Stocks fell yesterday. While the media blamed it on jitters over possible weak first quarter earnings, the more likely reason was simply profit taking.

First quarter earnings season gets started tomorrow as three major banks are due to report results in the morning.  The flattened yield curve and lower rates will be a headwind to traditional banking while the strong dollar will hurt international results. 

On the other hand, a strong stock market will benefit those banks heavily involved in the securities business.  Traditionally, however, the banks have not been a good barometer for how the rest of earnings season will look like.  The volume growth of commercial and industrial loans may give us some hint of activity but things like loan loss reserve changes and net interest margins are simply not very applicable to other business segments.

In general, economic activity was solid in Q1 but not spectacular.  The surge in consumer spending during Christmas season abated a bit.  Tax refunds are lagging behind last year even though total taxes paid on 2018 earnings are likely to be fairly flat or down slightly from 2017 before the tax cuts.  Higher incomes will push taxes higher as will the lack of deductibility of state and local taxes for those living in high tax states.  But the reason refunds are down is because businesses under withheld last year leading to a bit more money in consumer hands in 2018 and less in the way of refunds (or higher April 15 tax payments) this spring.   While some will see some noticeable benefit from the tax cuts, most of the advantage went to corporations and not individuals.  The largest beneficiaries will be those who used to itemize but can now take advantage of the enlarged standard deduction.  Generally, these will be families that don’t own their own home (i.e. renters) who don’t have large medical expenses or charitable contributions to itemize.

Away from the consumer, inventories swelled at year end.  Businesses reacted to rising sentiment late in 2018 and got a bit too exuberant.  That additional inventory appears to have hit certain industries harder than others.  The semiconductor industry is a case in point.  It may take another 3-6 months for inventories to normalize.  Another industry taking it on the chin in Q1 is agriculture.  A combination of high inventories, courtesy of the Chinese tariffs, and terrible weather have ravaged farm incomes.  The flooding in the Midwest will delay spring plantings at a minimum.  Some acreage may never get planted at all this spring.  That could inflate prices later this year but it won’t look pretty over the next several months.

But not all is doom and gloom. The recent drop in interest rates is bound to help the housing and auto industries. While the decline came too late to help first quarter earnings, traffic and orders are picking up.  Since investors look ahead, they will forgive weak Q1 earnings for the promise of better and brighter days to come.

Another area of strength is software, particular for cloud, customer service and cyber applications.   We are in a transformative period where the cloud is replacing on-site data centers, where customers are becoming more and more mobile, where phones are the go-to device for computing rather than the laptop or desktop, where multimedia is replacing text, and where digital wallets are supplanting paper money.  All those transformations are enabled by software.

Then there are the worlds where change is so vast and rapid that the evolution is more opaque that transparent.  Social media has changed all of us.  But it is still evolving.  Privacy is a huge issue today but it is only one of many.   Social media allows all of us to live within protected silos. We shut out what we don’t want to see.  Thus, it allows us to communicate but we communicate selectively.  For advertisers, and therefore, for the social media platforms, this is an advantage.  But it is also changing our ways of life in ways we don’t yet completely understand.  Its role, for instance, in shaping politics is still evolving.  Candidates use it to reach target audiences but those wishing to interfere also use social media to distort and twist truths.  How to regulate this world remains a mystery and could ultimately affect the profitability of the platforms.

Another area where the future is opaque is healthcare.  There is no question that more and more healthcare is needed and medical advances will allow us to live longer.  But what can we afford?  The number of nursing home beds over the next decade will probably be cut in half despite rapid growth of those over 80 years old.  Why?  Because nursing homes are expensive and much of the care provided there today will be provided in home or at other sites in the future to save money.  Left unchecked, entitlements and interest costs will soon consume over 50% of the Federal budget.   States now outsource Medicaid.  Drug pricing is under attack.  While lower drug prices are clearly a plus for consumers, drugs are far less than one-fifth of total health care costs.   The cost of hospital care is a far larger piece of the pie.  Thus, while technological advancement and new drugs will continue to lift earnings for part of the health care segment, pressure on pricing, and the need to move patients to the point of most cost-effective care will impact that industry for a very long time.

Back to Q1, this should be the weakest quarter for earnings in 2019, a combination of low GDP growth impacted by tariffs, weather and a government shutdown, as well as the strength in the dollar.  The year-over-year increase in the value of the dollar will fall sharply over the next two quarters will GDP growth should improve, partly in conjunction with lower interest rates.   On one hand, everyone knows Q1 earnings growth will be tough to achieve.  That should be priced in to stocks already.  On the other hand, the sharp rally in the first quarter suggests that for stocks to move higher from here, forward looking statements have to be quite optimistic.   That becomes a bit iffy given that issues like tariffs and Brexit remain unresolved. 

Thus, look for a mixed quarter and a bumpy stock market over the next 2-3 weeks.  Some backing and filling, after recent gains, would be a healthy outcome.

Today, Steven Seagal is 67.  John Madden turns 83.

James M. Meyer, CFA 610-260-2220

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