After an inspiring final day of Q1 led by the usual “window dressing” of mutual fund managers, news-driven volatility returned with a vengeance on Monday before recovering some ground on Tuesday. Although I rarely trust market moves on the last day of a quarter or the first day of a new quarter, there is little doubt that market volatility is back this year, as I expected it would be. Last year, rather than enduring scary selloffs to correct imbalances, the market simply rotated into neglected market segments from time to time. This conviction to stay invested was largely due to consistent improvement in global economic fundamentals coupled with rising optimism about new fiscal stimulus – leading to a fear of missing out. But given the passage of the tax bill and plenty of progress with deregulation last year, I expected investors this year to display more of a Missourian “show me” attitude as to what Corporate America actually would do with their newfound cash windfalls and looser regulatory noose. Would this truly spell the end of the capex recession, ushering in a new wave of onshoring, PP&E upgrades, hiring, buybacks, and M&A? For their part, sell-side analysts have been raising corporate earnings estimates at a historically fast pace.
But the proof is in the pudding, as they say, and the price run-up and elevated valuation multiples (that arose in anticipation of tax cuts and new corporate investment) were due for compression, as speculation gives way to reality, along with some “price rationalization” and deleveraging of speculative portfolios. And on top of those dynamics, the market is suddenly fretting about tariffs, trade wars, inflationary pressures, and the Fed. Nevertheless, there seems to be something for all investors to hold on to, as both fundamentalists and technicians alike should be excited by the lower valuations and successful tests of support in a climate of robust growth and corporate earnings. But I’m not talking about a return to market conditions of old, characterized by falling interest rates, slow growth, and low volatility, which rewarded passive investing in cap-weighted indexes with elevated P/E’s. Instead, we likely are entering a new era, characterized by rising interest rates, faster growth, and higher volatility, which rewards sound stock-picking.
In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model has fallen into a neutral posture during this period of consolidation and testing of support levels. Read on…
Investors seem to be focusing more on the threats than the opportunities right now. Besides P/E compression, price rationalization, deleveraging, and a fledgling rotation away from the dominant Momentum factor, investors are trying to assess the likely impact of the myriad news headlines, such as the President’s actions to address unfair trade agreements with tariffs meant to cajole some accommodation from our global trade partners. In addition, some of the mega-cap Tech stocks (e.g., FAANG) that have led the market for so long are seeing their business practices under attack, especially Amazon.com (AMZN ) and Facebook (FB). Also, we have a huge $1.3 trillion federal omnibus budget (despite full employment and solid GDP growth that would normally suggest a budget surplus) that some claim will bankrupt the nation. To be sure, there is nothing desirable about a budget deficit of $1 trillion and a national debt of $22 trillion (21% of GDP). And then there is the fear among some observers that new Federal Reserve chairman Jerome Powell is more concerned with normalizing short-term rates than he is about supporting the economy (the proverbial “Fed put”). Not to be outdone, Barron’s opined that corporate earnings growth expectations are so exuberant that there is likely more downside risk than upside potential as the earnings reports come in. Meanwhile, some market commentators are pointing to the strengthening technical condition of gold and bonds to say that stocks are in for more pain ahead. And lenders appear to be tightening their credit standards and lending less, suggesting all is not well on Main Street.
In other words, there are plenty of negative narratives flying around, and for the moment they are giving rise to the dreaded climate (previously witnessed in the 2H2015-1H2016 timeframe) of news-driven risk-on/risk-off trading, rising correlations, higher volatility, and reduced strategic equity exposures.
However, all is not lost. On the contrary, there is no denying the underlying strength in the global economy and the continuously improving outlook for US corporate earnings. In fact, it’s hard to fully predict all the various impacts (both direct and indirect) we will see from tax reform and deregulation over the next few years. 1Q2018 earnings reports are on tap in just a matter of days, and with the tailwind of massive tax cuts (corporate tax rates falling from 35% to 21%), consensus S&P 500 earnings are expected to grow +17% year-over-year versus 1Q2017 (up from expected Q1 growth of +11% at the beginning of the year and the best year-over-year performance since 1Q2011) – and many well-selected stocks should do quite a bit better. Moreover, economists generally expect GDP growth to come in somewhere in the 2.5-3.0% range, compared with 1.2% in 1Q2017. Inflation fears have tempered, bonds have caught a bid, and extreme equity valuations have fallen as technical support levels have been tested. And don’t forget, spring is in the air, which is a seasonally strong time for stocks, and Morgan Stanley estimates that about $400 billion in global dividends will be paid out this quarter, adding further buying fuel.
President Trump’s newly-imposed tariffs and his venting about Amazon’s fleecing of the taxpayer by minimizing its taxable income and by leveraging a government-subsidized US Post Office – not to mention its ability to steamroll both large corporate competitors and Mom-and-Pop shops alike – have certainly spooked the markets. After all, tariffs may spark a global trade war, right? And Amazon represents the future of commerce as it shakes up the world through “creative disruption” to the long-term benefit of us all, right? Well, perhaps, but to me these are simply the latest examples of Trump’s negotiating style, as he tries to stand up for the little guy without actually derailing growth in both the economy and the stock market that he so covets. Rather than watch trade negotiations languish in committee for years on end with no resolution, he skips the diplomacy and instills a sense of urgency with the stroke of a pen and some tough language. Likewise, rather than quietly cajole Jeff Bezos to pay higher shipping rates, he tries to humiliate him into submission. Remember his tough talk to Russia and North Korea about his willingness to engage in a nuclear arms race that we would “easily win”? Sounds a lot like his tariff talk today.