Q2 Update: Stock and Bond Tug of War

Stocks have surged since their December lows and continue to ride an upward trajectory into the second quarter indicating investor optimism about economic growth. At the same time however, investors have demanded shorter-term bonds and shunned longer dated maturities pushing the yield curve to flatten and even invert – usually a good predictor of recession. So, do investors think the economy is poised for growth or contraction? The truth is probably somewhere in the middle. Earnings estimates for the current quarter are pretty low and many equity investors are betting that the bad news is already baked into the current price. Better earnings or positive guidance could compel stocks to jump higher. More cautious investors are pointing towards the age of the current bull market, international trade disputes (especially US-China and Europe-Great Britain), and Fed tightening actions as reasons to decrease risk. We see further economic expansion but with volatility along the way.

On a diversification note, the world’s stock markets are moving less in sync with each other than at any time in the last 20 years – meaning that owing a diversified portfolio across the globe makes sense again. The low correlation can increase risk adjusted returns and any pull back could be a good time to add to international positions for long-term investors.

Good Start After Bad Finish

After closing out the year on a negative note with markets selling off aggressively in October and December, January brought the rebound we were looking for. Market uncertainty and unease began to take hold in autumn with ongoing tariff disputes with major trading partners (namely China) and an inversion of the yield curve. As traders flocked for the safety of cash we looked to both capture profits and find cheaper entry points for quality stocks and funds in client portfolios. In December we aggressively bought on big sell-offs and continue to look for opportunities as they arise.

Stocks prices change based on both current facts and future expectations. Towards the end of last year prices were sharply dropping based on the expectations that trade wars, currency fluctuations, higher interest rates, and many other factors were conspiring to drag on earnings. Then in January the hard facts of earnings started coming in painting a much different picture. Most companies are still reporting record profits despite all the noise. The markets remain volatile (as to be expected at this point in the economic cycle) but we still see economic expansion over the next few quarters at least.

Frightful October

Interest Rates and Revenue.

In the face of rising interest rates and an aggressive Fed, corporate revenue guidance for the fourth quarter has come in below expectations. These factors have combined to put the stock market into a tailspin. As corporate revenues decline (or grow more slowly), stock prices begin to look more expensive. Last month the ratio of price to revenue was the highest since the dotcom bubble of early 2000. Stocks have lost 10% of their value from the high in September, putting them in “correction” territory. They would need to lose another 10% for it to be considered a “bear market” and put an end to the current decade-long bull market since the Great Recession.

Economically, most economists are predicting growth for another year to year and a half before we enter the next recession. In the meantime we will most likely see continued volatility through the mid-term elections and then more normal trading sessions through the end of the year. It is expected the market will take another leg up prior to retreating heading into the next recession.

At HWM, we are closely monitoring indicators of the stock and bond markets and will move aggressively to mitigate account losses. One of the indicators we are looking at is the yield curve (a graph of interest rates from short-term CDs to long-term bonds). An "inverted yield curve" is a reliable indicator of an impending recession. As stocks or other risky assets become less desirable investors move into more stable investments of treasury bonds (typically longer-term bonds where the yield is greater). When this happens in conjunction with rising short-term interest rates (yields), you may get a scenario where, say a 2-yr bond is paying more than a 10-yr bond. When people are willing to lock up cash in a lower-yielding fund for longer periods of time, then they don't have much faith in the near-term outlook. The current yield curve is still "normal" looking but it is flattening. So far the canary in the coal mine is still alive but it may not be singing. 

The Oldest Bull

On August 22 the current bull market for stocks will officially be the longest in history – 3,543 days. While there are plenty of reasons to worry – high corporate debt levels, high price to sales ratios, high tariffs and trade war concerns, and mega-high returns for a select few tech companies – there is also ample reason for the rally to continue.

US economic fundamentals are strong and even showing signs of getting stronger. Profits are surging for some of America’s largest companies stuffing their accounts with cash. These cash hoards will be further augmented by the corporate tax reductions. This will inevitably lead to increased stock buybacks and more mergers and acquisitions, which directly favor stock price. In addition, cash will be deployed for increased productivity and/or hiring and wage growth.

