According to meteorologists, July was the hottest month, ever. It was a relatively “hot” month on Wall Street too, as stock prices rose once again, gaining 1.3% for the month (as measured by the S&P 500). Year to date, the total return from stocks now totals a remarkable 20.2%. Thus far in 2019, stocks have only had one down month. That was May, when prices fell 6.6%. Otherwise, it’s been a rewarding time to own stocks and most investors, while somewhat guarded, are pleased with this.
The return to stocks looks less remarkable when viewed over a rolling 12 month period. Stocks delivered a 7.9% return for the trailing 12 month period. This is not a bad return, but nothing remarkable, and less than the historical return for large cap stocks. Last fall, stock prices fell 6.9% in October and an alarming 9.2% in December. The market was a whisker away from a full 20% decline, typically the benchmark for a bear market. In January of this year, when the Federal Reserve indicated it would stop raising interest rates, stocks immediately rose and erased all of the losses from the second half of last year..
We are now just coming to the end of 2Q 2019 earnings season. According to FactSet Research, as of July 31, 76% of companies reporting had beaten earnings and 73% had beaten revenue. The reports were a good bit better than expected. In general, margin contraction was offset by higher revenue growth. In the end, the change agent was fewer shares outstanding due to stock buybacks. Analyst forecasts of earnings estimates for 4Q19 and for 2020 have been drifting lower. This is due to deteriorating economic conditions in the US and around the globe, and is being exacerbated by tariffs.
Since the start of the year, stock prices have been on the rise. This is not due to improved fundamentals or an increase in earnings estimates. It is simply due to an increase in the P/E ratio (the multiple the market applies to earnings) which has risen from 16x to over 19X today. The increase in the multiple is the result of the steadily falling interest rate expectations. The multiple is not likely to continue to expand. In my opinion, stocks are fully valued, based on what we can discern at the moment.
Unfortunately, at this juncture, bonds are expensive too. As measured by the iShares Core US Aggregate (AGG), bonds have returned over 6% year to date, more than double the 2.5% per year the 2.5% the AGG has averaged over the last five calendar years. Bonds are important. They provide reliable, albeit modest income. They can also provide some protection from volatility in a portfolio holding stocks. We refer to this as ballast. In a perfect scenario, stocks and bonds in a portfolio together behave in a non-correlating manner. This is more often the case when utilizing municipal or corporate bonds, as opposed to bond mutual funds.
The recent collapse in yields is a significant tell that the economy is stalling. Anxiety over the trade debacle, and hopes of monetary policy penicillin (ever lower interest rates) has become a volatility cloud over investors’ sentiment toward stocks. If the economy goes into a stall, or if we even suffer several quarters of flat or declining earnings, it will be a challenge for stock prices. The ability of central banks around the world to repair the damage from a metastasizing trade war is limited, at best.
Just the same, stocks remain the best game in town, especially when we consider a holding period greater than 12-18 months. I prefer US stocks due to 1) a high degree of transparency and communication with respect to assessing how businesses are faring, 2) our access to research and quality information from an accounting and reporting perspective and 3) a data base that enables us to sort and screen stocks quickly and effectively. One of the components of success in the complex world of investment management is keeping watch for changes on the margin.
It seems obvious that figuratively and literally, temperatures are rising. I hope August is cooler than July, but my confidence is guarded. We remain on alert to raise cash and take a more cautious position, as soon as we see the beginning of a trend. Heightened volatility can mask or mark the onset of a trend. Please feel free to check in if we have not spoken recently.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.