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Thursday
Jan102019

Q2 2018 Commentary

For everyone who got excited in the first quarter (either pessimist or optimist), the second quarter was a bit of a dud. 

Broad markets improved on their first quarter performance, allowing the S&P 500 to close the first half up 1.67% – a far cry from last year’s first half gain of 8.24%.  The Dow, meanwhile, closed the first half in negative territory (-1.81%), its worst H1 since 2010.

There were bright spots, with the tech-heavy Nasdaq and the small-cap Russell 2000 posting solid gains. There was also weakness, with foreign stocks falling more than 5%, led by emerging markets, which lost 10%.  As a whole, global stocks (inclusive of U.S.) are negative for the year (like the Dow, the worst start since 2010).  To add to the sources of pain, bonds remain a losing bet for the year as well.

What may be most striking to investors so far this year is the massive disconnect between the perceived strong domestic fundamentals and the weak performance from equities. 

Corporate earnings are growing at a substantial pace, where underlying fundamental growth is being supplemented by large corporate tax cuts.  Economic growth is accelerating.  Unemployment is low.  It is hard to find anything tangible to be negative about.

Yet market performance has failed to track these fundamentals.

In trying to draft a narrative, the most popular media culprit for this disconnect is the threat of trade war.  It is true that tariff announcements have coincided with many of the selloffs of the first half.  Trade protectionism is certainly a friction to global economic growth, but it is not clear that the state of trade conflict alone is significant enough to justify the duration of this pullback.

Instead, the difficulties in the markets likely extend to the one thing that we have been repeatedly discussing the last couple of years: valuations.

Valuations reached a new extreme in early January, hitting multiples last seen during the tech bubble.  The negative price action since the January highs, combined with rising earnings, has allowed valuations to normalize to a significant degree. On a trailing P/E basis, the S&P 500 is about 15% cheaper than it was at the highs. Despite the decline in multiples, stock prices remain extended by virtually every measure.

While we do not believe that tariff threats are the fundamental cause of the decline, they were a clear catalyst in the sense that they created a wrinkle in the unrealistic, unblemished expectations markets held in January – the types of expectations that allow multiples to rise in the first place.

We have argued that, at points in this rally, stocks were “priced for perfection.”  With massive corporate tax breaks on the back of an already strong profit picture, things were going about as perfectly as they could.  And while there are few blemishes in the current economic and profit performance, there are emerging flaws in the outlook.  That is where trade tensions have come in. They have cast a cloud on the sunny forecast. 

It is not only tariffs. Economic data was crushing expectations at the end of 2017 at the best pace in over five years.  Expectation beats, however, are generally followed by even higher expectations. At some point those expectations become too high, and by the end of the first half, the Citi Economic Surprise Index was negative following a stretch of disappointing data.  The data is still positive, but it is failing to meet expectations.

Market corrections do not generally wait for negative data, they look for cracks in the narrative.  The loftier the valuations are when those cracks emerge, the more downside markets have.  These are the risks we were dealing with at the start of the year, and though valuations have come down a degree, they remain historically high.

Our preferred valuation measure shows stocks to be trading at a 10% premium to the most expensive sustainable market in history (that is after adjusting for tax breaks).  And while it is always possible to set a new paradigm, there is plenty of evidence that higher valuations are correlated with lower long-term returns. 

In fact, if you look at just about any study trying to link today’s valuations to future risk/reward projections, U.S. equities are firmly in the wrong quadrant – signaling above average risk and below average returns. If you focus only on U.S. Growth stocks, the picture is even worse.

Because of these widespread valuation issues and the risks of tightening monetary policy, our default approach continues to be cautious.  After restrained buying in February, we have maintained a limited equity position.  As we enter the second half, however, we are more likely to sell into strength and again raise additional cash.

Despite our caution, there are some positive signals out there.  Out-of-favor quality stocks, our preferred value vehicle, had largely been left behind in recent rallies.  The end of the quarter, however, saw some long-overdue outperformance from many of these names.  Though there is a long way to go, some normalization between momentum and value strategies is a constructive sign.

We would certainly like to see some orderly normalization, but this market has already shown that it may not reward such hopes.  We cannot forget that the rapidity of the plunge earlier this year broke nearly 100 years of precedent – further evidence that restraint is prudent.

As we move towards the second half, we will continue to await prudent entry points, which have largely eluded us at recent price multiples.  We are in a period that suggests equities may carry historic risks, and our short-term focus is on the preservation of capital.

As always, we encourage our clients to reach out to discuss how we can best balance our investment approaches to suit your needs.  Thank you for your continued trust.

 

Robert B. Drach

Drach Advisors LLC

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