Investors Enter New Year With Combination Of Apprehension And Optimism

After an “investor’s paradise” year in 2017 – buoyed by ultra-low levels of volatility, inflation, and interest rates, and fueled even more by the promise of fiscal stimulus (which came to fruition by year end) – 2018 was quite different. First, it endured a long overdue correction in February that reminded investors that volatility is not dead, and the market wasn’t quite the same thereafter, as investors’ attention focused on escalating trade wars and central bank monetary tightening, leading to a defensive risk-off rotation mid-year and ultimately to new lows, a “technical bear market” (in the Nasdaq and Russell 2000), and the worst year for stocks since the 2008 financial crisis. Then, it was confronted with the Brexit negotiations falling apart, Italy on the verge of public debt default, violent “yellow vest” protests in France, key economies like China and Germany reporting contractionary economic data, and bellwether companies like FedEx (FDX) and Apple (AAPL) giving gloomy sales forecasts that reflect poorly on the state of the global economy. The list of obstacles seems endless.

Moreover, US stocks weren’t the only asset class to take a beating last year. International equities fared even worse. Bonds, oil and commodities, most systematic strategies, and even cryptocurrencies all took a hit. A perfect scenario for gold to flourish, right? Wrong, gold did poorly, too. There was simply nowhere to hide. Deutsche Bank noted that 93% of global financial markets had negative returns in 2018, the worst such performance in the 117-year history of its data set. It was a bad year for market beta, as diversification didn’t offer any help.

Not surprisingly, all of this has weighed heavily upon investor sentiment, even though the US economy, corporate earnings, and consumer sentiment have remained quite strong, with no recession in sight and given low inflation and interest rates. So, despite the generally positive fundamental outlook, investors in aggregate chose to take a defensive risk-off posture, ultimately leading to a massive selloff – accentuated by the rise of passive investing and the dominance of algorithmic trading – that did huge technical damage to the chart and crushed investor sentiment.

But fear not. There may be a silver lining to all of this, as it has created a superb buying opportunity, and it may finally spell a return to a more selective stock-picker’s market, with lower correlations and higher performance dispersion. Moreover, my expectation for 2019 is for a de-escalation in the trade war with China, a more accommodative Fed, and for higher stock prices ahead. Forward valuations overall have become exceedingly attractive, especially in the cyclical sectors that typically flourish in a growing economy.

Market Commentary:

2018 performance review and economic metrics:

Whereas 2017 was characterized by risk-on behavior and strong performance in the Momentum factor at the expense of Value, Quality, and Low-volatility factors, 2018 was marked by a risk-off flow of capital such that changed the market’s complexion entirely. The S&P 500 fell by -9% (total return) in December alone and lost -4.4% for full-year 2018 (versus +22% return in 2017, and -14.5% below its all-time high from September 21), while the S&P 500 Equal-Weight (RSP) was down -7.8% in 2018 (versus +18.5% in 2017), S&P 500 Growth (SPYG) was flat (versus +28% in 2017) and S&P 500 Value (SPYV) returned -9% (versus +15% in 2017). Also, S&P 400 mid-caps (MDY) was -11% in 2018 (versus +16% in 2017) and S&P 600 small caps (SLY) returned -9% (versus +13% in 2017). Note the continued outperformance of cap-weighted and growth-oriented over equal-weighted and value-oriented, and large caps over smaller caps in both the up-market of 2017 and the down-market of 2018, largely driven by capital flows into passive vehicles and algorithmic trading versus research-driven stock picking. More on this later.

S&P Dow Jones Indices reported that Healthcare was the top-performing sector across the cap spectrum. Among large caps, the only positive sectors were Healthcare, Utilities, and Consumer Discretionary. In mid-caps, Healthcare and Utilities were the only positive sectors, while in small caps, only Healthcare was positive. Energy was the worst performing sector across the cap spectrum (especially in the small cap space), hurt by the decline in oil prices, as oil closed the year around $46, which was down -23% from the $60 closing price at the end of 2017.

For the first half of 2018, US stocks were led by the mega-cap Technology names like Amazon (AMZN), Microsoft (MSFT), and Apple (AAPL), that dominate the cap-weighted market indexes, along with risk-on sectors like Technology (including semiconductors), Consumer Discretionary, Steel, Energy, and small caps. But starting on June 11, when the trade war with China escalated from rhetoric to reality, capital quickly rotated out of those risk-on market segments and into US large-cap defensive sectors like Healthcare, Utilities, Consumer Staples, and Telecom, as well as some mega-cap stalwarts. The table below illustrates this pre- and post-June 11 behavior, through the end of the year.

