Q1 2019 Market & Economic Review

U.S. stocks experienced a strong rally in the first quarter of 2019.  The biggest performance driver came from the Federal Reserve pausing their interest hikes.  Between 2017 and 2018 the Fed raised the Fed Funds rate approximately 8 times and until recently expected to continue raising rates into 2019.  The sell-off in Q4 was largely attributed to the Fed moving too fast with interest rates combined with lofty stock valuations and a mild slowdown in economic activity.  The Fed is also in the process of reducing their balance sheet by selling back the bonds they purchased during their QE program.  They reached a level of $50 billion per month but have since slowed the program dramatically and expect to put it on hold soon.  The Fed actions suggest that while the U.S. economy continues to improve, it remains in a fragile state.

Economically we are experiencing a mild slow-down as reported by Doug Short of Advisor Perspectives in his “The Big Four Economic Indicators”.  For example, January Real Income experienced a sizable decline, but that was after 8 months of growth and followed December’s increase of 1.06%.  Real Sales in February also dipped and 4 out of the last 11 reports have shown declines.  Industrial Production appears to be pausing, with a combination of 2 shallow declines and one small increase during the last three months.  Employment remains the shining star, but February almost reported a decline.  Here’s a look at recent numbers (several reports for March and one for February still need to be updated).

In a report by State Street Global Advisors, they reported confidence of North American investors shows a slight improvement while confidence for European investors declined further.  In the U.S. investors appear skeptical.  In Europe they are faced with BREXIT and a host of other challenges, including violent protest in Paris.

Regarding all the talk about the Yield Curve inversion, we remain in an extremely low interest-rate environment which may reduce the predictability of a future recession a yield curve inversion has had in the past.  The other factor to note is the long lead time between the inversion and the start of a recession (16 months since 1976).

We are at the very beginning of Q1 corporate earnings season.  As of last Friday, 25 companies have already reported quarterly earnings.  Overall the market expects a decline in earnings compared to a year ago.  However, as of April 5th industry analysts project a 8% price increase for the S&P 500 over the next 12 months according to FactSet.  During the last 5 years analysts have overestimated their 1-year price target by 1.5%.  The more constructive takeaway here may be the directional move versus the magnitude of the move, especially give the gains produces in Q1.

There are two developments currently working their way through the political process that could have a positive impact on the market.  A favorable resolution to trade negotiations with China and talk of an infrastructure bill, potentially ready for a vote this summer.  Positive developments in these two areas would go a long way toward helping the economy get back onto a stronger growth trajectory.

Overall, I feel pretty good about the economy and markets.

Spare Us the GDP Agony – Brian Wesbury, First Trust

Real GDP grew at a 2.6% annual rate in the fourth quarter, and while some analysts are overly occupied with this “slowdown” from the second and third quarter, we think time will prove it statistical noise.  Even at 2.6%, the pace is a step up from the Plow Horse 2.2% annual rate from mid-2009 (when the recovery started) through early 2017.

Fourth quarter real GDP growth happened in spite of a huge decline in retail sales for December (itself suspicious and likely to be revised higher, as job growth and retailer reports painted a very different picture).  Moreover, business investment grew at a 6.2% rate in Q4 and was up 7.2% in 2018, the fastest calendar growth for any year since 2011.

In 2018 as a whole, real GDP grew at the fastest pace for any calendar year since 2005.  And what’s even more impressive is that year-over-year real GDP growth has accelerated in every quarter since the beginning of 2017.  The first quarter of 2017 was up just 1.9% from a year earlier while subsequent quarters showed four-quarter growth of 2.1%, 2.3%, 2.5%, 2.6%, 2.9%, 3.0% and now 3.1%. We expect Q1-2019 GDP to slow like many other Q1s in recent years, meaning this impressive streak may come to an end.  But this too is just statistical noise, and the YOY trend should remain around 3%+ over coming quarters.

“Potential growth,” a measure of how fast the economy can grow when the unemployment rate is stable, has also improved. It’s calculated using “Okun’s Law,” which says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.

Working backward from the unemployment declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, potential real GDP grew at just a 0.6% annual rate.  But in 2018, with real GDP growth of 3.1% while the jobless rate dropped only 0.3 points, potential growth was 2.5%.

