Santa is Checking His List
Consider it an early Christmas present. In the month of November, the S&P 500 rose 1.79% bringing its gains to 5.11% for the year. The reversal from the prior month was pivotal. After October’s -6.94% beating, we needed this positive result to avoid having to take an even more cautious stance and raise cash levels. The stock market has been challenging.
I anticipate that it may take more time for the market to digest the selloff that began in early October. My hope is that we have seen the worst of it, but the 200-day moving average is in a downtrend, and that is not a healthy indicator. I also expect some earnings revisions to begin to temper investor enthusiasm, possibly spurred by the poorly performing energy stocks and fall-out from the trade war.
There are a handful of disparate circumstances unfolding that may become problematic. The oil patch is in disarray, and oil prices are in a freefall. Over the last month, prices have fallen by 25%. However, according to FactSet Research, the energy sector is expected to report the strongest earnings growth (+24%) for 2018 of the 11 S&P 500 sectors. That’s an interesting contrast. Historically, there has been an extremely high correlation between oil prices and earnings estimates from the energy sector. Therefore, oil prices are possibly foreshadowing a notable decline in the earnings forecast from the energy sector.
The housing industry may already be in a recession, with all manner of housing-related data (new home sales, housing starts, buyer traffic) showing signs of weakness. Housing stocks have done poorly. The mortgage lending business is now dominated by non-bank lenders, which are responsible for more than 52% of the $1.26 trillion in originations in the first nine months of 2018 (WSJ 11/22/18). The affordability of certain markets has made buying difficult. Further, the interest rate increases by the Federal Reserve are causing many potential buyers to take pause.
Corporate debt is another concern. The volume of corporate debt has more than doubled since the financial crisis of a decade ago. Credit rating agencies (Moody’s and S&P) have been actively downgrading debt issues to low or below investment grade. The primary concern is the waterfall effect from rising downgrades and defaults. The recent plight of GE is a poster child for this issue, and this is a problem that could spread like the plague.
While investors have celebrated recent US profits and economic strength, the above-trend growth rates are unsustainable. Growth rates in 2018 (20%+ EPS and 2.8% GDP) are skewed by tax changes, government stimulus, and other non-recurring impacts. Importantly, a growth reset (5-8% EPS and 2.4% GDP) should be more than sufficient for markets to continue to advance. In my opinion, 2019 will deliver growth for stock prices, though expectations will need to be tempered. Dividend yield may become a more important component of the total return than in 2018.
My thinking is to remain focused on US growth stocks but to pare back some of the higher-growth and higher-priced names. The style that may be most suitable for a flat or even declining earnings growth environment is referred to as growth at a reasonable price (GARP). We intend to focus on stocks that have stable growth rates, pay a reasonable dividend, and are not overpriced (on a P/E basis) in relation to both their peers and the market as a whole.
US financial assets have dramatically outperformed the rest of the world in 2018. Many investors are convinced that investing funds in regions, sectors or asset classes for the sake of diversification is a good thing. On the contrary, I believe it’s is more important to make investment decisions utilizing reliable information on the companies that we believe have merit and closely monitoring our exposure.
As we close out 2018, we are actively reviewing portfolios to take advantage of tax loss selling. It has been a challenging year, and we have purposefully taken gains in stocks that have outperformed over the last several years. We are all available to discuss this with you or to review your portfolio if we have not been in touch recently. We wish you and your family a wonderful holiday season and best wishes for a prosperous and peaceful new year.
Bruce Hotaling, CFA