Mid-Year Review: Great First-Half for U.S. Equities as Standard & Poor’s 500 Index Hits New Record High…What’s in Store for the Second-Half?
“I don’t make jokes. I just watch the government and report the facts.” – Will Rogers
In our opinion, 2019 is off to a positive start. Through June 30, the Standard & Poor’s 500 Index was up 17 percent, and the headlines in The Wall Street Journal describing the period read: “…Best First-Half in 22 Years”1. U.S. stocks exhibited momentum at the end of this six-month stretch as well, with the S&P 500 recording its best June since 19552.
This result came on the heels of a downturn in December, 2018, with the market lagging more than 19 percent intra-month from peak to trough during the holiday season, as many experts predicted doom and gloom for 20193. As you may know, we were not part of this pessimistic chorus. Going into 2019, we were looking for double-digit returns in U.S. equities and set a high probability target of 2,800-3,000 for the S&P 500. We believe that investors had become too pessimistic and were incorrectly speculating that potential major policy mistakes could lead to an economic recession.
Based on the data, we came to a different conclusion. We saw attractive valuation on Christmas Eve, with the S&P 500 only trading at 14 times earnings (S&P 500 price level at 2,351)4. Furthermore, we saw continued solid economic data — moderating in pace but still healthy — and the absence of typical recessionary signals prior to downturns. In our view, investors were jumping to the conclusion we would get worst-case outcomes on the two major policy fronts: Federal Reserve interest rate policy and U.S. trade policy, and that these anticipated policy steps would be bad news for equity participants. The December pullback, in our view, was based on emotions and not facts. Data told us at the time that this negative psychology should lift as we moved into the New Year and that best-case results on these policy issues were likely to be far from swift or perfect, but that they should be better than feared. Policymakers have too much at stake to embrace negative scenarios on both of these issues. This, coupled with continued healthy economic and earnings data, have given us the conviction to stay the course and maintain our positive view on equities rather than take a defensive stance. We are maintaining this cautiously optimistic outlook.
Good Returns But Far From Satisfying! Why is That?
With all of the positive market signals, we would expect most investors to be thrilled. In addition to the strong equity returns, during this first-half of the year, the U.S. economy celebrated a decade of recovery, earning the distinction of becoming the longest economic expansion in U.S. history5. Our country is experiencing 50-year lows for unemployment and unemployment claims. Wages are growing at an accelerated pace, and the consumer remains confident and ready to spend2. In addition, low mortgage rates are contributing to rising housing affordability and an increase in mortgage applications for new homes.
We have mixed news on the business investment front, yet productivity is showing signs of life after a dormant period. Overall the United States remains in a growth mode. Second quarter real gross domestic product (GDP) growth is estimated at more than 2 percent after 3.1 percent in Q1…conditions are moderating but still growing6. I don’t believe this is a recession.
Still, it’s our observation that U.S. investors appear to be unimpressed and remain in a dour mood as indicated by net outflows in equity holdings. According to Ed Yardeni, president of Yardeni Research, surveys show that investors believe in rising odds of recession within the next 12 months. We agree with Yardeni that, on these measures, this has been one of the most disrespected bull market advances and one of the most anticipated recessions on record. Why the negative perception in light of what we view as constructive data?
In short, we think it’s policy-related and the significant recent ying and yang in the news. This observation is what inspired us to channel Will Rogers and share his quote regarding government policy. We believe his satire on this subject is ever so true today, given the seemingly wide and sudden swings on the policy front in general. Six to seven months ago, the Federal Reserve was increasing rates, and, per the Fed Chair Jerome Powell, the central bank was “far away from achieving the neutral rate7.” Now a Fed rate cut seems all but certain. Such a tack can feel head-spinning, even if it is prudent.
On the trade-front, we’ve experienced several chapters recently. At times it looks as though trade negotiations will lead to a deal, but then, suddenly, there’s no deal. A couple of President Trump’s dinners with Chinese President Xi Jinping (one in Argentina in December and recently in Osaka) have appeared to put trade discussions back on track. Because of this, investors can lose faith in the data and may become paralyzed by fear that policy mistakes are imminent. We aim to stay grounded in the data, and it still tells a growth story.
Our take…Don’t let policy rhetoric and the headlines cause portfolio whiplash. Maintain balance and perspective.