The worst part of the GDP story is the political gamesmanship of those who say real GDP only grew 2.9% in 2018.  These data distorters are not looking at the size of the economy in the fourth quarter of 2018 compared to the fourth quarter of 2017; instead, they are comparing production through all of 2018 to production in all of 2017.

Here’s why their method is misleading.  Let’s say that in the first quarter of Year 1 a company earns $100 per share then earnings slip to $99 in Q2, $98 in Q3 and $97 in Q4.  Then, in Year 2, earnings start at $97 per share in Q1, go to $98 in Q2, $99 in Q3 and finally back to $100 in Q4.  Overall, for two years earnings per share were flat.  But that’s because earnings growth was bad in Year 1 and good in Year 2.  But the misleading method used by those saying the economy only grew 2.9% in 2018 would compare total earnings in Year 2 ($394) to total earnings in Year 1 ($394) and say the company had zero growth in Year 2!  But that’s nonsense.  What matters in measuring Year 2 is how much earnings grew during the year, and in our example, that was 3.1% in Year 2.

More commentary from Brian Wesbury can be found on his blog.

Inspiring Podcast by Great Investing Minds

Check out this podcast by one of our top investment providers, ARK Investment Management.  In Episode 9 of FYI (For Your Innovation) you are going to hear from three people.  The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist).  During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer.  A truly inspiring, power packed podcast, on investing in disruptive innovation.

Now We Need A Follow-Through Day

True, some of the largest single-day stock market gains come during bear markets.  December 26th, 2018 marks the first time the Dow Jones industrial average gain 1,000 point in a single session.  Experienced stock market investors know, one big up day does not mark the end of a downtrend.

Investors should also note, Wednesday’s advance was the first day of a rally attempt.  If stocks can stage another meaningful advance in the next 7 trading days, preferably on day 4 through 7, the worst of the selling may be behind us.  Rally attempts followed by follow-through days are no guarantee, but they often signal the start of a new uptrend.

Source: Investors Business Daily

There were other signs of optimism in Wednesday’s big advance.  Stocks from retails, software, internet and consumer spending led the market’s upside.  Growth stocks are preferred over mature, defensive sectors when leading the market out of its first bear-market correction in seven years.

The ratio of advancing stocks to declining stocks delivered wide breadth, another positive.  Nasdaq winners outpaced losers nearly 4-to-1.  On the NYSE, winners led by 5-to-1.

Also of note, there is a tiny but growing group of quality growth companies forming attractive chart patterns.  These companies feature strong fundamentals, especially in terms of sales and earnings growth.  Often, they are smaller, younger companies introducing new products and services.  It is one of the more encouraging signs given the renaissance of innovation and entrepreneurship underway, something we have not experienced to this degree since the 90’s.

If stocks can hold levels this week and deliver a strong rally on any day next week, that would deliver a perfect follow-though day and improve the odds of a new rally as we enter 2019.

Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

The Grind To Lower Valuations

Let’s think about the future for a moment.  After all, that is what the stock market is doing constantly.  Up to this point in 2018, the stock market has had a very positive view of the future.  Why wouldn’t it?  Corporate sales and earnings growth have delivered in the strongest economy since 2008.

In addition to an economy that is strengthening, we are also experiencing an innovation renaissance.  Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs.  If you spend any time following science and technology news, rarely a week passes without a new scientific announcement.  Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990.  The future did not look very bright.

The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds.  Many commentators point to the increase of debt by corporations as a major risk for the economy.  So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.

At some point in the future we will see another credit event like the sub-prime debacle of 2008.  That is the nature of a credit-based global economy and it will likely trigger a deep recession.  Perhaps we are on the verge of such an event but the high-yield market does not seem to think so.  It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.

Stockcharts.com, Dightman Capital

If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.

I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S.  But I digress, that is the past.  What is more important is will these policies allow the U.S. economic expansion to continue?

In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight.  I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession.  There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.

Are Cracks Forming in the High-Yield Bond Market?

While high-yields bonds (HYG) have held up better than equities, there are signs of cracks forming.

Negative developments at GE have caused some to speculate more highly leveraged borrowers are looking at downgrades.  The lower tiers of investment grade ratings currently represent a large number of bonds and if we see a series of downgrades pressure could mount on the corporate bond market, both investment grade and high-yield.

