Investor sentiment is too optimistic, market breadth deteriorating, and we are in a period of negative seasonality.
Over the past six weeks, the S&P 500 rallied by 10.6% because the Fed indicated that they would begin cutting short-term interest rates at its July 31st meeting and the trade negotiations with China were resumed. Investors drove the S&P 500 to an all-time high on the belief that the lower short-term interest rates and the end of the trade war would lead to a global economic rebound.
Stocks pulled back this week when President Trump showed his frustration with the lack of progress in negotiating an end to the trade war with China. The President stated that “we have a long way to go as far as tariffs where China is concerned if we want. We have another US$325 billion [of goods] we can put a tariff on if we want.”
In addition to the setback in trade talks, CSX, a $56 billion railroad that services the east coast, disappointed Wall Street by missing their earnings estimate and giving an uncertain economic outlook. CEO James Foote said on the conference call that “The present economic backdrop is one of the most puzzling I have experienced in my career.”
While investors were concerned about the lack of progress with China and an uncertain economic outlook from the U.S.’s largest railroad, New York Fed President Williams gave investors a reason for optimism. In a prepared speech, he said that “It’s better to take preventative measures than to wait for disaster to unfold cialis pris.” Also, central banks need to “act quickly” when economic growth slows.
Investors drove stocks higher on the belief that interpreted Williams speech as an implicit message that the Fed would act aggressively and cut rates by 0.50%.
Unfortunately, after the market’s enthusiastic reaction to the speech, the Fed scrambled to alter investors expectations. On Friday, the Wall Street Journal reported that “Federal Reserve officials signaled they are ready to lower interest rates by a quarter-percentage point later this month, while indicating the potential for additional reductions, despite the recent surge in market expectations of a half-point cut.” Investors were disappointed with the news of only a 0.25% interest rate cut and sold stocks.
Our View: This year, the S&P 500 is up more than 20% because of the Fed changed their forecast from three rate increases in 2019 to several “insurance cuts” to sustain the economic expansion. While the Fed’s dovish pivot drove the S&P 500 to an all-time high, there has been little positive change in the economy or corporate profits.
Stocks are near an all-time high because the Fed focused on placating Wall Street and minimizing market volatility through their constant verbal guidance. While the Fed has successfully driven volatility down and stocks higher, all they have done is pushed investors to take more risk. If they are not successful in stimulating the economy, or the trade war is not resolved, and recession follows, they will have set up investors for another brutal bear market.
No one can predict the stock market or the economy with any consistency, so it is essential to evaluate investments based on risk and reward. We believe that stocks offer very poor risk-reward. The market is pricing in the best case – i.e., the trade war ends, the new Fed easing cycle stimulates the economy, and corporate profits rebound in the fourth quarter.
In our view, even if the best-case occurs, stocks are already priced for perfection and have little upside because of their excessive valuation. Currently, stocks are selling at 21.8x its trailing 12-month GAAP earnings. This is a 45% premium to its historic average of 15 times earnings. Market capitalization to GDP also shows that stocks are extremely overvalued. In a 2001 Fortune Magazine article, Warren Buffet stated that market capitalization relative to GDP “is probably the best single measure of where valuations stand at any given moment.” Currently, stock market capitalization is 141% of GDP; this is significantly above the 50-year average of 65%.
In addition to valuation, we are concerned that investors have too much faith in the Fed’s ability to stimulate the economy. As discussed last week, we believe that the Fed is behind the curve and may not have the tools to fight a recession.
At 121 months, the current economic expansion is the longest on record, yet the yield curve (10-year to 3-month U.S. Treasuries) has been inverted for three months. Historically, when long-term interest rates yield less than short-term interest rates for three months, a recession has occurred in the next nine to eighteen months. Since 1960, this indicator has predicted every recession, while giving no false signals.
While optimistic bulls may believe that this time is different since the Fed is prepared to begin easing later this month, the slope of the yield curve indicates that the Fed was wrong and kept short-term interest rates too high for too long.
Since monetary policy works with at least a twelve-month lag, the economy will not benefit from this month’s rate cut for a long time. Also, since the Fed raised rates last September and December, the economy has not yet felt the negative impact of last year’s hikes.
Also, the Fed historically cut interest rates by 5.00% to fight a recession. Unfortunately, during the record 121-month economic expansion, the Fed only managed to lift interest rates from 0% to 2.5%. So, if the economic slowdown accelerates as indicated by the yield curve, the Fed can only reduce interest rates by 2.5%, or half of what they needed to do historically.
Finally, we believe that the Fed’s verbal interventions and attempts to reduce market volatility, have negatively affected the stock market’s ability to act as a discounting mechanism and a leading indicator of economic activity. We believe that the markets are higher not because the Fed’s action will stimulate the economy, but simply because the lower interest rates make companies more valuable – i.e., since companies are the present value of future cash flows, a lower discount rate makes them more expensive.
We are concerned that the stock market’s strength based on the Fed’s jawboning, masks the negative impact of the tariffs on the global economy and may embolden President Trump to extend the trade war into next year.
In summary: Despite the Fed’s promise to cut interest rates by 0.25% on July 31st, our investment posture remains defensive. We believe that stocks are priced for perfection, and the slowing economy and negative profit growth will disappoint optimistic investors. In our view, the stock market offers a poor long-term risk-reward. Valuations and profit margins are high and poised to regress to a normal level. Additionally, we expect that slower growth, coupled with increasing cost, will lead to declining margins and disappointing earnings. Finally, we remain concerned that investors are ignoring the yield curve, which indicates that the Fed is too tight and a recession is probable within the next year.
Our tactical equity allocation (six-month view) is negative. The market has appreciated by 10.6% over the past six weeks and has a poor short-term risk-reward. Investor sentiment is too optimistic, market breadth deteriorating, and we are in a period of negative seasonality. We believe that a July rate cut is fully priced into the equity market, and the primary driver of stock prices will be Q2 corporate earnings and guidance. Next week, 133 (26.6%) of the S&P 500 companies will report earnings
Our Strategic Asset Allocation (six-year view) remains underweight equities, overweight bond duration, and gold. We continue to believe that the stock market offers a poor long-term risk-reward. Valuations and profit margins are high and poised to regress to a normal level. Additionally, we expect that slower growth, coupled with increasing cost (wages, and interest rates) will lead to declining margins and disappointing earnings. Furthermore, 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.