Stock Market Volatility Continues

The roller coaster ride in the stock market continued this week, albeit with smaller moves than we saw last week. Let's jump in and look at a few of the factors the market is grappling with. 

Stock Market Volatility

We have seen stock market volatility spike higher in recent weeks. This spike began when Federal Reserve Chair, Jerome Powell, indicated during an interview that interest rates remained a long way from neutral, a point where interest rates are neither restrictive or accommodative of economic growth. This comment moved investors to sell bonds, and saw interest rates jump higher as we detailed last week

While there are genuine concerns that the Fed could raise rates too far, too fast, it is not a surprise to see higher market volatility as interest rates go higher. We believe the stock market can handle higher interest rates, however, sharp moves higher in rates like we have seen a few times in 2018 will lead to higher volatility. A key point to remember is that October is historically the most volatile month of the year for stocks. 

Earnings Growth

This earnings season has been very good so far with strong earnings reports from the likes of Proctor & Gamble, United Healthcare, Netflix, PayPal, CSX and many more. Third quarter earnings growth for companies in the S&P 500 are coming in at 22% so far. This outstanding growth has exceeded virtually every forecast analysts had coming into the year. This also comes on the heels of 25% growth in the first half of this year. 

Not all news has been great on the earnings front. Any company involved in housing or autos has struggled due to several factors, including rising interest rates. The housing market in particular has cooled, as higher interest rates mean higher mortgage payments for consumers looking to buy a new home or refinance. Existing home sales fell for the 6th straight month to 3-year low. We will be watching for signs of housing to firm. 

Market Technicals

From a technical perspective, the S&P 500 closed yesterday right on its 200-day moving average.This moving average has been key support for the stock market going back to the strong run that began after the election in November 2016. Some investors who are trend-followers like to buy when the market is above the 200 DMA and sell when the market drops below the 200 DMA.


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China

The slowdown in the Chinese economy continues, with 3rd quarter GDP growth slowing to 6.5%. This was the lowest rate of growth in China since 2009. The Chinese stock market has also seen a significant decline of 25% so far in 2018. That being said, expect the Chinese government to step up with measures to support the economy and the stock market. There are plenty of levers the government can pull in the short-run.
The trade dispute currently taking place between the U.S. and China continues with no signs of a resolution in the short-term. One concern some have voiced is that China could dump U.S. Treasuries on the market causing interest rates in the U.S. to soar, thus slowing the U.S. economy. China currently owns over $1 trillion of U.S. Treasuries. Click below for a detailed analysis of the situation which explains while it is highly unlikely China will go down this path as it would likely hurt China far more than the U.S.

https://qz.com/1419180/chinas-nuclear-option-in-the-us-trade-war-would-be-economic-suicide/

So while the U.S. showdown with China, fear of rising interest rates and the slowdown in housing and autos are clearly worth watching, it is also the case that we are in the midst of the best stretch of economic growth in the U.S. since the late 90's. Pro-growth economic policies have led to incredible increase in company earnings, the strongest small-business sentiment in 35 years and a surge in capital investment. 

As October winds down, volatility could remain elevated in the run-up to the mid-terms as markets work through the issues detailed above. Last week we raised an extra 5%-7% of cash in our portfolios, giving us more dry powder if the market volatility continues.

Blood on Wall Street

It was an ugly day in the markets with the Dow Jones Industrial Average down 832 points, or 3.15%, with the S&P 500 down 3.29% and the tech-heavy Nasdaq plummeting 4.08%. Days like today certainly are not a lot of fun but are a reality even during bull markets.

Last week interest rates shot up with the 10-year U.S. Treasury bond yield jumping from 3.05% to 3.24%, the highest yield on the 10-year since 2011. The S&P 500 is now down five straight days since this move occurred.

Let's not forget that in January of this year we saw the 10-year U.S. Treasury bond yield jump from 2.48% to 2.85%, which at the time was the highest yield since 2013. Stocks proceeded to fall over 11% into early February. It was a bloodbath, with five or six days of declines similar to what we saw today. However, over time the stock market digested that move higher in yields and went on to erase those losses and hit new highs.

