Back in November of last year, all investors were thrilled when the Dow Jones Index reached 23,500. Now, not so much. Between November and April, the Dow Index rose 13% to a peak value of 26,616 on Jan 26, 2018 and has now come all the way back down to 23,600, a decline of 11%. We are now at a level at which the market should find support.
Since the January peak, the tone of the market has changed from a tranquil rally to choppy and erratic with multiple 500-point daily swings both up and down. This increase in volatility is a sign that the market has become confused about the fundamental outlook and is looking for its next theme, either bullish or bearish. In my experience, when markets become this volatile, it is best to remove some equity risk from client portfolios.
Figure 1 – The Dow Jones Index Needs to Hold 23,000
The equity markets appear to be at a crossroads. Either the positive fundamental outlook needs to reassert itself, most likely driven by earnings outperformance, or a bear market will take hold. The bullish case should be driven by robust 1stQ earnings growth in late April and May, coupled with benign inflation and increased capital spending plans. The bearish case is premised on overly high market valuation, combined with too many investors overexposed to equities, which could lead to a waterfall pattern decline in the market, similar to Japan in 1992.
After 9 years of equity gains, many investors have let their equity exposure drift higher than their risk tolerance for several reasons. During the time-frame of low volatility, some investors took on more risk as the price swings were benign. As market volatility has increased, the daily dollar swings of their portfolios has become nerve wracking. Secondly, many investors have become trapped by their capital gains, since nobody likes to pay taxes. Thirdly, with low yields in the bond market, there have been few viable alternatives to equities. When the majority of investors are on one side of the market, it can move quickly in the opposite direction.
One cause for market concern is the unpredictability of U.S. economic policy. The range and randomness of threats and actions taken by the White House is contributing to the market weakness and volatility. Recent and expected trade steps along with political controversy surrounding social media companies and Trump’s attacks on Amazon have certainly unnerved investors. But it is the backdrop of a steady departure of moderate members of his administration that has greatly magnified the worries. The fear is that these moderates are being replaced by more hawkish and protectionist people who will be less likely to disagree with the President.
The unpredictability was highlighted by a series of tweets by Trump over the weekend criticizing Mexico and threatening NAFTA anew. Then, later on Monday, there were reports that Trump wants to complete new terms for the free trade agreement within the next two weeks. Without any further details, it is difficult to anticipate future economic and market direction when policy dictates are erratic. Given such uncertainty, investors are increasingly adopting the old market phrase “when in doubt, get out.”
Corporate Earnings are Expected to Accelerate in 2018 and 2019
For bulls, the start of so-called Earnings Season cannot begin soon enough. The first U.S. quarterly earnings report from an S&P 500 company will come on April 11 from Delta Airlines and then be followed on April 13 by JP Morgan Chase, Wells Fargo and Citigroup.
According to FactSet, the first three months of 2018 saw the largest increase in the bottom-up Earnings Per Share (EPS) estimates during a quarter since FactSet began tracking them 16 years ago. Consensus forecasts for the S&P 500 as a group are now up 5.4% to $36.24 per share from $34.37 at the beginning of January. The big question is to what extent all this is already discounted in the market and the extent to which the “good” news shifts investor attention away from the politically-driven economic risks.
Interest Rates Have Turned Higher
Washington and the public have forgotten that deficits matter. In 2017 the Federal deficit was $665 billion, 3.5% of GDP. Since interest rates have been low for almost ten years, borrowing money is thought of as almost free and certainly beats the rate of inflation. So why not go all in and borrow a lot more?
The President’s recent tax cut will add $1.5 trillion of fiscal stimulus into the economy. Then Congress will be spending an additional $300 billion in the new budget. Still pending is the infrastructure bill. To put this in perspective, the Obama stimulus when the economy was on the verge of a depression was approximately $831 billion. The tax cuts and new spending are like pouring gasoline onto a hot fire.
The annual amount of bonds issued by the U.S. Treasury is likely to increase from $420 billion in 2017 to over $1.1 trillion by 2019, a 160% increase. For example, the monthly auction of 2-year notes is likely to increase from $30 billion to $75 billion a month in 2020. Many new buyers need to be found.
Figure 2 – Interest Rates are on the Verge of a Major Breakout to Higher Levels
Interest rates are not likely to jump up overnight. At first there will be more bonds to be sold at auction, leading to an increased yield to clear the market. Then the increased fiscal stimulus will lead to higher wage rates and commodity prices. As inflation starts moving from its 1.5% - 2.0% band to 2.5% - 3%, 10-year Treasury rates could potentially reach 5% to 6%. This will increase the cost of borrowing for families, companies, municipalities and the government. Once a bear market in bonds starts, it cannot be easily stopped. In my opinion, the era of cheap money is over!
Investment Themes for 2018
With the recent increase in market volatility, we have moved client portfolios from aggressive to a more normal equity allocation. We have shortened bond maturities and increased bond quality, often by adding short maturity U.S. Treasury bills and notes.
While we remain hopeful that the earnings season will exceed expectations and drive the markets higher, we are taking a wait and see approach to equity allocation. As we are believers in higher interest rates over the next two years, our favorite equity sector is financial stocks. Emerging markets continue to remain interesting on a value basis as they continue to have the demographics for future growth opportunities.
Overall, we have slightly reduced portfolio risk and are hopeful that the earnings season will reignite the bullish trend. While the ride may be bumpy, we are optimistic that the performance for the year will be above average.