Was yesterday the bottom? We can all take a guess but the end of the correction should be near at hand. Q4 is seasonally strong but markets have corrected for legitimate reasons that need to be understood.
Stocks got pummeled yesterday morning, partly in reaction to a sharp drop overnight in China, partly due to a sharp drop in oil prices and a Saudi minister stated that its nation was ramping up production, and partly due to weaker than expected earnings from two Dow components. But they clawed their was back throughout the day and finished only moderately lower. At the day’s worst levels, the leading indices were at their lowest level since March. Some think a double bottom was set and the correction is over. Others are not so sure.
I am not going to weigh in directly other than to make the following points:
- By now most of our readers should know about my simplistic two-day rule. A trend (in this case down) isn’t broken until we have two meaningful up days in a row. While yesterday looked like it actually had a chance to finish higher, the rally petered out in the last half hour. Futures were sharply lower again overnight but were rescued to some extent by strong pre-market earnings from Boeing. Even if stocks rally today and finish higher (I said if), I won’t be convinced a bottom has been put in if there is no follow up tomorrow. The logic behind a two-day rule is that traders in a volatile market can create a short sharp rally that initially looks very encouraging. But a real rally requires investors, not just traders, to step in. That becomes evident on the second day.
- With that said, I have seen more V-shaped corrections in early October than in all other time periods combined during my career. There are reasons. First, corporations that report on calendar quarters cannot buy back stock in the first half of October in front of their earnings reports. Second, October is the end of the mutual fund year. Mutual funds wanting to mitigate capital gains distributions will sell their losers in early October. Most think tax loss selling hits a peak in December but, actually, the peak is right now.
- Fundamentals matter. Initially, a 40+ basis point increase in long term interest rates, combined with some hawkish commentary from the Federal Reserve suggesting it might take short term interest rates up to as far as 3.5% before the current cycle of rate increases is over ignited the correction. It had been hoped that when companies began to report third quarter earnings that the correction would end. But, so far, while the earnings themselves have been OK, the forward looking guidance has been mixed at best. A strong dollar, tariffs, and other factors are slowing demand. When companies with a very broad international customer base warn of tepid demand and customer indecision, one should take that to heart.
- At last night’s closing price of 2740 for the S&P 500, the index now sits at a level approximately 15.9x 2019 estimated earnings. Given that interest rates and inflation remain a bit below long term averages, that appears to be a reasonable price. If inflation picks up a bit, however, as we expect, and interest rates return to historic norms, stocks will trend toward historic average P/E ratios. Depending on one’s level of optimism, after the recent correction, stocks look fairly priced. To some, they still might be a bit overpriced based on historic averages. It is hard to make the case they are cheap. In a fairly priced market, there will still be winners and losers. The winners will be those companies that can grow and that can match or exceed expectations.
As I noted, we are hearing more caution this earnings season than we have for some time. Banks have been reporting very low levels of loan growth in the 0-3% range. Homebuilders, which were experiencing strong order growth until this summer, now report growth in the low single digit range as well. Order rates for semiconductors are falling and swelling inventory levels mean prices are destined to fall until balance is restored. Chinese tariff issues are beginning to cause some to redirect supply chains elsewhere in Asia. That isn’t a simple or inexpensive process. More and more we are hearing companies saying that they plan to take price action to offset added costs of tariffs, energy and transportation costs. What that says to me is that companies feel that they now have some pricing power. That is actually good news if it proves to be true.
Earnings per share are growing 20%+ each quarter this year largely related to the cut in corporate tax rate. Clearly, that rate isn’t sustainable once we anniversary the implementation of tax cuts in early 2019. Everyone knows that and it is already factored into stock prices. But even if the year-over-year growth rate slows, companies will still benefit from lower taxes, keeping more cash to invest or to distribute in some fashion to shareholders. But there are other factors at work besides taxes. GDP growth probably peaked in the second quarter. Third quarter through (and we will get a first peak on Friday) was probably about 3.3%. It should stay close to 3% in the fourth quarter. But headwinds are increasing. Tariffs is one. The stronger dollar could help exports but it will also mean foreign earnings of multi-nationals get translated back into less earnings. Higher interest rates are beginning to hit home. That is best seen in the housing market where existing home sales have declined for seven straight months. Despite sharply rising household formations, buyers are hitting an affordability wall as mortgage rates rise to 5%. Higher rates are beginning to hurt auto sales as well. Americans are saving more.
The key question, obviously, is whether the economy is simply slowing back to a more normal sustainable pace of growth or is on a path toward recession in 2-3 years. A lot obviously depends on the Fed which has a long history of starting to increase interest rates too late and then going too far. Given the Fed’s most recent commentary, the latter became a rising fear after the September meeting.
But it is far too early to reach any conclusions. This Fed, under Jerome Powell’s lead, is going to be a very pragmatic Fed. He is a businessman, not an economist. He isn’t theoretical; he seems to be practical. He sees exactly what you and I see. Rates have been increased six times so far in 2017 and 2018 with one more increase coming in December. There is a lag before the increases bite. Perhaps that is why housing started to tip over in late winter and has continued to weaken. The Fed almost certainly doesn’t want to pull the rug complete out from under the housing market.
Increasingly there are voices outside the Fed call for it to pause after the December increase and spend a few months or more to assess the true impact of the increases to date. It may well do just that but only if inflation remains tame. If inflation surprises to the upside for any reason, the Fed may add one or two more increases in early 2019. But if the CPI or the PCE index the Fed likes better stays in the 2% area or even a smidge more, look for a policy adjustment this winter. Slowing growth toward 2-3%, if it keeps inflation level, would be a good thing, not a bad one, in the Fed’s eyes. President Trump can do all the Fed bashing he wants; it won’t mean a thing if the data supports the Fed.
As for markets, Q4 is usually a very good one for stocks. Whether yesterday was the bottom or it sits a few days in front of us, I think seasonal patterns will provide a lift soon. But remember that stocks are not cheap. They only look cheap compared to 30 days ago. A sustained rally requires real increases in expectations. Without some resolution to the China tariff issues or a surge in capital spending, that seems difficult. In some ways we have been in a rolling bear market this year. At the start of the year, energy stocks were getting killed along with consumer staples, utilities and REITs. They have since recovered a bit. The same goes for media stocks. Early cycle stocks like housing, autos and banks, have been walloped with many down 20+%. These now look pretty washed out. Many homebuilders are now down to book value or less. Industrial stocks got clobbered as soon as tariffs became a weapon and are still searching for a bottom. Semiconductor stocks have rolled over as slowing demand growth has led to an aforementioned increase in inventories. The high flying tech stocks have taken a bit of a hit recently in the current correction but, so far, have held up pretty well. There are very few groups that haven’t been hit. In a sense, we have been rolling through a stealth bear market all year masked by some extraordinary performance by just a handful of stocks, mostly tech related. This is actually healthy.
Summing up, there have been valid reasons for this correction, one that seems to have run its course to a large extent. Whether it is over or not remains to be seen. If you want to be secure, wait for two strong up days to feel confident. There are bargains out there but all stocks are not bargains. This is an aging bull market. That doesn’t mean it has to end soon but it does mean that every once in a while excess exuberance has to be wrung out. Earnings are up 20%+ this year while prices are roughly flat. That is how one squeezes out exuberance. Next year earnings will be up closer to 5%. If stocks are roughly fairly priced today, they could move higher in line with earnings. A 5% move with a 2% dividend isn’t a bad total return.
Today, Ryan Reynolds is 42. Weird Al Yankovic is 59. Pele is 78.
James M. Meyer, CFA 610-260-2220
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