Unfortunately, I do not have a crystal ball, well I do but it just shows me colors- not helpful here. Back to being serious, I do not have a crystal ball, but the decline seen over the last week is very similar to many stock market corrections in the past. And while the corrections are not enjoyable they play a pivotal part in a longer-term bull market.

I will have more to say later this week on the bigger picture, but for now know I am watching the markets and your portfolios very closely.

Tesla CEO's Bold Tweet

For Tesla Chief Executive Elon Musk, outside-the-norm has always been the norm. Even by those standards yesterday Mr. Musk sent shock waves throughout the business community with message he sent from his Twitter account announcing he was considering taking the company private at $420 a share. Mr. Musk also indicated that funding had been secured.

The timing of the message, during market trading hours, was highly unusual for a message of this magnitude. Also, there was no explanation for how Mr. Musk arrived at the $420 per share figure.  Mr. Musk would need to raise an estimated $60-$70 billion in debt and/or equity to take Tesla private. That is an enormous task for a company that is still rapidly burning through cash. The SEC will certainly take a close look at Mr. Musk's tweets.

Time will tell what the outcome ultimately will be, but there is no question this is one of the wildest financial stories I have seen. Tesla's stock has never traded on fundamentals, and headlines around Mr. Musk have often been surreal. 

For more analysis on this story, head over for a take from MarketWatch.
 

Apple

Last week a significant milestone was reached as Apple became the first company to reach a valuation of $1 trillion. From the WSJ:

Apple’s rise has been propelled by the sustained success of the iPhone developed under late co-founder Steve Jobs, a product visionary who helped revive the company from a death spiral in the late 1990s. His successor, Tim Cook, has turned Apple into a cash-generating giant by pushing its existing products to prominence in China and cultivating its rapidly growing services business—moves that have helped stave off concerns about the absence of a new, blockbuster device.

With a market capitalization of $1 trillion, Apple is larger than the GDP of most countries, including Sweden, Saudi Arabia, Turkey and The Netherlands. It is a remarkable achievement, especially when you consider that the company had to reinvent itself multiple times just to stay in business. Their superior innovation, technology and marketing helped them become the first trillion dollar company.

Business Investment Accelerates

As we near the halfway point of 2018 several themes are emerging. Let's take a look.

Business Investment

After years of virtually no capital expenditures, businesses have significantly accelerated investment into things new buildings, equipment, vehicles and software. One of the biggest reasons for increased investment is due to the tax cuts that took place January 1st, 2018. During 1st quarter earnings reports, company after company have cited the tax cuts when asked what was driving increased investment.

From Reuters:

"U.S. companies could plow more of the money saved from sweeping tax cuts into business investment later this year, perhaps even surpassing a jump in first-quarter capital expenditure that was the highest in almost seven years, strategists and analysts said.  
Higher spending on technology, equipment and facilities could ease worries that S&P 500 companies have reached a peak in the profit growth investors are counting on to extend the nine-year bull market in equities. 
With data in from 94 percent of S&P 500 companies, first-quarter capital expenditures total $159 billion, up more than 21 percent from a year ago and on track to be the highest year-over-year growth since the third quarter of 2011, according to S&P Dow Jones Indices data." 
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Earnings Growth

When all was said and done 1st quarter earnings grew at a blistering 26.5% pace. After earnings growth had flat-lined in 2015 & 2016 financial analysts are forecasting growth of almost 20% in 2018. This would be an impressive number on the heels of 14% growth in 2017. Tax cuts, deregulation and consumer confidence in the economy have all played a role in the earnings surge. 

Not only were 1st quarter results impressive, but we saw the highest spread between companies rasising their earnings forecast and companies lowering their earnings forecast since 2003. 

