January 6, 2020

Top Investment Trends Affecting Your Portfolio This Week

 After Ending 2019 and the Decade on a High Note, Stocks Ended the Week Mixed After the U.S. Killed Iranian General Suleimani in Iraq

Stocks ended the holiday-shortened week mixed after the U.S. responded to an attack on the American embassy in Iraqi by killing Iranian General Suleimani on Thursday evening. Investors became concerned that the escalation between the U.S. and Iran would lead to higher oil prices and potentially another war in the Middle East.

The S&P 500 closed the week lower by 0.16%, while the tech-heavy Nasdaq 100 rose by 0.26%, and the small-cap Russell 2000 fell by 0.44%.  The MSCI EAFE Index (international ex-US and Canada), and the MSCI Emerging Markets dropped by 0.02% and 0.31%, respectively.

Due to the increased geopolitical risk, the bond market and the safe havens rallied.

The U.S. 10-year Treasury bond yield fell by 9bps to 1.79%, the U.S. Treasury long-bond (TLT) rose by 1.31%, and gold jumped by 2.26%.

The leading sectors of the S&P 500 for the week were Industrials (up 1.16%), Energy (up 0.85%), and Technology (up 0.47%).  The lagging sectors of the S&P were Materials (down 2.35%), Consumer Staples (down 1.38%), and Healthcare (down 1.01%).

Last week started on a positive note when President Trump, on Tuesday, announced that he and President Xi would sign “phase one” of the trade deal with China on January 15th, and he would later head to China to begin negotiating “phase two.” On Thursday, the Chinese announced a new monetary stimulus, which drove stocks higher on the belief that economic growth was poised to accelerate.

While the economic risks subsided, the turmoil in the Middle East escalated. After an American contractor was killed by Iranian-backed forces in Iraq and the American embassy in Iraq was attacked, President Trump authorized a drone strike, which killed the Iranian General who was believed to be orchestrating the attacks on U.S. assets. Iran vowed revenge and the financial markets sold off on Friday due to fear of retaliation and more conflict in the Middle East. While oil jumped by 3% jump and gold surged by 1.6%, the S&P 500 fell by a modest 0.70%.

Also, on Friday, the Institue for Supply Management reported that manufacturing activity fell for the fifth consecutive month, and contracted to its lowest level since 2009. The ISM estimates that the current level of manufacturing is consistent with 1.3% economic, which is significantly below economists' expectation of 2.0% growth in 2020. This weak manufacturing number is especially concerning because the progress in the trade war with China had a little favorable impact.

Despite Weak Fundamentals, 2019 was a Great Year for Stocks

Despite a slowing economy, no earnings growth, a trade war with China, and potential impeachment, stocks climbed a wall of worry to have a great 2019. The S&P 500 surged by 28.8% to post its best year since 2013, while NASDAQ rallied by 35.2%, and the small-cap Russell 2000 appretiated by 25.4% in 2019.

Despite the strength in the stock market, the safe havens performed well in 2019. Gold appreciated by 17.9%, and U.S. Treasury long-bond (TLT) by 11.5%.  Additionally, technology was the only sector that outperformed the S&P 500 in 2019. This lack of market breadth illustrates that a few very large technology stocks (Apple, Microsoft, Amazon, Google, Facebook) had a disproportionate impact on the S&P 500, which is a market-weighted index


The S&P 500 rallied by 28.8% and since earnings didn’t grow 2019, the stock markets appreciation was fueled by a significant increase in the stockmarket’s valuation:

                                          S&P 500          Trailing EPS       PE

December 31, 2018       2506.8                $151.60           16.5

December 31, 2019       3230.8                $152.97            21.1 

                                        +28.8%                +0.90%            +28%

In 2019, the significant increase in market valuation was because investors focused on the Fed’s dramatic pivot from raising interest rates and tightening financial conditions to cutting interest rates three times and printing $60 billion each month to grow their balance sheet by purchasing Treasury bills. Investors drove stocks higher on the belief that lower interest rates and an accommodative Fed would fuel economic growth and a profit recovery in 2020.

According to Factset, analysts believe that earnings will grow by 9.6% in 2020, on revenue growth of 5.4%. Stocks currently trade at 18.3 times next year’s earnings which are 22.8% above the S&P’s 10-year average PE of 14.9. While many pundits argue that stocks should sell at a higher PE multiple because interest rates are so low, it is interesting to note that interest rates are mostly higher than their 10-year average.

                              Forward PE      3-mo T Bill     2-yr T Note     10-yr Bond

10-year average        14.9                0.58%            0.96%            2.40%

Today                         18.3                 1.56%            1.54%             1.82%


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Chart of the Week
What is Driving the Market Higher?

In October, the Fed began growing its balance sheet by printing $60 billion each month to purchase Treasury bills to “paper over” problems in the overnight lending market (REPO market). While the Fed claims this is not QE (Quantitative Easing, which buys bonds to drive risk assets higher) because the financial assets they are buying have a short duration, it appears that the sudden increase in liquidity is driving stocks higher.

Since September, when the problems in the REPO market materialized, the Fed has grown their balance sheet by $400 billion and the S&P 500 appretiated by nearly 9%. Interestingly, before the "Great Financial Crisis", the Fed's balance sheet was only $800 billion.

Since the Fed indicated that they expect to continue their “not-QE” program until Q2 2020, this excess liquidity should drive stocks stocks higher into the second quarter, assuming no further escalations with Iran or China.


profit to GDP

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Market Outlook

In the short-term (three-months):  stocks are very overbought, investors are too optimistic, and we believe that the escalation with Iran could act as a catalyst for a 5% to 8% market correction. In our view, the stock market’s muted response to the escalation with Iran demonstrates to us an unhealthy level of complacency. We believe (hope) that Iran is reluctant to strike Americans or American assets, and if they retaliate, it will be limited to an attack on our allies in the region and/or energy infrastructure – similar to their attack on Saudi Arabi’s oil infrastructure in September. The market’s poor short-term risk-reward led to a reduction in our short-term tactical equity allocation.

In the long-term (more than four years): we continue to believe that the stock market offers a poor risk-reward. Central bank liquidity and not economic fundamentals drove stocks far from their intrinsic value. We believe the Fed’s aggressive monetary policy, coupled with a $1 trillion budget deficit, will weaken the dollar and lead to more debt and larger asset bubbles. Currently, the stock market is priced for perfection, and we believe that earnings are poised to disappoint as rising wages and an increased corporate debt burden lead to declining profit margin

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.