1st Quarter 2018 Review
The S&P 500 finished the quarter up 2.93%, fighting headwinds of threats of trade wars. While 2.93% is a slightly above average quarterly return, it was surprising that the markets didn’t react more positively given the record earnings reported during the quarter.
The S&P 500’s second quarter performance erased the negative performance found in the first quarter, pushing performance into positive territory. Even though all three months of the second quarter were positive, the S&P 500 price return index finished the first half of the year up a meager 1.67%.
What PGFG Like About the Markets
S&P 500 companies reported record earnings for the 1st quarter of 2018, reporting almost 25% quarter over quarter growth. As you can see from the estimates chart, 2nd quarter earnings are expected to be even higher, as are the subsequent quarters in 2018.
There are many ways to evaluate market valuations. The forward P/E ratio is probably the most popular way of evaluating the markets (the other common ways are found in the graph below). As we discussed in our 2018 market outlook webinar, we were concerned that the S&P 500 was overvalued. A market correction (lowering the “P” of the P/E ratio) and record earnings (increasing the “E” of the P/E ratio) has brought this popular evaluation tool back to 25-year norms.
Record Profit Margins
The S&P 500 reported the highest profit margins they have experienced in over 20 years (see below). This can be viewed as a glass half empty or a glass half full. One could argue that with such high-profit margins, they are sure to come down. I would argue that S&P 500 companies are being well run and should be rewarded for their excellent profit margins.
Record Dividends and Near Record Share Buybacks
S&P 500 companies rewarded investors with the highest dividend payments ever paid to investors and near record share buybacks. The combination returned almost $1 trillion to investors over the past four quarters.
Strong GDP Growth
The U.S. economy is currently growing at a 2.8% year-over-year pace. This is substantially higher than the 2.2% average growth since the end of the financial crisis, and it is slightly higher than the 2.7% average growth pattern over the past 40 years.
Many news agencies and analysts are expressing concern over the length of time that our economy has been expanding. Our economic expansion is the second longest expansion on record. Some would challenge that this means a recession is just around the corner. I would argue that this economic expansion is very different from all other expansions since World War II.
Economic expansions are measured from the previous economic high, the length of the recession, the recovery back to break even, and then the expansion that happened afterwards. As you can see from the chart, the red arrow indicates that it took the United States 15 quarters to recover from our prior recession. This was almost twice as long as any prior post-WWII recovery time. In addition, we had extreme government intervention to stabilize our economy. Quantitative easing didn’t stop until 2014 (marked by the orange line). While we have seen our economy expand, it has been anemic compared to prior economic expansions that have lasted as long. Our economy has only grown 14% bigger than where it was in 2007 (blue horizontal line). Previous expansions of this length produced two to three times more growth (horizontal green line) over the same number of quarters during their expansion. I believe that we will see our economy continue to grow for the foreseeable future.
Market Trend is Still Intact
No market goes straight up or straight down. The S&P 500’s overall trend is still strong and pointing in the right direction.
Continued Fed Action
The Federal Reserve kept their promise, raising rates a second time this year on June 14th. This is the second rate hike this year. Even though rates are rising, they are still historically low (as seen below).
Even with these two hikes, the December Fed Futures indicate that it is very likely that we will see one or two more hikes this year (as seen below). This will continue to place downward pressure on bond prices.
Fed actions are already having an impact on bond prices, as we’ve seen short and intermediate bond yield rise by nearing two percent. This should not be surprising because the Federal Reserve has raised rates by the same amount. The surprise is the flattening of the yield curve. As you can see from the chart, short-term bond yields have moved up substantially, while yields have dropped for bonds with a ten-year duration or longer.
Why is this Happening?
According to Bloomberg News, there is $8.1 trillion (yes with a T) in negative yield global debt. For example, a 2-year German bund is yielding -0.65% per year. Yes, that is correct. If you are German, buy your country’s 2-year debt, you will lose 1.3% over that two-year period. Guaranteed!!! Who signs up for such an investment? These investors are looking for a safe investment. They’ve been flocking to long-term U.S. Treasuries. More buyers mean more demand. More demand means higher prices. And if you remember, there is an inverted relationship between prices and yield. As prices go up, yields drop. That is why we are seeing a very unusual shift in our yield curve.
Why does this Matter?
Many companies in the S&P 500 use short-term debt to help them leverage their earnings. Higher short-term rates mean lower margins. Sectors that are more exposed to short-term debt are Consumer Staples, Real Estate, Utilities, and Telecommunication. Typically, higher short-term rates would have a positive impact on the Financial sector. Right now, the Financial sector is suffering because of the flattening yield curve. Banks, for example, borrow short-term and lend long-term. The flattening yield curve is compressing their profit margins.
But does this mean a trade war has begun? I don’t think so. As I have mentioned many times before in our educational pieces, you can’t renegotiate trade deals by saying “please.” You must take a very tough stance and you must be willing to follow up your threats with actual consequences. It’s kind of like disciplining a child. If you tell your child that if they continue to do what they are doing that they are going to be grounded for a week, then you need to ground them for a week if they cross the line that you set. If you then turn around and let them go out and play the next day, the child learns that there are no consequences to misbehaving. While the parent might feel like they are suffering alongside the child who is unhappy being grounded, that child will not misbehave if you stay firm and keep them in the house for the entire week.
China will continue their unfair trade practices until they are forced to do otherwise. The United States only exports $130 billion worth of goods to China. China, on the other hand, export $506 billion worth of goods to the United States. There have been multiple salvos shot across each country’s bow, warning each other that they won’t back down from each other’s threats on tariffs. But China has far more to lose in this game of chicken than the United States due to the trade imbalance.
On Tuesday (July 11th) President Trump announced a $200 billion tariff as a direct punishment for China’s intellectual property theft, sighting “China apparently has no intention of changing its unfair practice related to the acquisition of American intellectual property and technology.” China has promised to “strike back hard, and launch comprehensive measures that match the U.S. move in quantity and quality.” The question is, “how?” The U.S. only exports $130 billion of goods to China. They can’t directly match the tariffs imposed on them by the U.S.
As of July 11th, the Shanghai Stock Exchange Composite Index was down 16.36% for the year. This is obviously having an impact of the Chinese markets.
Uncertainty often weighs on the performance of the stock market. By far, the number one thing keeping this market from being up significantly is negative sentiment. People are investing by their gut, not their head. They aren’t being clinical with their decisions but rather reacting with fear.
There are many cultural differences between the United States and China. Trump’s tough stance will probably bring the Chinese back to the negotiating table, and when a new trade deal is struck, expect both sides to declare victory as a means of “saving face.” Don’t be surprised if you see this deal finalized in time for the mid-term elections in the fall.
Domestically things look very good. We had record earnings. Earnings growth was over 24% quarter-over-quarter and companies in the S&P 500 are expected to report even higher earnings. GDP is strong. Inflation is under control. Unemployment is non-existent (at 3.8%). Wages are increasing (putting more money into the average American’s hands). Companies are rewarding their investors by paying record dividends and buying near-record amounts of their company shares back. What’s not to like?
While we are currently bullish on the outlook of the markets, we are not married to this belief. The power of tactical portfolio management is the flexibility and the adaptiveness. Our investment team is constantly reevaluating the risk in the market. If we see the need, we will take all of our strategies to a more defensive allocation.
This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Polaris Wealth Advisory Group unless an investment management agreement is in place.