The institution that monitors the economy closer than anyone, the Federal Reserve, has come to the conclusion that the economy is quite healthy and ready for a normal rate environment. The Fed remains on track to raise interest rates several more times in the coming quarters and years to prevent the economy from actually overheating and causing high inflation down the road.

On the sentiment side, we are seeing more signs of greed but not quite like we see during market tops or just preceding a recession. In short, there are plenty of naysayers and cash on the sidelines to reasonably conclude that we have not entered into an era of “irrational exuberance” just yet.

A Comment on Risk

Risk is often misunderstood when discussing investing. Risk is the possibility that an objective won't be obtained. Investing, as Warren Buffet puts it, is the practice of foregoing consumption today in an attempt to allow greater consumption at a later date. Think of it as the opposite of Wimpy from Popeye - I forego a hamburger today so I can buy two hamburgers tomorrow.

By that standard, assumedly "risk-free" long-term treasury bonds are often much riskier than a long-term investment in common stocks (or stock funds). Even with very low inflation (as we have seen over the last decade) the purchasing power of government bonds erodes - especially when interest rates are low. As an example, in 2012 long-term treasury bonds decreased ones purchasing power through 2017. Note however, that on a very short time scale, say a day, week, month or even year, stocks will be riskier than short-term US bonds. But as soon as an investor's time horizon lengthens, a diversified stock portfolio becomes far less risky than bonds.

For most investors, those with longer time frames, investing in stocks is a less risky investment than one in bonds. This is a mistake made over and over again by even our most prestigious institutions like college endowments and pension funds. 

America’s New War: Trade

A war on trade is a war on profits and the markets are none too pleased. The White House remains committed to increasing tariffs on goods from countries he believes are ripping America off. Trump’s main target appears to be China after he backed away from imposing additional taxes on Canadian and Mexican products. China has responded with tariffs on 128 US products, ranging from frozen pork to California wine to fruit and ethanol. The Chinese Commerce Minister said it was suspending its obligations to the World Trade Organization to reduce tariffs on 120 US goods.

The markets have responded to these actions with great negativity. Wars, as we all know, have a tendency to spiral out of control and cause much collateral damage. This particular “war” has already gone from a targeted steel and aluminum tariff by the US against China to dozens of tariffs encompassing hundreds of goods between the world’s two greatest economic powers.

Buckle up, volatility is back and with good reason. A rotation into consumer goods and out of industrial goods may be wise as these two industrial titans exchange blows. Nevertheless, economic fundamentals remain strong and we look at market pull-backs as buying opportunities for long-term investors. 

Market Correction

Stocks plunged today with the Dow shedding over 1,500 points during the day as traders antsy about inflation tried to lock in their year-to-date gains. The markets are down 7% now from their highs set last month. This marked the largest one-day decline in 7 years. So, what is behind this move? Investors were spooked by a few things surrounding the following: the Fed, yields, and profits.

Firstly, there was a change at the Federal Reserve with Jerome Powell taking over for Janet Yellen as the new Chairman. Markets don’t like uncertainty, especially with regards to interest rate policy. Traders had gotten to know Yellen and now they will have to learn the tendencies and philosophies of a new captain guiding monetary policy. If inflation is indeed ticking up, there is a chance this Fed will act aggressively to combat it by raising rates. Traders just don’t know yet how the new Fed will behave and that scares them.

Secondly, yields have been creeping up, especially short-term bonds. This creates a scenario described as a “flattening of the yield curve,” where interest rates at the long end (30-year bonds) are not that much different from yields on the short end. Every recession is preceded by a flat or inverted yield curve.

Thirdly, traders were taking profits. The markets surged in January, recording its best start to a year in 30 years - and that came on the heels of a fantastic 2017. After the markets sold off a bit last week investors were ready with their fingers on the sell button for any signs of more losses to lock in their profits.

