The Intelligent Investor’s Market Memo – Oct 25, 2019 - Manley Capital Management, LLC

October 25th, 2019

Top Investment Trends Affecting Your Portfolio This Week

Corporate Profits are Slightly Better Than Expectation

Through October 25th, 40% of the companies in the S&P500 reported their third-quarter earnings. According to Factset, profits are likely to fall by 3.7% in Q3, which is slightly better than analyst’s September 30th expectation of a 4.0% decline. If third-quarter earnings fall, it will be the third consecutive quarter of declining earnings, which is the longest streak since Q2 of 2016. Currently, analysts expect that Q4 earnings will be flat (up 0.60%), which will lead to earnings growth of 0.60% for 2019.

According to S&P, the S&P 500 earnings have grown at only 1.8% over the past twelve months, so the S&P 500 sells at 19.7 times earnings, which is 30% greater than its long-term average P/E of 15.1.  Analysts expect that earnings will grow by 9.9% in 2020. Based on that estimate, the S&P 500 sells at 17 times forward earnings, which is 14% greater than it’s 10-year average P/E of 14.9.

Currently, stocks sell at a premium valuation (i.e., overvalued) because interest rates are very low (the ten-year U.S. Treasury bond yields less than core inflation) and investors believe that the Fed’s interest rate cuts and the pause in the trade war with China will lead to an economic acceleration next year.

Q3 Estimated Earnings for the Sectors of the S&P 500
  • Energy               -39.3%
  • Materials            -10.0%
  • Technology          -7.2%
  • Consumer            -3.4%
  • Financial              -2.6%
  • Industrial               0.7%
  • Communication    1.2%
  • Utilities                  5.6%
  • REITs                    5.0%
  • Healthcare            4.1%
  • Staples                -0.4%

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The Fed will cut interest rates, but will it be a hawkish cut?

Last December, the Fed raised interest rates for the fourth time in 2018 and stated that they would raise interest rates three more times in 2019 and continue their Quantitative Tightening program that sold $50 billion of bonds each month to reduce their bloated balance sheet. Unfortunately, the Fed underestimated the negative impact their previous interest rate hikes and the trade war with China had on the economy. This year, the contraction in the manufacturing sector, the slowdown in the manufacturing industry and an inverted yield curve (short-term interest rates yield more than long-term interest rates) forced the Fed to aggressively pivot from tightening to easing monetary policy.

On October 30th, the Federal Reserve will meet, and investors believe that there is a 95% chance that they will reduce interest rates for the third time since July.  In addition to the rate cuts, the Fed is “printing” money to buy $60 billion of U.S. Treasury bills each month for the foreseeable future.

While the economic data continues to slow, the Fed’s aggressive actions have stabilized the financial markets. The S&P 500 is near an all-time high, and the bond market has stabilized, which indicates that recession is less likely. Importantly, the market reacted well to recent weak economic data, which showed that investors are discounting an economic rebound due to the Fed’s action.

The S&P 500 is up more than 20% this year. Since earnings are mostly flat, the market’s 2019 rally was due to an increase in valuation, which we believe was driven mainly by the Fed’s dovish pivot – i.e., the shift from tightening to easing monetary policy.

On Wednesday, investors expect the Fed to cut rates by 0.25%, and announce a pause in their easing cycle. Currently, investors believe that there is only a 16% chance that the Fed will cut rates at their December meeting. While this pause should not be a surprise, we are concerned tha the Fed has recently had a problem communicating its strategy to the street. In fact, the market has dropped by more than 5% in the weeks after the Fed’s May, July, and September FOMC meeting.

Market-Based Indicators

Major Indices  
S&P 500 
Russell 2000 (small cap) 
MSCI EAFE (international) 
MSCI Emerging Mrkts 
U.S. Aggregate Bond 
60% Equity/40% Bonds 

This Week
3022.5  |  1.22%
1550.5  |  0.89%
1944.2  |  1.26%
42.7  |  1.72%
112.6  |  (0.16%)
0.67%

Y-T-D
20.6%
15.8%
9.1%
9.3%
8.5%
15.76%

12mo
13.7%
4.7%
3.8%
1.7%
10.3%
12.3%

Growth Indicators
3mo to 10yr Yield curve
2yr to 10yr Yield Curve
Baa Bond Yield
Baa Credit Spread

This Week
0.14%  |  +4bps
17bps  |  -1bps
3.94% |  -7bps
2.27%  |  -4bps

12-mo rate-of-change
-66bps
-11bps
-115bps

17bps

Inflation Indicators
10-yr Inflation Breakeven
U.S. Dollar
Gold
WTI Oil

This Week
1.65%  |  +5bps
$97.6  |  0.61%
$1505.3  |  0.75%
$56.7  |  5.18%

12-mo rate-of-change
-41bps
4.2%
21.5%

(17.4%)

Market Outlook

In the short-term (three months), we expect that stocks will rally into January on the expectation that the Fed’s dramatic policy shift (three rate cuts and purchasing $60 billion of T-bills each month) and the pause in the trade war with China will lead to an acceleration in economic growth next year. Also, we are entering the strongest three-month period of the year (November through January). Since the market is currently overbought and investors are too complacent (Vix is less than 13), we will wait for pullback to increase our risk exposure.

In the long-term (more than four years), we continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and high-profit margins that are poised to return to an average level. While investors believe that an easy monetary policy can drive economic growth, we are concerned that since rates are already low the Fed’s easing cycle will have a muted impact on economic growth.

Charts of the Week

​Corporate Bond Yields Have Plunged
Corporate bond yields and credit spreads are important economic indicators that we watch closely. The Fed’s aggressive pivot over the past few months has led to lower credit spreads and a sharp drop in corporate borrowing costs, which indicates that the economy is poised to recover, and a recession is unlikely. Interestingly, Baa corporate bond yield (the lowest level of investment-grade bonds) is at its lowest level since WWII (see chart below).

Source:FRED

S&P 500 Sector Performance Last 12-Months


S&P 500 Index
+11.72

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.