Stock prices, as measured by the S&P 500, rose 3.6% in July and are now up 6.5% year to date. In my opinion, these are reasonable (not too hot, not too cold) considering the backdrop. Take a look under the hood, and things don’t look too bad. Market breadth (measure of advancing stocks relative to declining) is fair, with 60% of the S&P 500 above its 50-day moving average. Strength among the tech stocks has been extraordinary, and they have contributed the lion share of the market’s gains.
Impressive 2Q earnings reports serve as the foundation of these gains. According to FactSet, 80% of S&P 500 companies have reported earnings surprises and 74% revenue surprises, the highest percentages since FactSet began monitoring them in 2008. The valuations (P/E ratios) of stocks across the board have been falling as a result, making the fundamental backdrop of the stock market that much stronger. Results are balanced, with all sectors showing positive earnings growth.
Some of the strength in recent numbers may be due to companies front-ending their sales in order to beat the coming tariffs. This may lead to a reciprocal slow-down, but that will reveal itself in the coming quarters. Stock buybacks, when companies retire (buy back) their shares and allocate profits across a smaller number of shares, typically boost share prices. The recent spate of buy-back announcements led year-end expectations to top the $1T mark for 2018, a nearly 50% increase over 2017.
Apple, for instance, repurchased $43.5B in the first half of the year. For comparison, Ford’s entire market cap is $40.1B. This was partly due to the tax overhaul, enabling repatriation of overseas dollars at tax rates between 8% and 15.5%. Further, chapeau to Apple, the world’s most valuable public company, and the first stock ever to reach $1T in market cap. A few others nearing the $1T mark, with impressive year-to-date returns are Amazon (59%), Alpahbet (Google) (19%), and Microsoft (27%).
Record earnings, stock buybacks, and buoyant stock prices aside, many investors are walking on eggshells. This is not surprising, as most would agree that the backdrop is difficult. The divisive tone of much of the news flow forces investors to soldier on. Our goal is to rely upon indicators with some degree of measurability to watch for tides that begin to turn. When that time arrives, we will look to buffer the effects of falling stock prices with higher levels of fixed income and cash.
We monitor multiple market factors, and any number of them could signal the onset of the next market cycle. Among them are relative strength and valuation. Additionally, we monitor interest rate levels, as the Federal Reserve is tightening monetary policy. Higher rates will eventually stall economic growth. Home sales have also slowed. This could be due to rising mortgage rates, a shortage of inventory, or in the US, the recent restriction on deductibility of state and local taxes, and mortgage interest. Globally, there is rising concern over a bust in the highly speculative Chinese housing market.
The elephant in the room remains the trade war. The government intends to modify China’s behavior with respect to trade and intellectual property by hitting them with a stick. Globalization and economic interdependence have positively impacted national economies around the world. The European Union, initially the Common Market, was formed to establish political end economic stability in an unstable region. I expect that the impact of the trade war will be greater on consumers’ wallets and US corporate earnings than on anything related to the trade deficit.
One final item, which we will have to confront one day, is the US Congressional Budget Office’s recent forecast for the US annual deficit to exceed $1 trillion in 2020. In spite of the underlying economic growth, the national debt is soaring and is forecast to exceed $33 trillion by 2028. Our nation’s leaders do not appear to have considered the negative consequences of too much leverage, and those consequences may unfairly become a political tool.
The market’s strength is enriching investors. At the moment, Wall Street likes its man in Washington, and that’s that. We are watching closely for shifts in the indicators and any other clear signs of change, but until then, we march on. Please feel free to call if we have not been in touch recently.
Bruce Hotaling, CFA