Has anything changed? Yes and no. The markets acted like markets again for the first time in a while. Equity investing comes with risk and volatility and those are two things we just haven’t seen in well over a year. So, the change is that normality has returned. Markets are supposed to rise in spurts and fits, not jump up parabolically. Fundamentally, nothing has changed. The economy is growing at a steady and increasing rate, corporations are flush with cash, earnings growth is strong, corporate debt-to-equity is very low, and interest rates (though rising) are still near historic lows. There is no reason to think that a year from now, let alone 3-5 years from now equity prices will be lower than they are today. Take these days in stride and remind yourself that market moves like this are normal and expected.

Tax Stimulus and Global Synchronization

The previous post briefly touched on market expectations for tax cuts and how various interests are competing to get certain provisions passed. Now that both houses of Congress have passed their own version of the bill, they will hash out the gory details and pass a final version. How this will affect individuals will differ based on your income, wealth, and location – a subject difficult to address broadly. The question we will focus on is how will this affect our aging bull market. The bill is overwhelmingly a gift to those with capital and to corporations more generally and stocks will surely get a lift from the corporate tax cuts. When companies pay less in taxes it frees up cash for mergers and acquisitions, company stock buy-backs, and distribution of dividends. Credit Suisse estimates that the 20% proposed corporate tax rate will boost earnings by 10% in 2018. The tax cut is coming at a very late stage of this bull market and has some investors worried that it will ignite inflation. One would think this would be cause for serious concern, but these are not normal times. Remember, we are just 8 years removed from the biggest economic catastrophe in a century. Inflation in the US on a year-over-year basis is currently running at 1.6%, which is not high. And although interest rates are low (conditions that are typically inflationary) the Fed has made it clear they will do everything they can to not allow a hyper-inflationary environment to develop. When you combine low inflation, increased corporate cash, and steady US growth with increased global growth, stocks look attractive even at these elevated valuations.

World manufacturing activity is at nearly 7-year highs as orders are coming in faster than anticipated and exports and employment are all up. By many indicators, global economic health has never been more robust. The number of countries in recession has dropped to its lowest level in decades. Synchronized global growth is finally in sight with no major industrial economy in contraction mode for the first time since 2008. World GDP is expected to advance to 3.5% this year and jump to 3.7% in 2018. For the stock market, this is all good news. More specifically, companies with exposure abroad have tended to reap the benefits over the last year. Those that derived 50% or more of their sales overseas reported revenue growth of 10% compared to 5.8% for all S&P 500 companies regardless of where revenues came from. In short, stocks have been on a long ride up but there are good reasons to believe the journey is not yet over.

Death and Taxes

As the Senate nears its vote on taxes, the minutia of the bill will be debated on the Hill with the hopes that some parts of it die before making it to final vote. One such provision is a change to capital gains taxations. Currently, investors can choose which “lots” of stock to take from when they sell. For example, a long time Apple investor may have bought the stock many times over the years with the oldest lots having a cost basis of a few dollars. If they were forced to sell the oldest lots first, an accounting method called First In First Out (FIFO), their capital gains would be enormous. However, if they sell the most recent long-term gains (as they can presently) the story would be much different. This is just one of the myriad changes proposed in the bill.

The US tax code is one of the most complex in the industrialized world and the effects of any changes are incredibly difficult to predict. But what we know for certain is that in the short-term the markets will be thrilled with the changes overall. On a longer time-frame economic implication are less certain, except of course for the massive deficits, which apparently both parties in the US love these days.

Fed Focus

The Fed kept interest rates unchanged for the month as was widely expected. However, the anticipation by investors of a rate hike coming next month is nearly unanimous. The Fed has been telling us for some time that the robust corporate earnings and job growth are warrant interest rate normalization - and they have a point. The unemployment rate is 4.2%, and this earnings season has seen three out of four companies surpassing earnings expectations and beating sales estimates, driving market prices to all time highs. As the Fed acts, we will be focusing on one of the oldest investing mantras on Wall Street - "don't fight the Fed". Higher interest rates might spook some investors and send them to the sidelines while the new rising interest rate era gets under way. Nevertheless, we don't scare easily and will remain focused on growing and maintaining wealth.