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Small Business Optimism

Given that small businesses are so critical to the U.S economy, the fact that optimism from business owners hit the highest level in 35 years should be very beneficial to the economy during the 2nd half of 2018.

Via NFIB:

“Main Street optimism is on a stratospheric trajectory thanks to recent tax cuts and regulatory changes. For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” said NFIB President and CEO Juanita Duggan.
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Investors could not have asked for a better start to the year for company earnings than what they have gotten. With small business optimism hitting records and a long overdue surge in business investment, the table is set for continued strength in the U.S. economy.

Next, we will look ahead to some of the challenges the market could face in the 2nd half. We will tackle the ongoing tariff negotiations currently taking place between China and the United States as well as the decision by the Federal Reserve to hike interest rates once or twice by the end of the year. We will also take a look at which investments have been the leaders and which have been the laggards in the first half of 2018.

Strong Earnings Growth Faces Off With Rising Interest Rates

Market volatility has persisted as wide intraday swings in stock prices have continued to be the norm following the stock market correction in early February. 

There has been a tug-of-war for the market's attention between higher interest rates and strong earnings growth. On one side the interest rate on a 10-year U.S. Treasury Bond topped 3% this week for the first time since early 2014. Coming into 2018 the 10-year rate was 2.40%. Remember that when interest rates go up that means that bond prices are declining. The Barclays Aggregate Bond Index, which is viewed as the S&P 500 of the bond market, is down 2.67% year-to-date and Long-Term U.S. Treasuries have declined 7.07% year-to-date. It has been several years since we owned Long-Term Treasuries as the risk of interest rates going higher outweighs the reward of earning a slightly higher yield. 

Also taking it on the chin this year:

Consumer Staples      -10.20%

REITS                        -9.02%

Utilities                      -3.05%

What these investments have in common is that all three doubled in price between 2011 and 2016, outperforming the S&P 500 as investors searched for high-paying dividend stocks with bond rates and money market rates extremely low.  

The valuation of these "bond-proxies" are still not cheap and if interest rates continue to go higher there will likely be more pain ahead for this group.

The high yield for the 10-year U.S. Treasury in 2014 was 3.03%. Earlier this week that level was tested again and rates subsequently backed down to under 3%. The issue for some investors isn't necessarily higher interest rates, but the concern is the potential for interest rates to quickly move higher making it more difficult for the market to adjust.  

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As we approach the halfway point for first quarter earnings reports, revenue and earnings growth continue to be sensational. Earnings are on pace to grow 21.1% with revenue increasing 7.6%. It was not too long ago that some analysts said that low single digits growth was the best that could be expected and that the days of faster growth across the board were gone. 

As of January 1st, 2018 the projected growth rate for first quarter earnings was 12.2%. Actual results are going to be nearly double those projections. 

A theme from 2011-2016 was that analysts were overly optimistic each year in their forecasts for earnings growth (and economic growth as well) and as the year progressed would have to cut their forecasts. 2017 earnings growth came in slightly below the initial forecast and so far in 2018 analysts have significantly raised their forecasts.

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Let's briefly touch on a few more issues. 

The Cass Freight Index gives valuable insight into the level of economic activity by tracking freight expenditures and freight volumes. This chart does a good job of illustrating the dramatic turnaround that has taken place in the U.S. economy since the beginning of 2017.

This index is a leading indicator of economic activity so the March reading is a positive for future economic growth. 

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The U.S. consumer continues to feel very good about the economic outlook. When consumers are more confident in the economy they tend to spend more.

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Part of the reason for the consumer's positive outlook is that their take home pay is increasing at the highest rate in over ten years thanks to the recent tax cut. March saw an increase of 7.5%, up from the 2%-3% range previously seen.

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As first quarter earnings season continues to unfold we will closely track not only the earnings themselves, but also companies outlook for the rest of 2018. We will also monitor interest rates with particular attention around the 2014 high yield of 3.03%. Keep in mind that strong economic data does not guarantee more upside for the stock market. That said, 20% earnings growth on the back of double-digit earnings growth in 2017 provides a strong foundation for stocks. 

