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Jul. 6, 2018 Commentary

2018 First Half: A Bit Odd, But About As Expected

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“There’s No Place Like Home” - L. Frank Baum, author of The Wonderful Wizard of Oz

Domestic stocks returns were positive, albeit not outstanding in the first half in 2018. Even though the end result was as expected, I’m sure it was disappointing to many investors after a very strong couple of years and a most promising start to 2018. Specifically, Standard & Poor’s 500 index generated a total return of 2.6 percent for the six month period. Not a bad report card in the midst of various headline concerns ranging from angst over the true nuclear missile ambitions of North Korea, to signals from the Federal Reserve that it intends to raise rates throughout 2018 and 2019, to the annoying rhetoric around trade and tariffs that we continue to endure. 

Now, to be fair and all inclusive, the large cap oriented Dow Jones Industrial Average didn’t do as well as the S&P 500; in fact, it declined 0.7 percent. This is mostly due to its heavy exposure to industrial and financial stocks that oddly didn’t seem to want to respond to the healthy economic backdrop. To round out the domestic lineup of indices, the tech-focused Nasdaq was on fire, posting a 9.4 percent return through June 30. The bulk of that — 6.6 percent — coming in the second quarter alone. Similarly, the smaller brethren contained in the Russell 2000 U.S. Small Cap Index recorded a 7.7 percent return for the same timeframe. It could be argued that much of the bounce in small caps is simply a catch-up rally as they significantly underperformed large last year. Still, this is impressive to see and certainly not typical behavior around market tops. 

We have several telling observations as we pause mid-year. The first has to do with geography. In the first six months of 2018, there’s no place like home. The United States was the best place to be by far, and that surprised many professionals. We thought U.S. stocks would provide solid, healthy returns in 2018, but we also thought international stocks might slightly outperform. In terms of the relative weakness overseas, economic growth does seem to have softened a touch in foreign markets during the second quarter, but it is still healthy. We sense the main culprit for the disappointing international returns is due to investors recognizing that export-driven markets are far more vulnerable to any adjustment in terms of trade versus the U.S. economy. We are much less dependent on trade in a relative sense.

The contrast between the accelerating economy and robust earnings trends in the United States, and the very different plateauing trend overseas, is becoming more visible to market participants as we move through the year. So, while the S&P 500 has advanced 2.6 percent this year, developed international stocks (MSCI EAFE) are off 2.4 percent; emerging international markets (MSCI EM) are off a greater 6.5 percent.  The good news: Our clients continue to have substantial domestic stock exposure and we continue to be impressed by the economic strength here at home.

The second key observation is the uneven path the S&P 500 took to land at the 2.6 percent return figure on a year-to-date basis through the end of June. After the nice 7 percent surge in the S&P 500 in the first several weeks of January and one of the best starts to a new year in decades, we saw two noteworthy pullbacks in the first half. The first double digit correction in late January/early February was ironically related to a growth scare and investor concern of accelerating inflation. The second high-single digit decline in mid-March coincided with the Trump administration announcement about potential tariffs on steel and aluminum. It caused concerns about trade wars and the polar opposite risk — looming recession.

Whew, this was quite a whirlwind in market psychology. Both of these periods were followed by relatively swift recoveries that took us back towards all-time highs. In fact, the Q2 return for the S&P 500 was a solid 3.5 percent which takes us to the 2.6 percent first half return for the index. However, because of the marked fits and starts and rotating issues of concern and the lousy final week in June to close out the second quarter, many investors were left feeling dissatisfied even though volatility only returned to normal levels from well below normal in 2016 and 2017, and returns were close to historical averages.

Ultimately, the real key though is what comes next…what do we think about the second half and beyond?

We’re Positive — Based on the Data

Bottom line, we remain constructive and see the market advancing further over the next 12 months. So many folks harp on the fact that this bull market is aged and getting very long in tooth and increasingly warn that we are at the cusp of a market top. We’ve seen these warnings ever since it began in 2009. Remember 2016? Weren’t then plunging oil prices, Brexit and an ugly presidential campaign all signals of an impending crash in the market? Not! While these were major headline worries at the time, the underlying fundamentals were actually trending in a very positive direction…the economy and earnings were accelerating while valuation was reasonable. The adjacent table we’ve put together is a summary of the various fundamental, valuation and technical data we follow closely. If the metrics in these various measures are at healthy levels relative to history and stable to trending in a positive direction, we rate them as positive; if they are at average levels but have been softening in their trend, we rate them as neutral and if below average and in a down trend we rate them as negative. Note that there are many green check marks next to each of these indicators and this keeps us positive. When you see a number of yellow and red check marks in these areas that means they are cautionary to negative...that’s when we adjust our thinking. It is the economic/financial facts and data that drive the market, not headlines.

