A Whole Lotta (Bull)
… to borrow a phrase from Led Zeppelin (who actually “borrowed” the lyrics from blues master Willie Dixon):
“You need cooling, Baby I’m not fooling. I’m gonna send ya Back to schooling”
The stock market shrugged off significant trade and geopolitical concerns in the second quarter of 2019, closing with a flourish which belied the venerable bull’s record status. Equities capped their best first six months of a calendar year since 1997, and even fixed income securities got in on the fun: yields went lower as investors bid up bond prices in anticipation of a Federal Reserve rate cut at the upcoming July meeting. The U.S. is enjoying the longest economic expansion since 1854, and policy makers are loathe to do anything which could cause the mighty bull to stumble and prematurely end its historic run.
There’s a whole lotta bull emanating from both D.C. and Beijing, too. Presidents Trump and Xi have both walked back expectations for a comprehensive trade deal, the recent shelving of additional tariffs notwithstanding. Tariffs are essentially taxes on consumers and companies, and they are now being driven more by individual personalities and agendas than sound economics. The negotiations are going to be a long grind at best, as the U.S. is seeking structural changes in the Chinese legal system to allow American firms to (finally) pursue legal remedies when their best technology is misappropriated by Chinese counterparts or business opportunities denied them on the tilted playing field of the Middle Kingdom’s mainland. Overhauling international trading norms is not a quick process.
World Asset Classes
Second Quarter 2019 Index Returns (%)
Equity markets around the globe posted positive returns for the quarter. Looking at broad market indices, US equities outperformed non-US developed and emerging markets during the quarter.
Value stocks outperformed growth stocks in emerging markets but underperformed in developed markets, including the US. Small caps underperformed large caps in all regions.
REIT indices underperformed equity market indices in both the US and non-US developed markets.
Shake it off?
Equity prices have shrugged off these very substantial concerns, despite mounting evidence that the global economy is slowing down… a deceleration which reflects deeper issues than simply the SinoAmerican impasse. A growing multinational chorus of executives and decision makers is citing the uncertainty created by the trade war for difficulty in formulating strategic plans and capital deployment. While many in the financial press focus on monetary policy (the Fed) and the as-yet mythical China trade deal, it’s the downward revisions of profit forecasts that have us most concerned.
Stock prices ultimately reflect the quality and future expectations for corporate earnings, and that’s what has us most worried. According to Bloomberg, 82% of the S&P 500 companies which revised their estimates heading into this quarterly earnings season have lowered them, and analysts have slashed company projections at the fastest pace in almost three years. If this seems vaguely reminiscent of the pattern we saw at the beginning of the third quarter last year (right before stocks plummeted nearly 20%), you’d be correct. The negativity surrounding corporate earnings is spreading, and Wall Street analysts have been pushing down estimates at the fastest pace since September 2017: last month analysts lowered forecasts on 116 more stocks than they upgraded them for. Companies have a steep slope to climb, as the stronger dollar, weaker oil prices, higher input costs and ongoing frustration with the trade war has forced them into a wait-andsee posture for the time being.
Wall Street is expecting corporate earnings to collectively drop 2.5% in the quarter which just ended, and it appears there’s more to it than the usual dance whereby companies lower their forecasts only to make subsequently beating those forecasts easier. If the earnings decline comes to fruition, it will be the first profit contraction in three years. But even though stocks are trading at all-time highs, with the 10-year US Treasury yielding about 2.0% (and trending lower), equities are not as expensive as they might otherwise appear.
It’s (NOT) the End of the World as We Know It
In 1987, the Georgia-based band R.EM. released a hugely successful album, Document, which included an iconic song “It’s the End of the World as We Know It (And I Feel Fine).” In keeping with the rockreferenced theme of this quarterly newsletter, we put a twist on R.E.M.’s lyric; despite what we see as the market’s overly optimistic assessment of the economy and pending corporate earnings, we do NOT expect the next decline to be sharply painful or persistent. Our base scenario calls for earnings to stabilize in the third and fourth quarters of 2019 before rebounding again. 2020 could actually bring a return to doubledigit profit growth. Companies are shifting their supply chains away from China, and a year from now their global production networks could look quite different.
Low unemployment, low inflation, low interest rates and improved visibility regarding the evolving international trade regime will stoke executives’ appetites for risk-taking and capital will start to flow once more. Those investments should reward equity owners with positive returns as President Trump can be counted on, like his predecessors before him, to advance policies which will propel the economy and the stock market to greater heights in an election year. We can also reasonably predict some distortions (like farm subsidies) aimed squarely at shoring up the president’s political base.
The Uncommon Average
“I have found that the importance of having an investment philosophy—one that is robust and that you can stick with— cannot be overstated.” —David Booth
The US stock market has delivered an average annual return of around 10% since 1926. But short-term results may vary, and in any given period stock returns can be positive, negative, or flat. When setting expectations, it’s helpful to see the range of outcomes experienced by investors historically. For example, how often have the stock market’s annual returns actually aligned with its long-term average?
Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 Index had a return within this range in only six of the past 93 calendar years. In most years, the index’s return was outside of the range —often above or below by a wide margin—with no obvious pattern. For investors, the data highlight the importance of looking beyond average returns and being aware of the range of potential outcomes.
Exhibit 1. S&P 500 Index Annual Returns
In US dollars. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.
TUNING IN TO DIFFERENT FREQUENCIES
Despite the year-to-year volatility, investors can potentially increase their chances of having a positive outcome by maintaining a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the US market. The data show that, while positive performance is never assured, investors’ odds improve over longer time horizons.
While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. By thoughtfully considering these and other issues, investors may be better prepared to stay focused on their long-term goals during different market environments.
Exhibit 2. Frequency of Positive Returns in the S&P 500 Index
Overlapping Periods: 1926–2018
In US dollars. From January 1926–December 2018, there are 997 overlapping 10-year periods, 1,057 overlapping 5-year periods, and 1,105 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.
An object in motion will remain in motion
The U.S. economy is the world’s largest and most dynamic – it retains tremendous inertia. Even though there is a discernable weakening in economic fundamentals, Newton’s first law is likely to apply, at least for the next several months. The forces which propelled U.S. institutions and markets deep into this economic cycle are weakening, but they have not reversed entirely. The benefits of recently lowered corporate taxes will provide a tailwind to ease the burden of companies’ leveraged balance sheets. A slowdown does not necessarily portend a recession, and we still don’t see a massive bubble developing (think internet stocks or housing), the bursting of which would cause significant and prolonged harm to the global financial system and equity values worldwide. Even though geopolitical tensions and global growth concerns make any forecasts even less certain than usual, we remain vigilant and cautiously optimistic. A short term cooling off in the market is not detrimental to the long term plans we have constructed on your behalf, and we are actively monitoring the trade and tariff situation to see which direction it will break.
In closing, we are always appreciative of the confidence you have placed in us as your trusted advisor. We are focused on the markets and are dedicated to serving you. Toward that end, we have added an important new member to our service team: Investment advisor Jeremy F. Stahl, who joins us with twenty years of experience in fiduciary portfolio management, trading and client consulting. He holds a bachelor’s degree from Temple University and an MBA in finance from the Smith School of Business at the University of Maryland.
At FMA Advisory, Inc., our capabilities in the realm of planning and financial modeling have never been stronger, and we would welcome the opportunity to meet with you to refresh our understanding of your current status and leverage our expertise on your behalf.
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