February Jobs Report Blows Past Estimates

Stocks soared last Friday as the February jobs report showed 313,000 new jobs were added in February, blowing past economists projections for 212,000 new jobs. This is an extremely strong showing considering the unemployment rate is already near historical lows at 4.1%. Also, labor force participation grew 0.3% to 63%, its largest one month increase since 1983. Over 800,000 workers came back into the work force. This is a very positive development for the economy and one that should continue. 

Almost 100,000 of the new jobs created were in construction and manufacturing. That continues a revival in those industries that has taken place over the past year.

Another key aspect of the jobs report was the growth in wages of 2.6%. The stock sell-off in February was initiated when the January jobs report was released and showed wage growth of 2.9%. This led investors to become concerned that higher wages would lead to a significant increase in inflation. A significant increase in inflation would lead to a quicker pace of rate increases by the Federal Reserve. The decline in wage growth from 2.9% in January to 2.6% in February should help ease the concerns about inflation.

The Federal Reserve's target inflation rate is 2% for the Personal Consumption Expenditures. Looking at the chart below it is notable that inflation has run well short of the Fed's target over the past 10 years.   

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Time will tell if investors really need to be concerned about rising inflation. For now the U.S. economy continues to show real strength with low inflation as the latest jobs report and Core PCE report confirms.

Stock Market Decline Jolts Investors

The peace and calm the stock market saw in 2017 has officially come to an end as the Dow Jones Industrial Average fell 1,175 points today. This was a decline of 4.60%. Over the last six trading days the Dow is now down 8.54%.

This has shocked a market that had not experienced a decline of 5% in over two years. 2017 was characterized by extremely low volatility in the stock market. Everyone knew such low volatility could not continue but no one knew when volatility would spike.

Many times during declines like we have seen in the last week, analysts rush to assign blame for the decline. The bottom line is that often times there is no major reason for the decline other than this kind of thing just happens from time to time in the market. 

Tonight some of the top reasons given for the decline are:

1) Fear of interest rates rising too quickly

2) Will rising wages trigger a significant increase in inflation?

3) Did computer/machine trading cause indiscriminate selling?

4) Will the new Fed Chair, Jerome Powell, look to increase the pace of Fed rate hikes from what we have seen from Janet Yellen?

In October of 1987 the Dow fell 508 points, which was 22.6%. That was a much more significant decline than what we experienced today and many investors still don't know the reason that decline was so steep. 

It is important to keep in mind that this decline has returned the market to levels last seen in mid-December, or less than two months ago. The positive data that drove the market higher in 2017 and early 2018 are still in place. Namely, strong earnings growth, improving economic growth both in the U.S. and abroad, interest rates that are still low on a historical basis and the tax bill that has already greatly benefited companies and workers. 

That being said, stock market declines and market volatility are still unpleasant. Obviously, no one has a crystal ball, so we will continue to closely monitor your portfolio and make any necessary adjustments should they be needed. 

One last thing, do not be surprised if tomorrow morning (Tuesday) stocks open down an additional 2%-3%. If that occurs we would then see if traders become buyers and restore some calm to this frazzled market.

U.S. Economy Continues To Gain Steam

As 2017 winds down recent economic developments have heated up. Let's dive in.

Tax Bill

Only time will tell what the ultimate impact of the tax bill will be. There is little doubt however that the reduction in the corporate tax rate from 35% to 21% will be beneficial. At 35% the U.S. had the highest corporate rate in the developed world. The 21% rate will make U.S. companies much more competitive on a global scale. A recent trend was for companies to move their headquarters out of the U.S. to countries with lower tax rates. With the new 21% rate there should be a dramatic reduction in these corporate inversions. 