Data that impacts revenues and earnings.

U.S. Economy Becoming More Balanced — More than Just the Consumer!

One thing that the bearish camp is missing in saying that this economy just can’t keep growing at this point is the increasingly more balanced nature of this U.S. economy. For years it was carried on the backs of consumers and solely a function of rising consumer spending. What we’re just now seeing is a nice uptick in capital spending, both a result of incentives in the new tax law to invest, repatriation and rising CEO confidence. Stimulus from repatriation this year alone should approximate $800 billion to the economy. What this may facilitate is improving labor productivity and the ability for companies to pay higher wages without crimping profit margins, thus perhaps providing an extension of the nice growth we’re seeing in earnings for longer than many expect.

We’re Not Pollyannish — We’re Monitoring Risk Items Closely

We constantly monitor the wall of worry to see if any of the items could derail the market. Trade rhetoric is certainly important to monitor, and we don’t want to make light of it. But, that’s what we think it is right now...negotiation and posturing not “trade war” in nature. And if there was ever a time to pushback on terms of trade with our partners, which are NOT reciprocal/symmetrical at present, the time is now. Why? The U.S. economy is strong and the current stimulus from tax law and stimulus spending swamps the economic drag from announced tariffs by a factor of more than 8 to 1 (see chart from Strategas below).

Size of Fiscal Policy Stimulus Dwarfs Tariff Proposals.

No doubt, the tariff rhetoric has pressured stock prices of industrial and semi-conductor stocks that could be most impacted by potential curbs on exporting technology to China and a global slowdown, should a real trade war ensue. And financials have also under-performed due to the influence these headlines have had on pushing 10-year Treasury rates back below 3 percent. We’ll watch these trends, but because we believe the trade risk is manageable, we expect these sectors to recover. Other sector/asset class thoughts…we are slightly more cautious on international and slightly more positive on small cap in the midst of this trade issue. The markets are recognizing that foreign countries are damaged more by tariffs and ongoing uncertainty on this front than the United States. U.S. small caps are well positioned because they are more domestically focused than large cap multi-nationals.

Bottom line, as long as there is no major trade war, we think folks will once again focus on fundamentals and the market should get a nice year-end lift, or at least lift in 2019.

As for fear of the flattening yield curve, historically the market loves a flattening yield curve. Only inversion creates problems, but even then be careful in immediately calling an end to the bull. Every recession is preceded by an inversion in the yield curve, but there are false positives and huge lags...not every inversion results in a relatively swift market top. In 2005, the curve inverted and the market continued to advance handsomely for another 21 months. It is a mosaic...we draw conclusions by looking at all the data...fundamental, valuation and technical, not just one factor; although yield curve analysis is a key fundamental factor we watch.

Let me close by saying that this year is actually evolving much as we expected. Unlike 2016 and 2017 in which we were publicly very bullish and looking for double digit returns, we thought 2018 would just be healthy/average for U.S. stocks. We publicly discussed this year being one in which “the economy and earnings outperform stock prices.” We anticipated earnings being stellar, but because this is so well known, and because of perception that the Fed would be hiking rates, we felt like there would be some modest P/E contraction (we think trade concerns have led to an over-correction in P/E’s at this juncture versus where we’ll be in 12 months) which would only result in mid- to high-single digit returns for the S&P 500 this year.

We thought volatility would increase back to normal. Finally, as is typical of mid-term election years, we thought returns would be back-end loaded in 2018. With the S&P 500 up 2.6 percent at mid- year, we’re on par for this result. That said, there is a risk that this calendar year is not unlike 1994 and 1984. Both of those years were periods in which the market was flat- to modestly-down despite strong GDP and earnings growth and periods where the Fed was raising rates in measured fashion. The good news: Ensuing calendar years (1985 and 1995) were very good for stocks as investors realized the fundamentals remained robust and measured Fed hikes could not derail those positive forces. 

Parallels to 1984 and 1994

Strategas Research, June 2018

Wrap-up

We remain forever vigilant in monitoring the wall of worry. We know these factors can temporarily spook investors and cause normal corrections. We continue to view them as just that...temporary and not significant enough in magnitude or long lived enough to be actionable. With this favorable backdrop grounded in the data, we believe holding positions and using any excess cash to take advantage of volatility and normal pullbacks is the right course of action given our longer term view.

 

The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy. The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s comprised of 500 stocks chosen for market size and industry group representation. You cannot invest directly in an index.

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