Despite New Tariffs and Mixed Economic Data, Stocks Rallied This Week Because the US and China Agreed to Meet in October.
After falling 2.9% in August, the S&P 500 rallied 1.8% this week as investors ignored the September 1st tariff increase and mixed economic data, and instead bought stocks because the Trump administration and China agreed to another round of trade negotiations in early October.
The tech-heavy Nasdaq 100 and the small-cap Russell 2000 increased by 2.1% and 0.70%, respectively, this week. International stocks also performed well, the MSCI EAFE Index (international ex-US and Canada) appreciated by 2.16%, and the MSCI Emerging Markets jumped by 2.6%. In this “risk-on” environment, the safe havens corrected — gold fell by 0.9%, and the U.S. Treasury long-bond (TLT) dropped by 0.8% this week.
This week the S&P 500 rebounded despite mixed economic news. On Monday, the ISM Manufacturing Index fell below 50, which signaled that manufacturing was in a contraction. It was also the weakest reading since August of 2016. Additionally, IHS Markit reported that their manufacturing index fell to 50.3, which was the lowest reading since September 2009.
While the manufacturing sector appears weak, the service sector, which represents nearly 70% of the U.S. economy, continues to perform well. On Wednesday, the ISM Non-Manufacturing survey showed that the services sector of the economy remained robust and grew at a stronger rate than investors expected.
Finally, on Friday, the Bureau of Labor reported that 130,000 jobs were created in August. Unfortunately, economists were expecting a report of 150,000 jobs, and since 25,000 jobs were due to the temporary hiring of census workers, this was a disappointing number. On a positive note, wages increased by 3.5%, which was the best level in ten-years (see chart below).
The Trade War is Hurting Corporate Profits
According to Factset, analysts expect the S&P 500’s Q3 earnings to fall by 3.6% year-over-year. This will be the third consecutive quarter of year-over-year earnings declines. Factset also indicated that declining corporate earnings were mostly due to weak international growth. In fact, Q3 earnings are expected to decline by 10.7% for companies that generate more than 50% of their sales outside the U.S., while companies with more than 50% of their revenue in the U.S. are expected to grow earnings at 0.4%.
Analysts expect Q4 earnings to rebound to 4.3% year-over-year growth in Q4, which will lead to 1.4% earnings growth for 2019. Additionally, the S&P 500’s earnings are expected to grow by 10.7% in 2020. Based on these numbers, the S&P 500 sells at 16.8 times the 12-month forward earnings, which is 13% above its 10-year average P/E of 14.8.
We believe that earnings expectations are too high, and stocks will be vulnerable when analysts begin to reduce their earnings expectations in the coming weeks. While the resumption of trade negotiations is positive, the tariffs remain in place, tensions are high, and any resolution (if at all possible) is many months away.
In addition to the trade war and the global economic slowdown, wages are growing at their highest rate in ten years. Tight labor markets, and accelerating wages will continue to pressure profit margins and negatively impact earnings growth. Unfortunately, what is good for “Main Street” is not always good for “Wall Street.”
Our Market View:
The S&P 500 is within 2% of its all-time high, yet we are in a trade war with China, global growth is weak, and earnings are expected to decline for the third quarter in a row. Additionally, interest rates have plunged this year, and the yield curve has inverted four months ago. This dramatic drop in interest rates indicates that bond investors are concerned that the Fed is too tight and economic growth is at risk. Commodity prices confirm the bond market’s message of weak economic growth — over the past twelve months, the price of oil and copper have dropped by 23% and 6%, respectively.
While bond and commodity investors appear concerned about economic growth, equity investors seem ebullient — the S&P 500 sells at a premium valuation and near its all-time high. While the S&P 500 has performed well this year, it is up only 5.3% over the past 21 months. Furthermore, the small-cap Russell 2000 is down by 11.7% over the past twelve months, while the MSCI EAFE Index (international ex-US and Canada) and the MSCI Emerging Markets declined over the past year by 3.3% and 0.7%, respectively.
In our view, such narrow market breadth indicates that the S&P 500 is benefiting from a “flight to quality,” which we expect will end soon, as the economy continues to slow and earnings estimates fall. We believe that the market is already discounting the best-case scenario regarding a trade agreement and a Fed easing cycle, and the stock market will be vulnerable to any disappointment.
While the S&P 500 has rallied by 18.8% this year, we believe the more critical measure of the market’s strength is its performance over the last twelve months, in which, the S&P 500 is up only 3.5%. Also, the leading sectors over the past year are the defensive, non-cyclical sectors (Utilities, REITs, and Consumer Staples) and Technology. Also, five of the S&P 500’s eleven sectors have declined over the past year (Energy, Financials, Materials, Industrials, and Healthcare)
In our view, the sector performance of the market over the past twelve months confirms the message of the bond market and is consistent with a slowing economy, and a “risk-off” environment. We are especially focused on the disappointing performance of the financial sector over the past year — since it fuels growth and is a leading indicator of the economy.
The strength of the defensive sectors of the market over the past twelve months confirms the message of the bond market and is consistent with a slowing economy, and a “risk-off” environment.
Our Tactical Asset Allocation (three to six-month view) is negative: Despite a 2.9% drop in August, the S&P 500 has rallied for two consecutive weeks and is within 2% of its all-time high. The VIX (the volatility “fear gauge”) fell below 15 last week, which indicates that investor sentiment is too optimistic, while breadth is weak, and stocks are in a period of negative seasonality.
We believe that the market is in a correction, and we will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve.
Our Strategic Asset Allocation (six-year view) remains underweight equities, overweight bond duration, and long gold: We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated. At the sector level, we remain overweight the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.
Our long-term asset allocation remains underweight equities because the market is overvalued, the profit cycle is slowing, and earnings are poised to disappoint as global growth slows and profit margins compress. In our view, the Fed tightened policy too much last year and the recent tariff increases will accelerate the slowdown in growth. We remain concerned that the yield curve indicates that the Fed is too tight and a recession is probable within the next year.
As value investors, we will continue to underweight our long-term equity exposure until the markets offer a favorable risk-reward.