Tariffs and Taxes
Stock struggled in May. As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%. This comes as something of a shock after four successive months of hefty returns. The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident. Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains. Stocks were routed in February 2018, in December 2018, and again in May of 2019. On one hand, this could be considered normal volatility in the market place. On the other hand, this “triple top” formation is considered a warning sign by technical analysts.
The 800 pound gorilla investors around the world are now contending with are tariffs. Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations. This has all changed. The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table.
The consequences for the American consumer is they either forego buying certain products, or pay more for them. Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue. Farmers, particularly soy beans, pork and cotton, have seen their businesses stall. The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.
It’s not at all clear the trade overhang will lift. This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes. We ought to expect this to be a lingering presence in the marketplace, until at least November 2020. The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick. Some of our research providers project the damage from the tariffs could be as much as 5% of earnings. This would ostensibly wipe out the forecasted earnings growth for the current year. A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?
Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence. Several April economic data points were down. Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession. The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada. Interest rates and inflation look to me as though they will remain low and range bound well into the future.
Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings. This is slightly below the 25 year average. Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages. The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.
On our end we are pleased the market continues to favor growth stocks over values stocks. The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd. We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook. Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time. We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade.
I expect the tension we see in the markets to continue, and it will remain challenging to own stocks. I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets. This makes good quality stocks the best game in town and one we pursue with vigor. Please feel free to check in in if we have not spoken recently.
Bruce Hotaling, CFA