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Change is Coming

The stock market is all about earnings.  Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation.  US stocks have been enjoying an unprecedented period of earnings growth and price appreciation.  Much of this stems from the stock friendly behavior coming out of Washington DC.  In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.

For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%.  The solid returns for the month brought the S&P back into the black for the year.  May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.

While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017.   I do not expect the S&P 500 to return 22% again this year.  Signs of trouble are brewing.  Few asset classes are faring well.  Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%).  Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.

It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary.  In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.

One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth.  The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits.  The US$ had been low, amplifying the effect.  Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.

Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order.  This is thin ice.

Much of the anticipated global growth was fueled by debt.  Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth.  This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark.  Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey).  Growth, measured by GDP has slowed.  The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.

The question isn’t so much if there will be trouble, but when.  I do not think any changes in asset allocation need to be made, yet.  I do expect returns to bonds to be minimal, and stocks to be in the average range.  I am pleased the market continues to reward growth over value.  This is a tailwind for our portfolios.  Our core approach to investing is referred to as GARP or growth at a reasonable price.  Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins.  The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions. 

One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive.  They tend to tick down the list of supportive economic or consumer data points.  There is a lot of cool-aid being consumed out there.  I’m not a contrarian, but I’m also not one to get sucked into the vortex.  The best course of action today is to avoid getting drawn in to owning too much stock.  We need to stay well invested, while hovering one foot over the break. 

Bruce Hotaling, CFA

Managing Partner

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