August 2019

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Attributed to Benjamin Graham

Benjamin Graham is known as the “father of value investing” and was Warren Buffett’s professor at Columbia University. He observed that in the short-run, markets vote on stock prices based on investor sentiment whereas in the long run, markets weigh the economic and fundamental evidence in pricing stocks. Markets quickly digested the July Fed rate cut then quickly pivoted to escalating trade wars, plummeting interest rates and elevated recession concerns giving investors a bumpy two-week ride. Going forward into 2020, the path for U.S. equities remains hinged to macroeconomics and fundamentals. Today, we briefly revisit the state of the U.S. stock market through those lenses.

Performance Update:

Despite two volatile weeks in the market, YTD returns (in red) for global equity markets remain broadly positive led by large cap U.S. equities where our current portfolio allocations are overweight. However, as the chart below reveals, 1-year returns (orange) are flat to modestly lower tracking the slowdown in corporate earnings. In 2018, the 25% cut in corporate tax rates fueled a 20%+ jump in S&P 500 earnings. In 2019, earnings growth of roughly 0% has left stocks searching for their next catalyst.

Since the July 31st Fed meeting, the S&P 500 remains in a trading range of 2800-3000 with volatile 1% intraday swings becoming the norm. We expect this to continue during this seasonally sluggish period for markets unless new catalysts emerge.

Source Data: Morningstar

The performance gap between large and small cap U.S. stocks can partially be explained by the sector differences between those indices. The S&P 500 large cap index has enjoyed a performance differential over the Russell 2000 small cap index in part because it has larger allocations to outperforming sectors (technology and consumer defensive) and smaller allocations to underperforming sectors (financials and materials). Sector performance can be seen in the chart below.

Source Data: Morningstar

Lens No. 1 – Macroeconomics: We highlight three key areas that dominate Wall Street’s obsession with forecasting a recession. Our focus remains on proactively identifying economic themes that shape portfolio strategy.

1. The U.S. Consumer: The U.S. consumer remains the bedrock of the U.S. economy. The weaker than expected University of Michigan Consumer Sentiment survey is not yet a concern, but it brings upcoming economic data into focus to confirm current consumer strength or identify emerging weakness. The best job market in 50 years along with record high stock prices are anchoring U.S. consumer strength and supporting both stocks and the U.S. economy.

2. Fed Policy: The Fed is caught between a rock and a hard place. The Treasury yield curve is telling the Fed they’re .5%-.75% behind the curve yet they can’t afford to deplete their monetary policy toolbox. Last week’s brief inversion of the 2-year/10-year yield curve and plummeting global yields likely triggered trading programs sending markets lower than they would have otherwise. Markets overreacted as if recession was imminent with the most oversold conditions for the S&P 500 since last December. They have since enjoyed a technical recovery back to the higher end of their trading range. We expect this trading range to persist in the near term as recession is not imminent.

Fed policies will be on center stage at this week’s annual Jackson Hole Economic Policy Symposium. Pressure will intensify before the Fed’s upcoming Sept. 18th meeting (immediately after the next ECB meeting) to make a bolder move with a .5% cut rather than the current consensus .25% cut. Failure to do so may disappoint markets and diminish the wealth effect consumers have come to enjoy. For now, accommodative Fed policy remains the market’s best friend. However, new rounds of monetary stimulus in both the U.S. and abroad will have a diminished economic impact compared to prior cycles. They have the power to extend the cycle but limited power to truly recharge it.

3. Trade Policy: Three things continue to hinder trade negotiations. First, new tariff announcements and elevated trade threats from the U.S. and China have escalated and positions have hardened. Second, the prodemocracy protests in Hong Kong highlight the geopolitical element to the trade negotiations we have now discussed for months. President Trump’s desire to discuss Hong Kong with President Xi introduces one more sticking point to potentially derail negotiations or delay them until after the 2020 U.S. elections. Finally, the closer we get to Election 2020, the greater urgency for President Trump to complete a trade deal. Speculation swirls that President Xi could straddle the fence and gamble on negotiating his best deal with whomever he believes will be the next president. In the near term, tariffs currently in place and announced are expected to be a .6% drag on U.S. GDP in 2019 but not lead us into recession. Markets would cheer the completion of a trade deal more than the content of a deal, which remains elusive.

Takeaway: Persistent concerns around the yield curve, clumsy Fed messaging and continued trade tensions have increased recession risks. However, we continue to think the Fed is committed to extending this economic cycle and will send a dovish signal at this week’s Jackson Hole Summit. Economic growth is a prerequisite for earnings growth and both are currently stuck in the low single digits. A dovish Fed surprise and a trade deal are the two biggest factors needed to drive earnings expectations and stock prices beyond their July record highs. A status quo stalemate would test market patience with elevated volatility.

Lens No. 2 – Fundamentals: Valuations of U.S. markets are elevated but not excessive versus other developed markets. Low interest rates and steady revenue growth have supported equity prices in 2019, but earnings growth needs a catalyst for markets to break out of their trading range. S&P 500 price-to-earnings ratios peaked in January 2018 at roughly 18.2. Applying that PE multiple to the currently expected $166 in S&P 500 2019 earnings generates an S&P 500 price of 3021, near the July record high. Fourth quarter and 2020 earnings estimates need to see upgrades for markets to break decisively above the July highs.

A Word of Caution on Market Timing:

Investor patience can be tested when confronted with rising volatility and panic selling like we saw on Aug. 14th. However, reacting to elevated volatility by selling at times of stress without a plan to reinvest until it is “safe” after markets recover is a flawed plan. The reward of being right sometimes is not worth the penalty of being wrong over time. Consider the chart below that depicts S&P 500 price returns for the 5-year, 10-year and post Lehman time periods to illustrate the impact of missing the best and worst 10 days.

For the most recent five years through Aug. 9, 2019, an investor who:

– Bought and held the S&P 500 generated an annualized price return of 8.55%
– Missed the 10 best days generated only 2.42%
– Missed the 10 worst days generated 16.36%

Source: Ned Davis Research

We understand this is an extreme example. However, the illustration magnifies the cost of trying to time getting out of a volatile market while remaining under invested during a market recovery.

Developing your own asset allocation plan consistent with your goals and risk tolerance that can be adjusted under different risk regimes is a better plan for long-term success than timing extreme market moves. We will keep you posted as developments unfold over the months to come, but for now, continue to expect stocks to trade in a tight but volatile range.

Jeff Terrell, CFA

Chief Wealth Market Strategist

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors

The Morningstar indexes are unmanaged, weighted indexes of stocks and bonds providing a broad indicator of price movements. Individual investors cannot directly purchase an index.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.