The cause of the October/November decline is a significant reduction in forward looking earnings expectations tied to both slower future growth and a strong dollar. If the peak stress is to be in early 2019, stocks, which look ahead, may be near the end of their correction.
Stocks fell sharply yesterday extending their down day losses to almost 4%. The selling accelerated after President Trump strongly expressed support for Saudi Arabia, a signal markets took to mean that any production cut announced by OPEC at its December 6 meeting will be less than previously expected. As a result, oil prices tumbled and turned the energy sector into the worst performing sector in yesterday’s market.
With the U.S. now exporting more than 3 million barrels of oil per day as the largest producer of oil in the world and likely to increase next year as new pipeline capacity comes on stream connecting key fields to the Gulf Coast shipping ports, it could well be that low prices are more destructive to our economy than productive. Yes, low prices provide some benefit to consumers and industries dependent on energy input.
In that regard, a new report out this morning showed durable goods orders, ex-defense and aircraft were flat in October after posting small declines in August and September. One of the keys supporters of the Trump tax cuts suggested was that a large corporate tax cut would provide capital to support a surge in investment spending. While spending did accelerate in the first half of 2018, it appears to have slowed markedly since mid-summer. Part of the early year strength was energy related as oil companies sharply expanded production. In fact, production rose so fast that it outstripped to ability of existing pipelines to move product to appropriate markets. While spending for new pipelines has accelerated, drilling for new oil in areas where pipeline capacity was insufficient slowed. Now, as the industry can look forward to mid-2019 when new pipelines will be coming on, collapsing prices may give drillers pause relative to starting new wells.
The supply/demand imbalance that has caused the sharp drop in oil prices is almost all due to an expansion in supply. Even with some slowing in worldwide economic growth rates, expanding economies in China, India and other emerging markets is keeping demand buoyant. But with the expansion of production in the U.S. and the decision by President Trump to delay sanctions on Iran just as it was pressuring Saudi Arabia and Russia to increase production to offset the impact of sanctions, has led to a sharp drop in prices. While Mr. Trump’s decision to stand by Saudi Arabia 100% may reduce the size of the production cut planned in December, the Saudis and the Russians are highly dependent on the cash flow from oil sales. There is no way that a modest increase in supply will offset a 25%+ decrease in the price of a barrel of oil. Prices are normally weakest at this time of year anyway after refineries go down in the fall for maintenance and inventories of crude build up. Saudi may lessen the planned supply cut in December but, as P.T. Barnum said, once fooled, shame on you; twice fooled, shame on me. Mohammed bin Salman may owe a bit of gratitude to President Trump but just as Mr. Trump persistently puts America first, he must put Saudi first. A further collapse in oil prices is not in his interest. As noted above, I’m not confident it is in our interest either. A good part of the profit recession of 2015 related to a lack of spending and income in the U.S. oil patch.
Getting back to the market as a whole, I want to start by reiterating that stock prices are almost entirely a function of earnings, interest rates and the value of the dollar. Earnings continue to grow but it is clear that growth rates are decelerating. Moreover, while U.S. GDP appears to be on a path to slow to 2-3% next year from 3%+ this year and a peak of 4.2% in the second quarter, earnings growth next year could almost disappear entirely in the first half for companies that do a lot of business overseas. In the first and second quarters of 2019, the year-over-year increase in the value of the dollar will approach 10%. That isn’t as extreme at the 20%+ hit in 2015 that caused an actual profits recession, but it is of sufficient scope to keep the rate of earnings increase to low single digits. Obviously, if the dollar rises further, it will become more of a headwind. But rising currency values make our goods more attractive to others and raise the price of imports. Currencies serve to correct worldwide economic imbalances. If the U.S. is growing much faster than everyone else, a rising dollar will serve to reduce that discrepancy as we export some of our growth to the benefit of others. Thus, over time, one should expect the pace of increases in the value of the dollar to slow or even reverse. For equity investors, that suggests the peak year-over-year headwind should be in the first half of 2019. Since stocks reflect perceived economic circumstances 6-9 months ahead, the correction of October/November should be discounting that fact right now.