Largely because of investors’ preoccupation with potential worst-case outcomes on the policy front, we’ve seen dramatic shifts in headlines on stock performance in the last seven months. It can’t be summarized in one nice package about the “Best First-Half in 22 Years.” There were a number of good and bad chapters, with a productive net result. During this time, we’ve seen headlines such as “Worst December [for the S&P 500] Since 1931”8, followed by “Best Start to the Year (through April 30) since 1987”9 and “Second Worst May Since the 1960’s”10. Then, of course, we saw stronger returns in June 2019 than we had seen in that month in more than 60 years, as was alluded to earlier.
This roller coaster ride of gains and losses in stocks can make your head spin, absent an investment process to analyze market conditions. These fears about policy mistakes tend to cause sell-offs and then the facts tend to come out. Healthy economic and earnings data is released along with news that perhaps policy is more thoughtful than feared, and the market recovers…wash, rinse, repeat. The challenge is, in this environment, it’s easy to get caught up in the emotion and the performance whirlwind — to sell stocks, become more defensive and then suffer from portfolio whiplash via the period-to-period swings, costing yourself money. We like to say, “Don’t mistake activity for progress.”
Based on the data, we’ve remained invested in equities and have kept balance in our portfolios. We’ve maintained a blend of asset classes and a blend of different types of stocks within U.S. equities that include consistent-growth stocks, cyclical-growth stocks and high-growth stocks. And that targeted and strategic bond exposure provides a ballast during the months when investors may be negative about the direction of policy. In our view, staying the course during these temporary periods has been prudent. The S&P 500 was up 8 percent over the last 12 months and 6 percent since Dec. 1, 2018, when I saw the recession chorus start to sing loudly. Looking at stock market performance, it doesn’t seem to us like a lot of tactical adjustment was needed or helpful during this time frame.
An update on policy events/discussions with China at the G-20:
- Outcome of the talks were about as expected. We saw no breakthrough, but no disaster scenario either — a net positive. A home run announcement didn’t happen, but the deferral of additional U.S. tariffs imposed on China and the announcement that the two parties have re-engaged in negotiations, was achieved. We believe this is both a relief and constructive for the equity markets. While details are yet to come, other nuggets included Trump’s mention that the United States will allow the sale of certain components manufactured by U.S. semi-conductor/technology companies to Huawei after all — an olive branch extended to China. They returned the favor via potential additional purchases of our agriculture products. These gestures may signal room for compromise versus pure rigidity in the discussions.
- We think these discussions will continue to generate volatility in the markets and be a modest headwind for economic growth until an agreement is reached. After that, we expect CEO confidence to rise to a level that drives a broader acceleration in capital spending and allows for a more balanced foundation for economic growth now primarily dependent on the U.S. consumer. However, we continue to believe an agreement may be achieved and worst-case outcomes may be avoided. Both sides have significant incentives to strike a deal and the costs to President Trump only become more real as the election approaches and the economic impact to U.S. consumers of incremental tariffs are realized as much greater. Chinese President Xi Jinping has a softening economy to worry about. What is his “no-deal strategy”? Hope Democrats win the election? Or that a new administration caves on trade despite the fact that the average American now supports more fair terms with China? And hope the Chinese economy doesn’t have a hard landing with the political risks associated with that? If the Chinese once thought that if Trump is defeated and a potential future Democratic administration would be soft on trade, they may now realize that this is a dangerous supposition.
- If trade discussions are stretched out significantly and get uglier in tone/breakdown, we expect the Fed to be more accommodative and aggressive on cuts, which would provide support to equities.
The table below shows our 2019 outlook for the S&P 500. We continue to assign a 75 percent probability that the S&P 500 ends the year in a range of 2,800 to 3,000. This is exactly the same range we outlined when we introduced them last January. We recognize the S&P is currently close to the upper band. This upper band at 3,000 represents a reasonable 16 times multiple on consensus 2020 earnings of $185. This actually is a conservative multiple in the midst of the low inflation, low interest rate environment. We are biased to raise our upside target to 3,200-3,300, but refrain from doing so at this time until we get more information in the early goings of the second half on the U.S. economic front and get a firmer read on anticipated Fed rate cuts and progress in the trade negotiations.
If healthy economic data continues to be released demonstrating moderate growth, coupled with any reasonable news on one or both of these policy issues, it would warrant an upgrade in our target. Any combination of news flow on these items that is constructive could provide a lift to market psychology, and hence P/E multiples, and would increase our confidence that the consensus 2020 EPS figures are achievable, or close to it.
Our Mid-Year Review webinar covers our second-half outlook in detail, including risk factors that would get us to change our view, in the coming days. Enjoy!
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