For days now Floridians have been in a state of suspension – the massive hurricane Dorian sitting just off the coast. It ravaged the Bahamas and is now making its way slowly northward. Much as they try, meteorologists (and presidents) cannot truly predict the direction or the intensity of a hurricane. So, Floridians are more or less forced to brace themselves, and then wait it out.
In many ways, this tension is precisely what investors in the equity markets have been facing. For the trailing 12 month period, stocks have generated a total return of 2.92%. This was hard-earned, as during that period of time, stocks fell during 4 months, and in each case, by an average 6%. Year to date, stocks have rebounded off their 2018 year-end low for a total return of 18.34%, as measured by the S&P 500. In stormy August, stock prices fell 1.81% and were down on 10 of 22 trading days. The worst damage was from three days in particular, when prices fell nearly 3%, and those happen to be the three worst trading days of the year so far.
There are a lot of things investors in stocks and bonds are fixating on. High on the list is the trade war the administration boldly initiated, and the resultant economic fallout around the globe. Economic fundamentals are beginning to erode and it’s not clear how some aspects of the global economic mosaic will repair itself. For instance, distribution channels have been shut, supply chains cut and re-routed, hours worked in manufacturing are on the decline and corporate (S&P 500) revenue growth has fallen from 8% a year ago to 2%. Corporate leaders are less likely to make capital commitments related to trade as long as Washington is unreliable.
While Washington has taken to brow beating the Federal Reserve Bank in an attempt to influence policy, it is not clear monetary policy functions as it once did. We are late in the economic cycle and rates have been low for a long time. The 10-year US Treasury note, which anchors many aspects of the borrowing markets (student loans, mortgage loans) is now at roughly 1.45%. It is nearing the record 1.36%, the lowest level ever, set in July of 2016. The Federal Reserve Bank and the European Central Bank are both expected to lower their respective benchmark rates later this month by 0.25% and 0.10% respectively. Neither of these amounts are significant, economically, apart from the symbolic messaging. People, and companies, are unlikely to change their behavior due to a 0.10% drop in rates.
Fallout from the protracted low interest rates is evident in the banking system. This is most apparent in Europe, where many banks have arguably never recovered from the financial crisis in ’08, and the sovereign debt crisis that followed in ’10. In the US, commercial banks have recovered, but they still cannot overcome the business challenges of perpetual low interest rates which pinch profit margins, and sow doubt in borrowers minds that rates may go lower. There is the fear rates are under pressure only to stave off recession. For monetary policy to work, bank lending is key, and people have to have a degree of confidence to borrow.
Based on our work, I continue to focus on select stocks that screen well for their growth characteristics, constraints on capital spending and strong levels of free cash flow. We are watching, though have not begun to own more defensive or value oriented stocks. As we’ve discussed, (the market) the S&P 500, is selling for 17x forward earnings ($178 per share). In general terms, for stock prices to move higher, either the multiple, or earnings, must rise. At the moment, the factor allowing the multiple to rise has been falling interest rates. Corporate earnings estimates have been declining, since Q1 19, as analysts have been revising their forward estimates down. Select stock picking, and judicious timing is the way forward.
The big question today is, how does this curious backdrop begin to disentangle itself? With no clear path forward, we have to continuously monitor the underlying activity in the markets and stock specific fundamentals for signs of real change. When we have some greater degree of clarity we will act accordingly. In the meantime, please feel free to check in if we have not spoken. I hope you are enjoying both the start of the new school year and the onset of fall and the cooler weather it will bring.
Bruce Hotaling, CFA