Commentary | 2Q 2019
Updated: Mar 5, 2020
“During summer, ants think about winter.”
- Jim Rohn
2019 Q2 Market Recap
At this point every year it always amazes me that half the year has elapsed already. I always ask myself the same question – how did it go by so quickly? Well, it’s certainly not because the earth is hurtling through space any faster than it used to (about 67,000 mph according to Cornell University in case you are curious). I think it is because the news du jour consumes our attention, and it changes every day. Take your pick – Fed policy, yield curve, Q1 earnings, trade disputes, ‘Medicare for all’, geopolitics, debt ceiling – to name a few. I honestly can’t quite recall what the headlines were even just a few days ago. The pendulum swung from positive to negative and back, resulting in market volatility especially during May.
The Fed helped drive the market higher by indicating that it might not only stop raising rates, but instead might lower rates in 2019. Market participants believed that the Fed was foreseeing weak economic growth and might begin a policy shift in favor of increased growth.
The ebb and flow in the tariff imbroglio stimulated market reactions, both positive and negative. Each time there appeared to be a path to reducing tariffs with one of our trading partners, the market responded positively, and each time we withdrew from the negotiating table and threatened to raise tariffs, the market reacted negatively. Currently, the biggest source of instability is our confrontation with China. Both parties have engaged in a game of dueling tariffs. There are some indications that the trade dust up with China is about more than a level playing field for bilateral trade. We have claimed that there are national security issues involved as well.
For example, investors were anticipating a grand trade bargain going into May, and the equity markets continued their ascent from the first quarter into April. However, they were jolted out of their state of calm by a series of presidential tweets on May 5 announcing that tariffs on $200 billion of Chinese goods would increase from 10% to 25% starting May 10. That sent markets swooning, and stocks that had exposure to China bore the brunt of the damage. Cyclical sectors such as Consumer Durables, Energy, Technology, and Materials were out of favor, and from a factor standpoint, valuation underperformed during the month. Early June brought some respite from the carnage as hopes emerged of a resumption in dialogue between the two countries, and the increasing likelihood of a personal meeting between President Trump and Chinese President Xi Jinping at the G-20 meet in Osaka at the end of June – a meeting that did end up taking place. The markets recovered and ended up posting positive returns for the quarter. Time will tell, but as recent history attests, celebrations about a seeming end to the trade dispute have proved premature.
Market gyrations enable us to reaffirm two fundamental precepts that we hold dear:
Equities are long-duration assets, so take a long-term view
As David Rosenberg often asserts, “time in the markets is more important than timing the markets”
Market Outlook and Positioning
In our previous quarterly commentary, we referenced a set of economic as well as bond market data that has historically augured an economic slowdown. We are writing this commentary in early July, with the equity markets celebrating two events:
A ‘trade truce’ between the US and China following the face-to-face meeting between the presidents of the US and China in Osaka at the end of June
The increasing odds that the Federal Reserve will cut the Fed Funds rate in July, and in September
While this may usher in a ‘risk-on’ environment, we have no intention of deviating from our investment process. To reiterate from our previous letter, we would continue to focus on valuation and analyst revisions in our stock selection, maintain adequate diversification across sectors, and be cautious of companies with excess financial leverage when rebalancing the portfolio.
Real GDP is expected to grow at a rate below 1.5% in the second quarter. This rate is well short of the 3.1% growth experienced in the first quarter. The Fed’s current estimate for economic growth in all of 2019 is 2.1%. The anticipated rate of growth of corporate profits has been revised downward as well. Profits fell by more than 3.0% in the first quarter and they are expected to decline by an estimated 2.6% in the second quarter.
A combination of appreciating markets and declining earnings has caused the trailing price-earnings ratio to exceed 22 by the end of the second quarter. This value is well above the historical average of about 15. Investors should be cautious about the market’s elevated valuation in case falling profits and declining real growth persist. Currently, the Fed expects real growth to remain positive, but continue to decline through 2022.
While the stock market was rising, the bond market was establishing patterns consistent with expectations for a recession. By the end of the second quarter, the yield on three-month government obligations was higher than that for the ten-year bond. In the past, an inverted yield curve has typically presaged a recession. Not only is the shape of the yield curve consistent with an oncoming recession, but its level is consistent with little or no real growth for the foreseeable future. The yield on the ten-year obligation was barely over 2.0% at the end of the quarter. In general, rates at this level indicate that bond market participants are expecting real growth plus inflation to average 2% or less over the next ten years. To be sure, there are variables beyond inflation and real growth that drive interest rates, but they tend to be transitory.
At the end of the quarter, market indexes, like the Dow Jones Industrial Average (DJIA) and the S&P 500 Index (S&P) were at or near their all-time highs. When contemplating what the future holds for the market, it is a worthwhile effort to examine how it rose to these lofty heights. Some analysts point to the end of the “Great Recession” as the beginning of the current bull market. The National Bureau of Economic Research (NBER) places the end of the recession at or near June of 2009. The market began to recover in March 2009. However, this perspective misses the forest for the trees. The bull market began in the second half of 1982. In July of 1982 the S&P was below 110. At the end of the second quarter of 2019, the S&P stood at 2971. The year 1982 represented the end of a long period of stagnating values for the S&P and the DJIA. In the period from January 1965 through June 1982 the S&P produced an annualized, inflation-adjusted rate of return of -1.2%. In the period from June 1982 through June 2019 the S&P produced an annualized, inflation-adjusted rate of return of 9.0%. It is important to focus on inflation-adjusted returns. Returns that lag inflation indicate unhealthy capital markets and a declining capital stock.
The period of stagnating and declining market values persisted through the administrations of four Presidents: Johnson, Nixon, Ford, and Carter. There were four Fed Chairs as well in that same period: William McChesney Martin, Arthur Burns, G. William Miller, and Paul Volker. As administrations and Fed Chairs changed, inflation rose, unemployment rose, interest rates rose, and the stock market languished. These conditions were driven by policies that included rising tax rates and regulations, and a monetary policy that drove inflation.