KFAC - Market Update

Scott Kays, CFA, CFP®

December 7, 2018

This year has been a tough one in a lot of ways for investors. For most of the year, the major indices were showing gains, but this masked a lot of turbulence going on under the surface.

Most people use the S&P 500, which consists primarily of large U.S. companies, as their reference for how the stock market is performing. The S&P 500 is a capitalization-weighted index, meaning the larger the company, the bigger its influence on the index’s return.

For a good part of the year, large growth companies (mostly in the technology sector) experiencing outsized returns drove much of the S&P 500’s performance. Many, if not most, investors who had portfolios broadly diversified outside of domestic large-company growth stocks experienced performance significantly below this index. This occurred because many other areas of the stock market, such as international, emerging markets, and value, were not faring so well.

Even bonds, typically thought of as relatively safe investments, have experienced a negative return for the year thus far as measured by the Barclays Capital U.S. Aggregate Bond Index.

Then, at the beginning of October, volatility jumped significantly, and the market began turning down. As of this writing, that slide continues. What is driving this downturn?

A few negative factors have weighed heavily on investors’ minds recently. First - that the Fed will raise rates too far too fast, causing a recession. The Fed has been raising rates because of its concern that the economy is overheating, possibly leading to future inflation. Labor markets are very tight—evidenced by the low unemployment rate— and wages have been rising at an accelerated pace lately. Economic growth is strong, and various measures of inflation have increased over the last couple of years. By raising rates preemptively, the Fed hopes to slow the economy down to a sustainable level and prevent inflation from taking hold while simultaneously avoiding a recession—a tough balancing act!

Part of the Fed’s problem is that their actions generally do not fully impact the economy for about six months. Therefore, they are acting today based on their predictions of where the economy will be six months from now. This explains why they have often been wrong and raised rates too far.

In recent months, Jerome Powell, Chairman of the Federal Reserve Board, has made statements indicating that the Fed still had a good bit further to go before interest rates reached neutral. This spooked investors and invoked fears of a Fed-induced recession. The good news is that inflation measures have recently showed signs of easing. Plus, the effect of at least two interest rate hikes have still not worked their way through the economy. Chairman Powell unexpectedly reversed course and stated in a speech last week that interest rates were just a touch below neutral. Though this statement seemed to contradict his earlier comments, investors welcomed it. The market rallied sharply on his change of heart.

The market has also been concerned about a potential trade war with China. For years, China has engaged in trade practices with the United States that many, including myself, would consider unfair. President Trump has instituted some tariffs, and threatened more, on imported products from China if the Chinese are not willing to negotiate better trade practices and agreements with the United States. Investors have worried that this trade war (actually, it’s been more of a spat up to this point) could have a negative impact on the global economy.

A trade war would hurt China much more than us. Why is that? According to the Census Bureau website (https://www.census.gov/foreign-trade/balance/c5700.html), Chinese exports to the U.S. totaled almost four times that of our exports to them last year.

Indeed, the Chinese economy has slowed recently, and their stock market has suffered. That does not mean the U.S. would escape unscathed by a trade war or that we would not experience some short-term pain. However, I believe investors’ fears may be overblown, and the potential long-term good that could come from a more fair-trade arrangement with China could be huge.

The market rallied sharply again last Monday as President Trump indicated that significant progress had been made in trade talks with President Xi over the weekend at a G-20 summit in Buenos Aires, Argentina. The positive reaction was short-lived, however, as investors, on Tuesday, began fretting about the lack of details on an agreement.

Where does all this leave us now? In my opinion, the fundamental underpinnings of the economy and market are solid. For the third quarter, companies in the S&P 500 index reported over 20% year-over-year earnings growth. Analysts project similar growth for this quarter as well. Strong earnings growth and a relatively flat market have resulted in much better market valuations then we had at this time last year.

The strong earnings growth has been driven by a few factors, not the least of which is the recent tax cuts. Since earnings are measured on an after-tax basis, charging companies lower taxes automatically results in higher earnings, all other things equal. Companies have used the tax savings to, among other things, buy back shares and invest in capital equipment to increase their productivity. Both of these bode well for future earnings.

In addition to better stock market valuations and solid earnings growth, economic growth has picked up significantly over the last year, with growth averaging over 3% over the last four quarters. This is somewhat stronger than the average growth rate of the last decade.

In short, market downturns are never pleasant, but they are part of investing in the stock market. It would be nice if their timing and depth could be predicted with some level of precision, but they cannot. Upturns have always followed downturns, and stock market investors have been rewarded for staying the course during periods of volatility. In fact, bull markets are normally birthed at the height of pessimism and bad news.

The worst bear markets have occurred during recessions, and we do not see a recession in the U.S. as likely in the near future, which leads us to believe this downturn will probably be relatively short-lived and, short of an external shock, not extraordinarily deep. Rather, we view it as ordinary volatility and a run-of-the-mill correction.

Thank you for your continued confidence. Feel free to reach out to your advisor if you have questions or would like to discuss your portfolio.

 

Enjoy your weekend!

Scott

 

Scott Kays, CFA, CFP®, is President of Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at skays@scottkays.com. 

 

This report and Mr. Kays’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors.  No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment.  Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances.  Past performance of any investment mentioned is not a guarantee of future performance.  Statements regarding the investment concerns and merits of any investment and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation.  Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned here in.