February 2019

What a Difference a Month Makes

After the worst December since 1931 stocks rallied for the best January since 1987. The SPX rose by 7.9% for the month.

Stock market pundits, after three horrid months October through December 24,  saw the 20.2% SPX decline as a harbinger of a coming recession.

Then the new year began and tax selling stopped. On January 4, the Federal Reserve Chairman Powell, clearly stated the march to ever higher rates was coming to a halt. Trade talks with China were back on track.

Despite a record long partial government shutdown over funding the Wall, which further highlights the political divide in our country, the stock market bounced and bounced and bounced again. Half of the prior three month swoon was erased, as fear of loss turned to fear of missing out.

Last Friday, after the January Fed meeting and reiterations by Mr. Powell of his new patient data dependent policy, a January jump of 304,000 new jobs was reported. This marked another in a long string of job gains far exceeding the pre-Trump economy, all without an inflationary basis. While the unemployment rate rose to 4%, previously sidelined workers found jobs, increasing the participation rate.

This trend in job creation led most economists to put off recession forecasts until 2020. With 2020 being an election year, the government has in past decades pulled out all the stops to keep our economy humming.

We now see a market landscape pocked with negatives namely an early stage trade war, global GDP slowdowns in China, Europe and Japan, political strife here and abroad plus, the beginning of a divisive Presidential campaign.

What is an investor to think, never mind do, with hard earned funds?

A famous market technician, Bob Farell once stated, "Excess leads to an opposite excess." Euphoria turns to despair. Then we slowly rebuild confidence.

During volatile markets, many investors review and reassess their goals and redefine a time frame for future cash needs. Risk tolerance levels are tested during sharp market declines and sometimes investors realize they cannot handle wide swings that come along with large equity allocations.

Everyone loved 2017 for its unusual above average returns and low volatility. Thus, 2018 started with high confidence, ended with big volatility and investor sentiment plunged. CEO's put capital spending plans on hold and analysts lowered earnings forecasts. A strong U.S. economy coupled with 23% earnings growth did not stop a steep market decline. In January 2019 analysts lowered Q1 earnings forecasts 4.1 %, the largest decline since the - 5.5% of Q1 -2016.

J.P. Morgan, the banker, when asked for his opinion on the market famously stated,  "stock prices will fluctuate." No one can consistently predict what the stock market  will do in the short term. What we do know is that an aggressive stock allocation requires a strong stomach and a long time frame. If you can't deal with market swings you need to reduce risk exposure in your portfolio or you might reactively sell at a very bad time.

Warren Buffet stated he'd rather a larger return with more volatility than a smaller return with less volatility. Most investors dislike falling prices but some like Mr. Buffet enjoy the buying opportunities most declines present.

Unfortunately, the days of strong bond returns with low credit risk are mostly in the past. Yields on 10 year Treasuries peaked at 14% in 1984 and bottomed at 1.32% in 2016. Long term government yields were 2.25% in 1946, 3.25% in 1956 and sit at 2.73% today.  A lot of volatility occurred during those decades. Last year bond returns did not offset or cushion the stock market slide.

The governments of China, Japan, Europe, Britain and the U.S. have tried to smooth economic cycles with both monetary and fiscal policies over time. Some attempts have met with success and others failure. Economic cycles cannot be repealed by government policy or decree.

The Fed was created as a lender of last resort and was needed in 2008 but it has also caused recessions with tight policies. Earnings growth plus Fed ease or contraction cycles push stock prices up or down. Timing is always uncertain as markets in the short run often move with emotions and headlines.

In 2018, SPX earnings grew 23% , which did not stop a 6% SPX price decline. Earnings will grow again in 2019, +4-8% with a consensus 2019 estimate of $172. GDP will likely rise about 2.5%. The rate of earnings growth this cycle has clearly peaked but value defined solely by the market P/E multiple has dropped from 18x in early 2018 to 15.7x today.

The good news is that oil prices have rallied, recession fears have abated, Fed policy has gone neutral to dovish. China trade talks are progressing against the March 1 deadline. This long expansion cycle may be extended with steady interest rates and pending trade deals.

America, according to letter writer Jim Grant, required 192 years to amass its first $1 trillion in gross public debt. Now we have a $22 trillion fiscal deficit growing by $1 trillion this year. Corporate debt has also reached new highs with 50% of that total rated BBB, only one grade above so called "junk" status.

Despite conflicting conditions, we see value in certain areas of both the stock and bond markets. Emerging market stocks are attractive relative to U.S and European stocks. The U.S market has out performed foreign markets over 1,5 and 10 year periods but growth in EM economies will likely exceed U.S growth this year. The strong U.S. dollar has given up ground year to date versus a basket of trade weighted currencies easing profit headwinds.

In the U.S. we eventually deal with economic problems even though it often takes too long and the politics surrounding issues can get very ugly. Over long periods of time stock prices climb as the economy grows.

We are now energy self sufficient, we lead the world in technical innovation and health care breakthroughs. We have a huge manufacturing base that thrives with far fewer workers. Since 1970 our GDP is up 250% making us the richest economy in the world. We have population growth and over one million immigrants per year adding their talents to our economy.

With time, patience and a proper asset allocation, depending on your personal risk profile, an equity laced portfolio will likely increase in value. Given a slowing global economy, dollar based bonds have attractive yields.

We anticipate another volatile year but with positive results.

Please let us know if you wish to talk about your account, discuss your risk tolerance or redefine your financial goals.

The year has gotten off to a strong start just like last year. We shall see if slower growth with positive earnings can lead to better price action.

Disclaimer: These stock market observations are confidential and proprietary. They are for informational purposes only and are not intended to be used, and may not be used, as investment, legal, accounting, tax, or other advice. No express or implied representation or warranty is being made with respect to their accuracy or completeness. No obligation exists to inform the recipient when the information herein is no longer current or accurate. These observations do not constitute an offer to sell or a solicitation of an offer to buy any securities or interests in any investment vehicles managed by CFA or an associated person or entity, or to provide investment advisory services.