Sector performance 2018

Even though the outlook for the cyclical sectors held up, with earnings beats and raised guidance, prices fell precipitously as investors feared the uncertain impacts of trade wars and Fed policy. It seemed nobody believed the guidance and they didn’t want to be last one out the door.

But the US economy is showing no signs of an imminent recession. During 2018, final Q1 GDP came in at a 2.0% annual rate, Q2 was 4.2%, and the BEA’s third estimate for Q3 (published on December 21) was 3.4%. Looking ahead, the Atlanta Fed’s GDPNow model (as of January 8) is forecasting 2.8% for Q4, while the New York Fed’s Nowcast model (as of January 4) forecasts Q4 at 2.5% and 2.1% for 1Q2019. Overall, the Federal Reserve expects the final 2018 full-year growth rate to be in the range of 3.0-3.1%, followed by 2.3-2.5% in 2019. The IMF forecasts global growth of 3.7% in 2019, which includes 2.5% GDP growth for the US. Brian Wesbury, Chief Economist at First Trust Advisors L.P., is forecasting 3.0% U.S. economic growth in 2019 as the benefits from tax reform and deregulation play out over the next several years.

Other metrics look quite good, too. Employment is strong, as nonfarm payrolls had a blowout report in December showing 312,000 new jobs, which was the biggest jump since February. Average hourly earnings increased an impressive +3.2% year-over-year, which is the best growth rate since 2008. Unemployment remains low at 3.9% and the labor participation rate rose (i.e., more people returned to the job market). Moreover, Jobless Claims remains near the lows of the economic expansion (note that prior to every recession since 1970, the number of jobless claims was on the rise). Consumer and business confidence both remain near record highs. Consumer spending is strong, as holiday retail sales hit all-time records, and DataTrek reports that sales of large pickup trucks in 2018 outpaced 2017, as “…key buyers here (small businesses) clearly still feel positive about their near-term outlook.” Furthermore, operating leverage of households and businesses is not unusually high, nor is household and business capital spending (as percentage of GDP). A lot of institutional capital is idle and needs to be deployed to hit return targets. In addition, the 10-year yield has fallen well below 3%, which justifies higher equity valuations (both on a discounted cash flow basis and on a relative valuation basis versus bonds).

US corporate profits in 2018 grew nearly 20% (of which about half was organic growth and half attributable to the tax cut), which was the fastest pace since 2010. For 2019, earnings growth for S&P 500 companies is forecasted to be a slower-but-still-healthy 9% for full-year 2019 (to about $173 per share), so although earnings momentum may be slowing, it is nowhere near contracting. Also important to note, the long-term earnings growth rate (looking beyond 2019) recently has increased, as analysts see more favorable opportunities ahead – essentially pushing out some sales that were previously expected in 2019 to 2020-2021. Thus, when you couple the positive earnings expectations with low inflation and interest rates, higher stock valuations (e.g., P/E multiples) certainly seem justified, as opposed to the dramatic compression in forward P/E ratios we saw in 2018, which was more reflective of a climate of earnings contraction, rising interest rates, and economic recession.

This all supports the notion that the US economy is trying to launch into the elusive “boom phase,” which should be quite favorable stocks. I agree with Dubravko Lakos-Bujas of JP Morgan, who recently wrote, “We expect the equity pain trade to be on the upside, given diminishing tariff and Fed related risks, positive earnings growth, attractive valuations, continued shrinkage of equity supply via buybacks, and given very low investor positioning.” Thus, even beyond 2018, it seems that US stocks have some years left in this uptrend.

Assessment of my 2018 forecasts:

As for my beginning-of-year forecasts for 2018 (which I derived from the consensus earnings outlook and underlying assumptions suggested by Sabrient’s models), I predicted a solidly up market, fueled by new fiscal stimulus, strong corporate earnings, persistently low inflation, and only a modest rise in interest rates. I expected Treasuries to catch a bid whenever the 10-year yield rose above 3.0% (essentially capping any spike in yields). I also predicted some compression in forward P/E ratios – from 18.5x in the S&P 500 at the start of the year to perhaps 17x by year end – as the speculative move in stocks during 2017 in anticipation of tax cuts gave way to a “show me” mentality among investors about how corporate leaders would actually deploy their extra cash to build value in their companies’ stock. In addition, I pointed out some risks to my thesis, particularly the uncertain impacts from the gradual deleveraging of massive levels of global debt and an overly hawkish Federal Reserve.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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