Lions, Tigers, Bears & Trade Wars – Oh My!

Volatility has returned to the markets. What to make of it and how to respond accordingly.

While it may seem like ages ago, the bull market was at historic highs earlier in the year (January 26th), but since then headwinds have picked up. It’s fair to wonder if things could get even worse from here on growing geopolitical tension.

2018 has been a whole lot different than 2017. Last year, stocks marched higher with only minor pullbacks; the largest peak to trough decline for the S&P 500 was less than 3%. 2017 was a year that lacked turbulence and rewarded investors handsomely.

Since early February, volatility has returned, taking stocks on varying swings of good days and bad. Many of those episodes were based on errant tweets that became de facto policy statements. Investors have had a hard time knowing how to respond to the daily barrage of tweets.

I’m sure I’m like most in that I abhor uncertainty, but every day we seem to be awaking to surprise policy moves that could start to harm the economy. I generally disdain discussing politics, so my thoughts aren’t political statements rather commentary on events that affect investors’ monies in the capital markets.

For long-term investors, we should all look past it, but I know that in the short-run discounting such hyperbole can be tough to do.

I like to look at more persistent measures that better gauge the markets. I consider them 3 legs to a bar stool – the nation’s overall economic situation (+); corporate profitability (+); and investor sentiment or crowd psychology (~).

National Economic Growth
We’re in the 3rd (very soon to be the 2nd) longest economic expansion in U.S. history, an expansion that’s broad-based across a full range of sectors with consumer spending, manufacturing activity and construction all showing robust figures as part of a global trend of stronger-than-expected growth. Looking ahead, U.S. gross domestic product (GDP) growth could well average 2.5% this year and next.

For now, there aren’t any real signs that the economy has fundamentally down-shifted. The expansion that started 9 years ago is still underway, buoyed by near record-level stock market performance, low unemployment, robust job growth and other key economic indicators heading in the right direction.

While job productivity has slackened, it’s made for an environment where unemployment is extremely low, allowing for wage gains to build as talent becomes increasingly scarce, forcing competition amongst businesses to bid for workers. While that’s good for workers finally getting their fair shake, it’s wage inflation that the Fed Reserve likes to tamp down so look for 2-3 more benchmark interest rate hikes over the remainder of the year.

1st Quarter Corporate Earnings Outlook
Corporate earnings, the primary driver of stock prices, still look great according to FactSet. For the first quarter, earnings growth rate for the S&P 500 is expected to increase by 17.1% (reports have started to come in, and we’ll get most throughout the rest of the month). The forward 12-month price-to-earnings (P/E) ratio for the S&P is currently around 16.5, above the 5-year average of 16.1 but down significantly from overstretched P/E valuation in January. While earnings are expanding, valuation multiples are contracting (at least until stock prices start to pick up again).

What’s driving a good amount of earnings-per-share (EPS) guidance is good end-demand growth, both domestically and abroad. Secondarily, this is the first earnings report where we’ll feel the impact of the new tax act in lowering corporate tax rates. While the statutory rate is now lower, many multinational companies’ effective rates are already much lower. The effects of lower individual tax rates on investments made are more indirect and probably won’t be felt in earnest until tax season next year.

Global Growth
Spurred on by higher profits and buoyant stock markets, companies around the world appear to be loosening up their purse strings as capital spending starts to tick up (barring growing worrisome protectionist trade friction). Hopefully as the global economic expansion gathers speed, capital investment will stoke not just demand, but ultimately higher wages and inflation, especially when employers have been reluctant to spend even amid an economic upswing.

Analysts’ S&P 500 Price Target
For the 1st quarter of 2018, the S&P 500 lost -1.2% in value, the first down quarter since the 3rd quarter of 2015. Since then, we’ve had a rocky start to April.

According to FactSet, industry analysts (bottom-up price targets) see roughly a 16% increase for the S&P 500 over the next 12 months. At the sector level, Health Care is expected to growth by 18.8%, Information Technology by 18.2%, and Energy by 18.0%. The Utility sector is expected to see the smallest price increase, +4.8%.

Corporate leaders, in their earnings announcements, will also give us guidance on how they expect their businesses to be impacted by the threat of tariffs. Economists and Wall Street analysts will also be chiming in as to the cost in terms of economic growth, jobs, and earnings.

Investor Sentiment
According to the American Association of Individual Investors (AAII) weekly sentiment survey, for the week ending April 4th, pessimism about the short-term direction of stock prices has spiked to its highest level in more than 7 months.

The reason for the dramatic change in mood? Tariffs, counter-tariffs and an escalating trade war with China, let alone a pending renege on NAFTA which would ensnarl all 3 of our largest trading partners, accounting for about $1.7 trillion of trade annually, according to the U.S. Census Bureau.

If there’s a somewhat positive take-away, it’s that tariffs will take several months to implement, so there’s time to negotiate, find common ground, and curtail escalating the matter.

Détente will surely be at hand. But, ramifications of irreconcilable ideological and economic differences between an aging superpower and a rising superpower will linger on in some form or fashion (similar to the Soviet area).

Technology Stocks
Another concern weighing on investors is within the technology sector. Facebook is embroiled in a controversy over privacy and data sharing, and Amazon, up 50% in the past year, sank after the president renewed his attack on the online retailer.

Because of Facebook’s scandal, techlash has been gaining momentum. Since consumer data is the key competitive edge of social media firms, it means there’s always a heightened level of risk and uncertainty surrounding one’s personal information. I don’t think the Cambridge Analytica scandal even remotely compares to Equifax’s data breach in which Social Security numbers, names, addresses and even some bank information was stolen. And, nearly half of the nation has not taken any action to protect their data since the Equifax breach, according to a recent MagnifyMonyey survey. Wow!

