What Did We See?
- Markets around the world diverged in the second quarter of 2018.
- The US fared relatively well while Emerging Markets and Asia have stumbled.
- Volatility and fear has increased around the world as trade rhetoric heats up.
- Europe continues to see some weakness while the UK saw a significant bounce back.
Where do we stand?
- The resetting of expectations and “breather” we have talked about for some time came in Q1.
- Q2 brought us a consolidation phase that is not too uncommon after a correction.
- The earnings and global growth outlook remains supportive of higher than normal valuations for now.
- We continue to rebalance your accounts accordingly.
Confusion of Confusions…
In what is widely accepted as the oldest book ever written about a stock exchange, the Spaniard Joseph de la Vega (in 1688 no less!) did a masterful job of encapsulating the intricacies of speculation. It is a great read that we suggest anyone so inclined to explore. Confusion of Confusions (originally titled Confusion de Confusiones), holds many nuggets of truth that still bear relevancy today. One of those truths was his “Fourth Rule of the Share Market.” Specifically, “He who wishes to become rich from this game must have both money and patience.”
Today we are presented with a stock market that is more confusing than certain, more stuck than trending. After a very strong January rally and subsequent aggressive decline, the markets have moved relatively sideways since mid-February. While the overall trend higher is still intact as of the time of this writing, the prevalence of rhetoric around tariffs, an aging bull market, rising interest rates and “the coming recession” have led market participants to take pause. While the U.S. market performed better than most global markets in the second quarter the question remains, where do we go from here?
Earnings Drive Stock Prices
If the old adage that states “earnings drive stock prices” holds true then the US markets should be able to “survive” the trade rhetoric. US companies are healthier than they ever have been. US unemployment is at the lowest level since 1969 and wage growth has been accelerating, driving strong gains in retail sales. US earnings growth has outpaced the rest of the world primarily due to tax cuts and stock buybacks. Even without these “one time” accelerators, the operating earnings of large US companies are likely to grow in the double digits this year.
If 10% or more earnings growth is not enough to drive prices higher or at least sustain the equity indexes at these levels then the market must be overvalued today. Yet, when we explore the valuation metrics of US equities we don’t believe that to be the case. The forward price-to-earnings ratio ( a commonly used valuation metric) today stands at just slightly above 16. This is actually slightly lower than it stood at the end of the first quarter. It is in line with the five year average and about 10% above the 10-year average. (That 10-year average includes the period of the “great recession” of 2008/2009.) In 2000 (right before the “dot-com” bubble burst) that same valuation metric stood at about 26. All of this speaks more to a “rolling bear” than it does a market collapse.
A “Rolling Bear”?
To quote from last quarter’s newsletter:
“As we have been pontificating for some time, the US equity markets spent much of 2017 (and all of the fourth quarter) in a “melt-up” scenario. A perfect storm of strong economic data, low inflation, a complacent Federal Reserve and the prospect of a boost from corporate and personal tax cuts all conspired to drive equities higher. This drive higher came with no regard to risks (geopolitical or otherwise) and with little to none of the volatility one would expect to accompany a market that returned more than 20% in 2017.”
This is a much different market today. Today the markets are seeing the risks that are rising in global markets. However, the markets are not applying a “one size fits all” attitude to how those risks are accounted for. No, the markets have been selectively applying those risks in a much more “rolling” fashion, moving from one region or sector in step fashion. The series of blows that the markets are wrestling with have effected riskier assets first (like Emerging Markets – down more than 3% during the quarter). Meanwhile, those assets deemed to be safer havens (US Large Caps for example) have seen little effect or even positive returns. Eventually one would expect all areas to have been effected but by the time US Large Caps are addressed the other areas very well may have recovered.
The same scenario can even hold true for sectors within an index. US technology stocks were the darling of the indices earlier this year but have been seeing selling pressure as of late. While nothing is immune to this type of a “rolling bear” the more defensive sectors (consumer staples, utilities, selective healthcare) may fare better for a period of time. Let’s take a closer look at these markets.