Next, let’s look at interest rates. Today, the 10-year Treasury yields a tad over 3.05%, about 20 basis points below recent peaks. As growth forecasts slow and inflationary pressures recede, yields should stabilize or even decline. The Fed is searching for the neutral Fed Funds rate that neither gooses the economic nor impedes growth. It feels 3-4% growth is beyond what our economy can sustain without forcing prices higher. Sustainable growth is closer to 2%. The question today is whether the Fed needs to do any more to move growth lower. Fiscal stimulus passed in 2017 and 2018 will still be flowing through the economy in 2019. But the tax cut benefits will begin to abate and the impact of tariffs will hurt. They serve as a tax lowering demand and squeezing margins. Tariff uncertainty is also a major factor curtailing investment spending. Without an acceleration in investment spending, it is unlikely that we will experience a durable lift to productivity, an essential to keeping growth elevated above 2%.
Putting all this together, we face very slow profit growth in 2019, with modest changes to the value of the dollar and the course of interest rates. The Fed will almost certainly raise rates 25 basis points in December but will show increased uncertainty over the need for many further increases. If, as many economists predict, we are already on a glide path to 2% growth, there may not be a need for any further increases. The next possible increase would be in March. If not then, it could be delayed until June. The data between now and then will dictate the Fed’s actions.
I think markets today are not fussing any more about the Fed. They remain nervous that Trump could decide to go all in on tariffs in January if talks with China late next week go badly. But such a move would have grave economic consequences for our own economy over the short term and would almost certainly lead to another significant leg down in stock prices. Mr. Trump has said repeatedly that he regards the stock market as a barometer of his administration’s economic success. He almost certainly doesn’t want to be the cause of a further decline of 10% or more. Moreover, if he puts tariffs on all Chinese goods and China doesn’t flinch, what’s his next step? He may not have thought that through but I am sure many of his advisors have. He may have to take bolder action some day but my guess (and it can only be a guess given Mr. Trump’s volatility) is that he will stand pat for a while and let negotiations move forward. We will know more within a couple of weeks. If that proves accurate, within 3 weeks, markets will have a lot more certainty regarding the path of tariffs, oil prices, and interest rates.
But the reason stocks are weak today is really all about earnings. Estimates coming out of the summer were for growth of 10%+ next year and now it looks like something less than 5% is more likely with negative growth in the first half of 2019 possible for most multi-national companies. That is the biggest cause for the decline we are experiencing. In the stock market, it isn’t about GDP; it’s about EPS (earnings per share).
We have done the exercises several times in recent weeks that suggest fair value for the S&P 500 is somewhere in the 2700-2800 range. At 2900+, the late summer highs, stocks were overpriced. Today, with the S&P at 2641, they are modestly underpriced. Stocks can remain overvalued or undervalued for a considerable length of time but they eventually correct to the mean. There has been a lot of technical damage to this market and one should tread carefully. Today, there is a full day of trading but volume should dry up this afternoon at traders head off for Thanksgiving. Friday is a half day due to the holiday. With very light volume likely, I wouldn’t expect as much volatility but one never knows when emotions run high. Traders are looking for a capitulation flush where stocks drop even more sharply than the last couple of days on very high volume. That doesn’t mean it has to end that way. But given recent behavior, the mood is no longer buy the dips; it’s sell the rallies. That will probably happen until there is that cathartic flush or traders are convinced that a successful retest of the October/November lows has occurred. With all that technical mumbo jumbo aside, what long term investors need to keep in mind are two thoughts. First, markets that are now below fair value have less long term risk than buoyant markets far above fair value. Second, if you believe in asset allocation, slowly you might put fresh money into stocks, not bonds to compensate for the recent decline in equity prices. That may be hard to do but today you would be a buyer at much more favorable prices than you were two months ago.
Today, Michael Strahan is 47. Goldie Hawn turns 73.
James M. Meyer, CFA 610-260-2220
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