified to own large, medium, small-size companies and foreign growth and value-style funds. Second, we de-risked the stock portfolio allocations in December (or early January in many taxable accounts) to rebalance an appreciated exposure in riskier growth-style funds (which owned more expensive tech exposure) into value-style funds. We also own foreign stock fund exposures which are helping diversify portfolio returns. Third, and important, we own active managed no-load mutual funds, with a couple of ETFs in select areas. Active managers employ security selection criteria and portfolio management disciplines that attempt to manage risk; this key attribute provides a buffer during market drawdowns. Passive index strategies (and many ETFs) that “own-it-all,” experience the full movement of the markets; risk cannot be dialed up/down. Even portfolio bond allocation exposures remain de-risked, as this asset class remains a difficult area to invest for the last few years (given low interest rates). Short-term market price action may remain poor. It should be encouraging though that cross asset class action does not indicate financial panic. It is important to be reminded that 12-month returns are very attractive – double-digit positive for portfolio objectives oriented toward growth (see Benchmarking pg. 3). Long-term investing pays attractive rewards.
Most corrections prove to be buyable entry points to the next rally. Yes, there remain concerns over market multiples; valuation is generally elevated but is more attractive than at any point since early 2016. We do not view that the current “noisy news-driven” market environment will evolve into a bear market. More about the market backdrop in another article; but simply stated, the underlying economic fundamentals lend support to a resumption of the current bull market as this year progresses. There is progress in the current corrective process, but more work will occur – time and emotion adjustment is ahead, leading up to the resumption of the Bull run.
Beauty Bests Beast
Try saying “beauty bests beast” 3 times, rapidly. Now, what does this title suggest about the investment environment? The end of March was a “beast?” Alternatively, it was a “beauty” for economic data and continued restrained inflation.
The current business cycle is old, yet not as robust relative to past experience. A number of current economic and political events are creating significant worry for investors. Friction is keen between favorable economic developments (“Beauty”) and those that constrain growth (“Beast”). Components making up the “beast” include tariffs; possible new regulations on FANG & Big Tech; a new Fed composition and policy direction (how fast and how much will rates rise as policy normalizes); and government partisanship – all increase uncertainty about the future. Will the “beast” prove to be too much? Alternatively, attributes of “beauty” include high consumer confidence; unemployment claims at 45-year lows; house prices rising; tax reform and lessening of government regulations; and business confidence is high. In general, we expect “beauty” will best the “beast.” This is, nevertheless, a fluid backdrop for the economy and financial markets. Markets like to test a new Fed Chair, and are doing so at this time.
During times of economic and market friction, market valuations undergo compression. We believe this corrective process is unlikely to progress into a severe downside event. Reason – both domestic and global economic backdrops remain solid, growing in a synchronized manner with generally low, moderate (slow rising) inflation. During 4Q2017, company earnings grew at 15% year-over-year (y/y). US company earnings are expected to expand in 1Q by that much or more. Important too, dividends increased by 9% y/y. These boosts result from strong future earnings expectations, tax cuts, record corporate cash, and business confidence. With so much global liquidity (from easy monetary policies), businesses are actively making deals to buy other businesses in pursuit of growth; deal-making is rapid during this time of market revaluation. These business actions are significant positives in the market backdrop, which should boost confidence to remain long-term about the current Bull market.
Not to be negative, …recessions typically do not start with interest rates and inflation low. Bull markets do not die until the yield curve becomes inverted (short interest rates would be higher than long rates); and low quality bond rates rise quickly after economic growth fears develop. In general, none of the recession/bear market signposts exist today.
As the year progresses, we expect a synchronized global economic growth environment will provide an upward path for stocks, interest rates and inflation. There remains plenty of time for both the economy and bull market to run. But as we stated in the outset of 2018, it may be that the economy performs better than the stock market this year; but both should be a positive experience.
Some Smoke, Little Fire (Tariff Talk)
Since late-January, inflation, tariffs and possible trade wars are the related worry items for markets. Trade tariffs are governmental skirmishes that disrupt global economic growth by changing pricing on products and global supply chains; they are often stragflationary. Stagflation is an undesirable condition defined as slowing economic growth (stagnating) at the same time the price of products are rising (inflation). Tariffs ultimately create stagflation. No one benefits from a trade war, especially one in which the tariff imposing country is raising costs on its own consumers. This is a cause for concern, particularly if escalation builds.
As bad as all that sounds, let’s keep the issue of tariffs in context. In part, that is because of the way our “negative, bad-news” media does its reporting. Please note: tariff announcements are only PROPOSED – not actual; not yet in effect. Proposed tariffs are unlikely to become effective for months to come, and will be modified/adjusted before. Tariffs will not be instituted while negotiations occur. Trade tensions will be a long and hard negotiation process that will “sound” angry. And, no one wants the path of trade wars. While not many of us endorse Trump’s style or methodologies, it appears he is always negotiating in pursuit of what he believes is pro-growth (even when actions appear the opposite, like via tariffs).
Since mid-March, the stock market has reacted with negative mood to proposed tariffs against China and others and probable retaliation. Two-thirds of this market correction took place after the first headline crossed on March 13. It is interesting though to look at the numbers – the economic impact of recent fiscal policy actions. It appears investors are overestimating the potential impact of increased trade tensions and underestimating fiscal stimulus In December, tax cuts of $200 Billion were passed and are estimated to boost economic growth; fiscal spending will add another $100 Billion in growth; AND repatriation of foreign earnings by companies will bring $500 Billion back to the USA. That adds up to $800 Billion of extra money to boost economic growth in 2018. On the other hand, tariffs of $37 Billion are a subtraction to growth by comparison (see chart pg. 3). We are not yet hearing about negotiations beginning between China and the US; but tough negotiations will assuredly occur. We only hear news of harsh words with threats by both sides (and Trump’s twitter does not help). Look at NAFTA – it started off sounding terrible, but the renegotiation process is progressing. Negotiations may provide a better business position for the US in various areas of trade, and thereby benefit economic conditions in 2018 and beyond.
Financial markets are reacting to the threat of greater escalation in the short term. We sincerely hope all the noisy news does not impact business confidence. During an unsettled time, investors can benefit from the market corrective process that adjusts market valuations lower. That means buying stocks “on-sale.”
One last thought – recall our February commentary, “Super Bull”. During the 3 super Bull cycles since the 1920s, there were 18 declines of -7% or more, with the 3 biggest declines being -17%, -19%, and -21%. These market corrections created emotional moments that caused investors to “feel” the bull market was dying. Bull market runs are not straight up, or gradual upward paths. They incorporate up/down variations which often provide a corrective “pause that refreshes.” We suspect the current correction, dramatized by tariff wars, is a news distraction that provides attractive opportunity for long-term investing. It’s probably more smoke, than fire.