Stocks fell sharply on Friday after a report out of China pointed to slowing retail sales.

When the market closed, the leading averages were right at their 52-week closing lows. Futures this morning point to a lower opening, more on momentum and sour sentiment than on any sign of fundamental weakness. 

We have had multiple retests of the2580-2600 region in the S&P 500. Whether that range will hold one more time is up for debate.  Any breakdown below that level could be harsh but there are more reasons to believe a bottom is near at hand than not.  While the economy is definitely slowing, there are no signs yet of a pending recession.  I say that often and the retort is that economies can go from good to bad surprisingly quickly. But even accepting that statement as true, there are always early warning signs of economic deterioration. Right now, most of the apparent slowing is overseas.  It is tempting to think that overseas weakness will spread here but one should note that our trade activity is a much smaller percentage of GDP than for almost any other major nation.  While we do still import oil, we produce most of our own food and, net, we are now close to energy self-sufficiency.  Most of what we import relates to the fact that the related goods can be made more cheaply in a foreign country.  And if the country of manufacture runs into problems, in most cases it isn’t all that difficult to move to a supplier in another land.

Where economic weakness or other geopolitical concerns overseas comes into play concerns demand for our exports.  We are major exporters of aviation and defense equipment, for instance. We also sell products, like drugs, for which American companies are the primary worldwide supplier.  Finally, we sell more food to the rest of the world than any other nation.  While demand may vary slightly from year-to-year, price is more important than volume.  Price depends somewhat on economic demand but the bigger factor is whether which determines crop size.  When crops are larger than expected, weaker prices often result.  But prices don’t always move together.  This year, beef prices are up but hog prices are down. Such disparity is more common than not.

Thus, we are relatively insulated from weakness overseas as long as the weakness isn’t extreme.  A strong dollar translates foreign activity back into fewer dollars and hurts earnings of multinational companies but the pace of activity, measured in physical volume remains solid.

If weakness overseas isn’t providing the wakeup call that an economic slowdown is near, one must look for other signs.  About the only domestic sector in actual decline is housing. The culprits there are rising interest rates combined with above average price increases since the Great Recession. Over the past 2-3 years, the pace of price increases has started to decrease starting with some high profile markets, like New York City, and gradually spreading to most of the nation’s hottest markets like California, both North and South, andSeattle.  Price is always the mechanism to restore balance.  Unlike the period leading up to the Great Recession when one of every two homes was sold to anon-occupant, this time around, there is very little speculation going on.  People who are buying homes today are doing so for life style reasons, not economic. In many markets, rents are rising faster than home prices, a sign some rebalancing is taking place. The rate of new household formations today equals or exceeds the pace of homebuilding. Inventories are tight.  What is inhibiting growth at the moment is cost, not demand.  That should be self-correction with a major downturn. 

Another major market that is now flat after growing at a sustained pace is the auto market.  For several years post the Great Recession, demand was aided by a bit of catch up. Once job seekers found employment, they started to buy cars again.  But as more millennials moved to urban centers, they had less need for cars.  From a profit standpoint, the auto companies continue to do well because of a mix shift from conventional cars to SUVs and trucks.  That won’t last forever but as millennials start families and move to suburbs that require two or more cars per family, demand should reaccelerate. Over time, the impact of ride sharing and Uber will take some toll on demand but those forms of transportation are more urban-centric.

Away from cars and houses, demand seems strong.  Consumers are both buying and saving more, an almost perfect combination. Credit card usage is rising.  This promises to be a good Christmas.  Manufacturing continues to be strong.  Some suggest the benefit from the tax cuts will only be a one-time event. While the year-over-year impact of the tax cut on corporate earnings will result in much smaller growth comparisons beginning with the first quarter of 2019, the incremental cash available for corporate investment or for incremental dividends or share repurchases will continue to be elevated versus historic norms.  With stocks theoretically prices to a present value of future cash flows, the rise in dividend payments approaching 10% year-over-year provides the best basis for a solid floor for stock prices.  With the 10-year Treasury now yielding less than 2.9% and the S&P 500 yielding about 1.9%, any persistent growth of dividend payments in excess of 5%, let alone 8-9%, should make stocks very competitive versus bonds.  Indeed, one can construct a very diversified portfolio of high quality stocks paying 3% or more with annual dividend increases.  Ultimately, it will be valuation that helps a market find a floor in a non-recessionary environment, even one in which sentiment is as weak as it is today.

None of this precludes further near term downside.  We have a big Fed meeting this week that could prove disappointing if the Fed raises rates and hints too strongly of several more rate increases to come in 2019.  While almost everyone expects the Fed to say it is data dependent regarding future rate increases, any hints that it still believes that neutral is farther away than 2.5% than most investors believe could set off more selling.  PresidentTrump threatens to shut down the government Saturday if Congress doesn’t give him $5 billion in wall funding.  It almost certainly won’t unless he gives the center and left a lot of concessions.  Normally, a short-term government shutdown doesn’t spook markets much but with sentiment as bad as it is now, this time could be different. There is also a big option expiration at the end of this week to throw into the mix.  Therefore, as I have been noting recently, this should be a very volatile week. 

At the end of 2018, I noted we were living in the best of times but before long, the good news of earnings momentum and tax cuts would be history making the second half of 2018 tougher than the first.  Valuations were becoming stretched. That became crystal clear in February.  Indeed, for most of 2018, the story of the equity market was a reduction of P/E ratios to a more historic norm as interest rates were rising toward neutral.  2019 could turn out to be the exact opposite.   P/Es are now normal to slightly below normal. Any further market weakness will make valuations more enticing.  Sentiment, which was near euphoric a year ago, is now as bad as it has been since 2015-2016 and approaching levels last seen in the European debt crisis of 2010-2011.  Earnings continue to rise but the pace in the first half of 2019 will slow to low single digits and could even be negative for multi-nationals due to the strong dollar.  But Fed policy,Brexit and trade should become smaller issues after the first quarter.  Assuming the dollar stays relatively close to where it is today, currency headwinds will lessen in the second half of the year. 2019 is shaping up to be a bumpy ride early and a rather pleasant one later in the year.

There are two storm clouds to watch for, however. The first is trade. All the above presumes no all-out trade war withChina in 2019.  There are a lot of words to describe Mr. Trump’s policies and actions. Subtle isn’t one of them.  While hitting hard can be good, it can have bad consequences as well.   Second, isMr. Trump himself.  With the House now under Democratic control, the actions of the Trump administration are going to face heightened scrutiny.  Disregarding any talk of impeachment, the administration will be taken to task many times over the next two years.  In the 1970s, scrutiny by Congress and the media ultimately brought down the Nixon administration.  In no way, am I suggesting the same will happen this time around.  But I am suggesting that these investigations have the potential to undermine smooth government and souring American confidence.  That isn’t a prediction but it is a statement of a possible storm cloud to watch for.  All the investigations to date have come during a period of a Republican-controlled Congress.  Actions and reactions going forward are hard to predict and, therefore, increase uncertainty.  But until there is a trade war or a negative economic reaction to any political misdeeds, I will label the two more red herring risks than substantial concerns.

Today, Chase Utley is 40.  Pope Francis is 82.

James M. Meyer, CFA 610-260-2220

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