The U.S.
The strength of the U.S. economy allowed the Federal Reserve to raise rates again in June while signaling two more hikes this year and a further three more in 2019. While the Fed may be forced to slow this pace of rate increases their intention is clear. The Federal Reserve wants to normalize the interest rate environment. While the Fed has been acting, the yield curve has seen some significant shifts. Simply put, the yield curve is the difference between short and long term interest rates. The Fed’s actions have “flattened” the yield curve and many fear they will ‘invert” the yield curve. An inverted curve is one where short term rates are higher than long term rates. An inverted yield curve has historically been a very good indicator of an impending recession.
While the yield curve is something to keep a very close eye on, the economy in the U.S. remains strong. As cited earlier, economic indicators (Unemployment, wage growth, earnings, etc…) are all seeing strong gains. The only concern is whether or not we are at the peak of these indicators or there is more room to grow. U.S. Treasuries can’t seem to hold above 3%. This could very well indicate that the peak in growth has been seen in the near term. This is not a terrible thing and doesn’t mean a recession is coming. However, it may mean we are closer to the end of the party than many people think.
The Rest of the World
The rest of the world did not fare as well as we did. In the Eurozone economic indicators have continued to weaken. This caused the ECB (European Central Bank) to announce that they would not be looking to raise rates until at least next summer. The ECB has remained highly accommodative and those markets remain stable enough. In a turnaround from last quarter, the UK saw a bounce back in retail sales, combined with the lowest unemployment since 1975. While this would suggest that UK rates will rise at some point this year, their market saw the best return out of the group last quarter. However, expect volatility there around continuing Brexit negotiations.
The emerging markets and Asia experienced the worst of the trade war rhetoric. As the dollar continued to strengthen, fears of an all out trade war drove emerging markets and Asia (Ex-Japan) into negative territory for the quarter.
In summary, the global bull market trends are intact but weaker. The US economy has grown almost continuously since the 2009 bottom. Unemployment around the world remains low and inflation is in check. We are undoubtedly closer to the end of this secular bull market than the middle but it is likely not over yet. We remain positive on global growth but aware of the uncertainties that exist.
Where do we stand at Shorepine Wealth Management?
Earlier in 2018 we experienced the correction we have been expecting for some time. Oftentimes, after a correction we see a consolidation period where things get “confusing”. That is where we are today. As of the end of the quarter, the Large Cap index was trading right in the middle of the range that has been in place since early February. At the same time, the “rolling bear” has been moving from one region (or sector) to the next. It is still a great time to be an investor. However, one’s attention in the near term needs to be on the recovery from this rolling bear.
Corrections are good things. They reset investor’s expectations. They ensure that individual stock level valuations are warranted and earned. They bring opportunities for investors to rebalance and re-invest. They clear out “melt-ups”. Markets correct on average about once a year. Our last correction was over two years ago, so we were well overdue.
As discussed earlier, today the forward looking P/E on the broader large cap market has moved from a high of above the 18 level at the beginning of this year to slightly above 16 today. That is a significant reduction in valuation. We have moved back off of what some would consider overvalued and we would could consider the market fully valued now.
We will continue to work together to navigate these markets to the best of your current situation, goals and risk factors. As always, we wish you well for the coming quarter and look forward to talking about your investments soon.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to contact me. As always, if you know anyone that may benefit from working with Shorepine Wealth Management we would cherish the opportunity to introduce ourselves.
We appreciate your being a part of our family and wish you all the best!
Investment Products are Not FDIC Insured. No Bank Guarantee. May Lose Value. Investing involves risk. All written content on this website is for information purposes only. Opinions expressed herein are solely those of Shorepine Wealth Management, unless otherwise specifically cited. This is neither a solicitation of offers to buy securities nor an offer to sell securities. Past performance is no guarantee of future results. Material shown here is believed to be from reliable sources however, no representations are made by our firm as to another parties’ accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. Shorepine Wealth Management, LLC is a registered investment adviser offering advisory services in the State of California and in other jurisdictions where exempted.
