February Investment Comments
Volatility returned to the stock market in 2018, ending the gentle melt up that investors had enjoyed. The S&P 500 dropped at least 10% in three separate months last year—February, October, and December. Stocks battled back bravely from the first two corrections, but a weak December finally torpedoed the S&P’s 2018 performance. After a -9% showing in the final month, the index ended the year down 4.4%, breaking a nine-year streak of positive total returns.
From its September intraday peak to its December nadir, the S&P declined a hair more than 20%, the traditional line demarcating a bear market. The index has since come back more than 10%. If the rebound holds then we may have just experienced the shortest bear market in history, lasting only about 48 hours. Traders sometimes speak of “purely technical” moves, and we have to say that an exactly 20% drop followed by a sharp rebound does suggest that something other than economic and business fundamentals took control of the joystick for a minute.
Of course, stocks could always turn back down again. On the subject of fundamentals, the data we see says the selloff was overdone. The old joke is that the stock market has predicted nine out of the last five recessions. However, the stock market’s predictive success has been much higher when you take bear markets as a signal of recession. Historically, the market has rarely experienced a 20% decline without an accompanying economic recession. Right now seems like an exceptional case. There is simply no hint of recession in the economic data. We see some signals in the financial markets, but not in the real economy financial markets depend on.
GDP growth has averaged more than 3% over the last twelve months. The Federal Reserve Bank of Atlanta recently published a strong estimate of 2.8% growth for the fourth quarter of 2018. The unemployment rate remains under 4%, and workforce participation continues to increase from its 2015 lows.
Markets look ahead not back, so it is possible that recent weakness signals a looming risk that simply hasn’t shown its face yet. It would take a major shock to sink an economy performing at our present level, so what could possibly do it?
Global growth is slowing. Chinese imports dropped precipitously at the end of 2018 according to data from the Wall Street Journal, and the slowdown appears to be weighing on the export-dependent German economy. Japan, another export-dependent country, reported a severe 2.5% drop in Q3 GDP. Now that’s economic contraction! The U.K. continues to experience sub-1% growth, with Brexit uncertainty weighing heavily on business and consumer confidence. The U.S. economy is not particularly trade dependent, however, and it would take a lot more trouble than we are seeing internationally to cause significant contagion here at home.
Short-term interest rates have continued to increase, but without an attendant increase in long-term rates. This has created a very flat yield curve, which has historically signaled impending economic trouble. The Federal Reserve is eager to withdraw monetary stimulus, and its members would probably like to see long-term rates increase significantly. However, the Fed has relatively little power over long-term rates, which are set by market forces. Probably owing to the economic conditions described above, the world appears unprepared for historically normal rates to make a comeback. This ceiling has fixed income analysts questioning whether the Federal Reserve can continue to raise its target rate if long-term rates fail to respond. The consensus is “no,” with the odds of any 2019 interest rate hikes currently handicapped as only about 1-in-6.
It is still hard to find a compelling case for recession. Global growth is modest but not abysmal, and the flat yield curve is probably attributable to a slightly overeager Federal Reserve rather than a slowing economy.
We can’t blame market participants for feeling a little pessimistic. An ongoing government shutdown is presently reminding us how dysfunctional our two-party system can be. So far, the shutdown’s substantive effects are largely concentrated upon furloughed and unpaid government employees. It will take time for their suffering to show up meaningfully in the measured economy, by which point we would hope a compromise has been reached. Assuming a satisfactory resolution to the shutdown, it seems like the big risks to financial markets are more perceived than real right now.
We should note that stocks derive their value from corporate earnings, not overall macroeconomic performance. These two things tend to be highly correlated—businesses generally make the most money when the economy is performing at a high level—but it is also possible for the rate of profit growth and economic growth to diverge for periods of time. We may be entering such a period, which in turn may explain why financial markets are flashing warning signals when major economic indicators are not.
The canaries in the stock mine are starting to wheeze. Cyclical industries like homebuilding and semiconductors did poorly in 2018. Homebuilders were very weak in the beginning of the year and, no surprise, the housing market cooled dramatically in the second half of the year. Semiconductor stocks were big laggards in the second half. As if on cue, their largest downstream customer, Apple, shocked the market on January 2nd by preannouncing revenue expectations 8% below analyst estimates. Competitor Samsung reduced its estimates as well. With cyclical stocks rolling over, some analysts are warning of an impending “earnings recession,” where aggregate corporate profits decline despite generally favorable macroeconomic conditions. Cyclical stocks always tend to extremes, however, and it is easy to get carried away projecting a major downturn when the reality is much more modest slowing.
Valuations remain generally consistent with the low level of long-term interest rates. After a year of negative returns, the S&P’s forward P/E ratio is now 8% below its 5-year average according to FactSet’s January 11th Earnings Insights by John Butters. If anything, we would say the market looks a little cheap right now. This could imply that forward earnings estimates are too optimistic, meaning forward valuations are actually higher than they seem, or it could signal that long-term rates will rise. It is possible neither will happen—rates could stay low while corporate profits advance. Both are unlikely to happen together. It is hard to imagine that long-term rates will recover meaningfully without business performance keeping pace.
A balanced investment strategy should reliably participate in periods of economic strength and also weather periods of economic softness. You can’t afford to miss the bull moves, and you can’t let the bear moves knock you out of the game. With financial markets sending out warning signals that aren’t confirmed by the economic data, this seems like a particularly good time for investors to move slowly. Invest in a diversified portfolio of companies that also look good on their individual merits. Stick to a sensible plan over time, and your results will be fine no matter what comes.
Miles G. Putnam, CFA