Another very positive change was reducing what has been called the repatriation tax. Under existing law companies have paid the 35% tax rate on profits they had made overseas that they brought back to the U.S. This tax was in addition to companies paying taxes to the country in which the profits were earned. The tax bill reduces this rate to 15.5% and going forward the U.S. will not tax foreign profits brought back home. Estimates are that there is anywhere from $3 trillion - $5 trillion in cash that could be brought back into the U.S. by this change.

The ink is not even dry on the tax bill and we are already seeing companies reacting positively to the passing of the bill:

AT&T has announced that due to the tax bill passing Congress they are giving 200,000 employees an immediate $1,000 bonus and they will be spending an extra $1 billion in capital expenditures. 

FedEx's Chairman Frederick Smith said that the tax bill will prompt the company to increase hiring as well as new business spending as the tax cut will give them an extra $1.3 billion in profits. 

Fifth Third Bank announced that with the passing of the tax bill they will be raising minimum wage at the bank to $15/hour and will be giving over 13,000 employees a $1,000 bonus.

Economic Growth

The New York Fed just raised their 4th Quarter GDP estimate to 4%. This is coming on the back of 3Q GDP rising at the fastest level in 3 years. A narrative by some economic analysts in 2016 was that the U.S. economy had entered a new normal where GDP growth couldn't exceed 1.5%-2%. We have seen this year that pro business policies have buried that narrative. We expect GDP growth to continue above 3% in 2018.

Consumer Confidence

Since the election in 2016 a common theme has been a major increase in confidence in the economy both by consumers and businesses. 

U.S. Consumer Confidence just hit a 17-year high in November as U.S. consumers are more and more confident in the economy and the jobs market. This increased confidence has led to a major increase in U.S. retail sales. Holiday spending is off to a fantastic start. 

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It isn't just the U.S. consumer whose confidence is soaring:

The NFIB's Small Business Optimism Index hit a 34-year high in November. Small business owners are the top job creators in the U.S. so this is a very positive development.

U.S. Homebuilder confidence hit the highest level since 1999. New home sales also recently hit their highest level since 2007.

Earnings

The final number for 2017 earnings growth will not be known until 4th Quarter numbers are reported by companies in January and February, but based on real numbers in 1Q, 2Q, 3Q as well as 4Q estimates, 2017 earnings growth for the S&P 500 will be close to 12%. 

Earnings growth has been a significant driver of U.S. stocks in 2017. The earnings outlook for 2018 is also very strong and with the passage of the tax bill some analysts are expecting 13%-15% earnings growth.

The U.S. economy has heated up in 2017 with consumer and business confidence soaring and strong corporate earnings growth exceeding expectations. The passage of the tax bill will mean lower tax rates for many U.S. companies which will lead to higher earnings in 2018. However, one factor that will be critical to market returns in 2018 will be the movement in interest rates. We will address this issue and more in an upcoming post. Merry Christmas.

Social Security Checks Rising in 2018

The Social Security Administration has announced that recipients will be receiving an increase of 2% in 2018. This is an announcement that will be welcomed by retirees who saw only a .3% increase in 2017 and no increase in 2016. 

Unfortunately many recipients of Social Security who are also on Medicare will find that the Social Security increase is eaten up by higher premiums for Medicare Part B. 

Since 2000 the average Social Security increase has been 2.2%. 

The Wall Street Journal has more.
 

China Update

Over the past decade cash from China has been deployed into assets such as stock, bonds and real estate around the globe. The Chinese government, concerned by the level of cash leaving the country, has put capital controls into place to slow this flow of cash leaving the country.

From the Wall Street Journal:

China’s seemingly insatiable demand for foreign assets has driven up prices for everything from U.S. Treasury bonds to global companies to luxury real estate. Now, a combination of market forces and capital controls are choking off the flow of Chinese cash. Asset markets around the world will have to adjust.

As Chinese exports boomed starting in the early 2000s and foreign investment flooded into the country, the central bank recycled these inflows into foreign government bonds, mostly Treasurys, to keep the yuan from rising. The buying persisted for over a decade, driving bond prices up and driving yields down globally.