While other tech companies fell in sympathy over Facebook’s problems, I don’t see that much follow-through collateral damage to other tech companies and industries. This whole issue may blow over just as quick as it started.

FAANG Stocks Bursting?
I don’t necessarily think so, but these stocks were/are ripe for profit-taking as investors have been increasingly risk-off and looking to lock in gains. Sure, some of the shiny veneer has come off, but tech stocks, specifically FANG stocks (Facebook, Amazon, Netflix, Google) or FAANG (inclusive of Apple), or Fab 5 (inclusive of Microsoft, minus Netflix) have been some of the biggest bull market gainers, even after their recent price drops. These mega-cap tech stocks have lured investors with momentous gains more than triple the market since 2016.

Will technology, in general, be out of favor? Not likely, but there could be a rotation out of FAANG into more fundamentally sound growth stocks elsewhere in the space. There will still be money earmarked to the technology sector, especially big-cap names that offer ample liquidity.

As this rotation within the all-important tech sector transitions, it’s incumbent upon investors to identify where the next big moves are coming – artificial intelligence (AI), robotics, cybersecurity, financial technology (fintech), mobile computing, cloud computing, autonomous cars to environmental technology. Health care too will be a beneficiary as we witness genetics research break-throughs, which will hasten people living longer – and they’ll need income to support themselves in their golden years.

Should you lower your overall tech exposure? That depends. As a Bloomberg Businessweek article recently stated, “Investors comfortable with risk and who have years of earnings power ahead might be happy with their tech exposure. They can ride out market cycles. It’s more complicated for those approaching or in retirement, who have less time to rebuild savings. It’s important to know whether your retirement fund is heavy in tech and to be comfortable with the increased volatility that may bring. Panic selling rarely turns out well.”

Heightened Volatility Weighing on Investors
Investors seems particularly worried right now that a big change is under way. That’s at least what the financial news headlines would have you believe; these news outlets are media companies vying for your attention as much as Facebook.

There are important concepts to remember however. In every decline, no matter how severe, markets ultimately tend to stabilize, and so far, this correction is run-of-the-mill.

Cognitive Dissonance
Remember the last time stocks fell so hard? You probably don’t, and that’s making it all seem a little harsher than it is.

It’s a fact of life of the mind that things always seem worse in the present. But in fact, they’re not. Behavioral economist & Nobel prize winner, Richard Thaler, explored biases and cognitive shortcuts that affect how people process information.

[Read more here: https://www.bloomberg.com/news/articles/2017-10-27/how-to-profit-from-behavioral-economics].

In this bull market alone, there’s been 5 other corrections like this one, and it’s taken around 7 months on average for equities to climb out of their hole, data compiled by Bloomberg show. Based on that path, investors’ anxieties will linger until August.

At the same time, just because bouts of losses are normal doesn’t mean they’re painless, especially when momentum stocks (FANG) are leading the way lower. But the statistic is a reminder that it’s unrealistic to expect a market recovery to involve a straight line back up.

It seems even worse because of how placid markets have been since the last disruption. While individual stocks seem to be regularly rising and falling 5% these days, consider that in 2016 and 2017 the S&P 500 went through several long stretches without posting a single up or down day of more than 1%. Through April 10th, 1% daily moves in the S&P 500 has occurred 28 times this year. In 2017, we only had 8 such days.

“You had this incredible low-volatility environment, but markets are supposed to go up and down,” stated Michael O’Rourke, Jones Trading’s chief market strategist.

A move back to a normal market environment is usually hard to take. According to LPL Research, the average intra-year pullback (peak to trough) for the S&P 500 since 1980 has been 13.7%; half of all years had a correction of at least 10%; 13 of the 19 years that experienced an official correction (10%+ down) finished higher on the year; and the average total return for the S&P during a year with a correction was 7.2%.

The take-away? Turbulence surfaces more often than we recall and patient investors who don’t react emotionally have historically been rewarded. Don’t let short-term market volatility guide your allocation; your investments should reflect your time horizon.

Moving Forward
Springtime is here – a time of rebirth and regeneration, so while the weather may still be a bit cold or inclement, it offers up to evaluate the year so far, to review one’s long-term goals, and clean one’s minds (and homes) as we get ready for summer fun.

Your money life should never be ignored, but it shouldn’t be all-encompassing that it captures too much time away from what you love and care about. The idea is to find a workable balance between your money life and the rest of your life.

I have a hunch that most people would agree they should invest for the future. My second hunch is that many individuals don’t know how to start and are afraid of making serious mistakes, so initial impetus fades.

The work I do, and that of my fellow advisors, is about creating better outcomes for investors. I hope you find my communications informative and not too heady. Please contact me with any questions you may have, and if you or anyone you know is in need of advice, please send them my way.

Author: Eric Linser

Eric Linser, CFA, is a San Francisco-based Private Wealth Manager with Green Valley Wealth Advisors, an affiliate of Naples Asset Management Company, LLC, a federally registered investment advisor (RIA). Eric’s expertise is in providing comprehensive wealth management services such as investment counseling, financial planning, and retirement plan services to individuals, families, businesses, and foundations. A particular focus is on generating income for retirees, and keeping savers on track to fund future goals. For over two decades, Eric has helped provide wealth planning guidance so that his clients could achieve financially secure retirements. He is trained, experienced and credentialed to design and execute a plan that best meet your aims. Plan for your future; invest in what matters.

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