I am still viewing this entire episode as a cycle slowdown and not the end of the cycle.  The Fed will likely put the break on interest rate hikes in 2019 if credit markets continue to rumble.  The real estate market has already broadcast a slowdown and change in buyer behavior attributed to higher interest rates.  Weakness in the corporate bond market has their attention.  One aspect that may be overlook in the corporate market, however, is the impact of corporate tax reform on the ability of borrowers to service debt more effectively.

The U.S. economy is still doing well and there may be more to come if congress can get together on an infrastructure project.  Trade talk with China remains a risk but so far the impact to the U.S. has been limited.

I have set another alert for the high-yield market.  Should it trigger I will become more concerned about junk bonds rolling over which would likely represent a negative development for stocks.

Sellers Push Markets Lower; Most Stock Breakouts Hold

After a swift and intense decline in October, U.S. stocks are trying to rally but face renewed selling pressure in November.

One of the current challenges is the performance of international stocks.  The economic recovery and central bank policies of Europe, Japan and China continue to lag results in the U.S.  This divergence has created a significant valuation gap and instead of international stocks catching-up to the U.S., investors may be looking to revalue U.S. stocks lower.

Here is a look at the Price to Earning (P/E) and Price to Book (P/B) ratios of international (EFA) and emerging market (EEM) stocks compared to the S&P 500 (IVV).

IVV  P/E 23.29, P/B 3.33  (U.S. Stocks)

EFA  P/E 13.87, P/B 1.59  (Developed Country Stocks)

EEM  P/E 11.94, P/B 1.52  (Emerging Market Stocks)

State Street, BlackRock, Dightman Capital as of 11/12/18

As the data above shows, U.S. stocks are trading at a premium to the rest of the world.  The P/E ratios above are calculated using 12-month trailing earnings.  If 12-month forward earnings estimates were used the P/E ratio for US stocks would be significantly lower.  Strong earnings growth projection for U.S. stocks explains why there is such a large difference between trialing and forward P/E calculations.

The risk to U.S. markets is a reduction in the P/E and P/B ratios through lower stock prices despite a healthy U.S. economy and corporate earnings environment.  Stocks could trade down another 10-20% from current levels to narrow the gap but U.S. stocks should be able to maintain their independent valuation despite lower growth and valuations in other parts of the world.  This would be based on continued sales and earnings growth.  High growth environments are often reward with premium valuations.  In terms of opportunities in international stocks, eventually they may represent an attractive investment opportunity but as a group they appears to have more economic work to complete before they can stage a strong recovery.

Interestingly, leading growth stocks have held-up pretty well during the selling this past week with the number of stocks reaching new highs for the NASDAQ well above lows back in October.

It will be important for the New Highs-New Lows index to move back into positive territory.  The performance of leading stocks is an important sign of when to potentially take defensive action.  If high-growth stocks are holding up in a market correction, the likelihood of a bear market is lower.

End of This Cycle

Some commentators are suggesting we are at the end of this cycle.  However, they may be failing to recognize that in this cycle we spent the first 8 years in repair mode and only recently began a phase of strong economic growth.

Weak Credit Markets

Another clue to the health of the overall environment can be found in credit markets.  Some commentators have suggested the flat yield curve is a sure sign of a pending recession.  What they may fail to realize is this is a common occurrence for years leading up to a recession as short-term rates move higher while long-term rates remain somewhat anchored due to a deflationary trend cause by globalization.  We are only one-year into a rate rising process and remain at very low rates.  Some rate sensitivity has been reported which may help The Fed pause at some point in 2019.

High-yield bonds are holding up well which is something we would not expect if we were moving towards a change in the market cycle.

Mid-Term Results

The stock market had a strong day on November 7th and some observers believe there is a reasonable chance of an infrastructure bill passing which should be well received by the market.

Trade Negotiations

In terms of the international trade, progress has been accomplished.  However, China and the U.S. have very different approaches, definitions and attitudes on the subject which could mute economic growth next year if an agreement is not reached.

There are always risks and “what if” considerations when monitoring market cycles.  On balance I believe we are still in an expansionary phase economically which could last longer than many people anticipate.  There are risks and conditions could change quickly but in total I believe the current selling is corrective in nature, and even if we see additional declines, I believe stocks will resume the current uptrend.