Bear Trap

Stock prices, measured by the S&P 500, generated a meager 0.1% total return for the month of March. After January and February, when prices were clearly punching above their weight, things began to taper off.  The change seems largely due to the relentless circus underway in Washington DC.  At its height, optimistic and often fallacious tweets stoked investors.  Recently, reports of corruption and self-dealing have thrown a wet blanket on the party.  Normally, with the total return to stocks up 6.07% for the first quarter of the year, folks would be heading for the car dealership.  Instead, bullish investor sentiment has dipped to the lowest level since the election. 

Year to date, results have been driven by strong results from the technology sector (+12.4%). Consumer discretionary (+8.2%) also outperformed, but only when the extraordinary performance of Amazon is factored in.  According to Bespoke Investment Group, Amazon was responsible for one-third of the sector’s gain in Q1.  This is astonishing considering 6 of the 10 worst performing stocks in the S&P are from this sector, most of which are retail stores you know.  On the losing side of the equation, energy was -7.2%.  This was a surprise, as crude and especially natural gas prices struggled throughout the quarter.  In 2016, the energy sector returned 42.6%.  If there is a silver lining here, it’s the sky-high incidence of M&A in the energy sector.  According to Deallogic.com, corporate transactions in the oil and gas space totaled $96.7bn through March, the highest level ever.

From a fundamental perspective, not a lot has changed since last month’s letter.  Expected aggregate 2017 earnings for the S&P 500 now stand at $131, and the index is in the 2,350 range.  More importantly, estimates for 2018 are in the mid $140’s, according to data compiled by FactSet Research.  These numbers do not include any upside that might result from either fiscal stimulus or tax cuts.  Until the 2018 estimates become more viable, and unless stimulus comes to pass, the market as a whole is fairly priced.  The complacency that initially lulled investors as stocks began their end of year lift off remains firmly in place.  I recommend buying and owning only a select portfolio of stocks, as opposed to buying the market.  

The macro backdrop is murky, only because more can go wrong than right.  Stocks are clearly the best house on the block and near term, I expect earnings to hold up.  Inflation is modest, and that’s important for stocks since high inflation typically suppresses the market’s P/E ratio.  Keep in mind, the Federal Reserve did raise the Fed Funds Rate for the second time in four months.  Bonds and bond proxies have been under the thumb of a threatened steepening yield curve.  A drag is the continuing high value of the US$.  And, labor markets are at full-employment. It’s difficult for any government to effectively stimulate a full-employment economy, with a limited (or likely shrinking) labor supply and the intention to replace technology (productivity) with good old fashion labor.

The threats to a favorable outcome are many, and highlighted by the illogical talk of reviving the coal industry. The whole idea that this industry is relevant or will produce meaningful jobs is misguided. Coal is a dirty resource in an irreversible state of structural decline.  According to Morgan Stanley Research, coal production from 2014 – 2018 is expected to be down 67% in Central Appalachia and 19% in Northern Appalachia.  Natural gas is the leading source of power generation in the US, and it is transported via pipeline, just imagine that.

I think we need to proceed with caution here.  In Wall Street parlance, a bear trap is a head-fake, an indicator that the bull market has or is about to reverse course. It induces investors to sell, while the market continues its upward trend.  This has sadly been the case for many investors unable to stomach the swamp 2.0.  We’ve become conditioned, with the trauma of 9/11 and the financial crisis clear in our memories.  Fear can often be an unmanageable emotion, and lead to regrettable decisions.  My suggestion, for now, is to wait until the market begins to show us it wants to change course, rather than making premature guesses.  Please feel free to call me if you would like to review your asset allocation and the best path for you going forward.

Bruce Hotaling, CFA

Managing Partner