Stocks staged a modest rally on Friday with the Dow breaking an 8-day losing streak. But the rally lost steam in the afternoon while most of the problems plaguing the market in recent weeks still evident.

Tariffs – Over the next three weeks the next modest wave of tariffs are due to be implemented unless intervening negotiations settle outstanding issues to the satisfaction of the Trump administration. While there has been a little movement, (e.g. the Germans talk of removing tariffs on imported U.S. cars) the movement has been slight. Over the weekend, the President stiffened his stance against China threatening to limit Chinese purchase of American technology. While the Chinese equity markets have fallen more than ours over the last several weeks and China would suffer more direct economic harm than we would in a tariff war, one can’t conclude that, as a consequence, China will be the first one to blink and back down. While it is generally assumed that China will have to become more respectful of intellectual property rights over time and has taken advantage of its emerging market status to limit foreign imports, Wall Street isn’t convinced that an escalating trade war is the most efficient way to arrive at that conclusion. So far, there has been much more rhetoric than action but the risks that the harsh words turn to harsh actions is increasing.

Interest Rates – Long term rates have risen to close to 2.9% from 2.4% since the start of the year. We have also seen two interest rate increases from the Fed on the short term side. Thus, the curve has stayed about the same. It is still rising but is flat enough that some worry about inversion if the Fed keeps raising short term rates, the curve could flatten further or even invert, a harbinger of recession. There is also risk that the above trend economic growth we have been experiencing year-to-date could finally spill over into accelerating inflation. That would be even more likely if broad tariffs are introduced forcing prices and inflation higher. For now, however, inflationary pressures remain relatively tame.

Earnings – There is little doubt that second quarter earnings will be very strong thanks to recent tax cuts and accelerating GDP. However, a strengthening dollar will through a bit of a monkey wrench into the earnings of certain multi-national companies. Still earnings growth, year-over-year could still exceed 20%. That compared with a stock market that is barely up so far this year. The problem, from an earnings perspective, is that the 20%+ year-over-year growth isn’t sustainable into 2019. Given that stocks are forward looking, the real question today isn’t earnings for the remainder of 2018 but the outlook for next year. All other things being equal a 7% growth rate, in line with normal historic patterns in a growth economic world, would seem logical. But that depends on a constant dollar and no acceleration of tariffs, two big ifs at the moment.

Narrowing Leadership – Of the top 20 performing stocks in the S&P 500 this year, only one has a P/E ratio below the market mean or median. A handful have no earnings at all. If you are looking for so-called bargains with P/E ratios in the single digits that populate the list of 100 worst performing stocks in the S&P 500. Portfolio managers whose performance is measured quarterly against the S&P have been chasing or are being forced to capitulate and chase the high flyers. But history suggests that while this strategy can work exceedingly well over a relatively short period of time, chasing momentum without any regard to value almost 2

always ends badly. In recent weeks, as we approach the end of Q2, while the Dow has been in a slow but steady decline, the NASDAQ 100 has been setting all-time record highs. Let’s just say is there is very little margin for error. In the meantime, other sectors that had been strong earlier in the year hit some potholes. The financials were hit by a flattening yield curve. The energy stocks suffered as oil prices pulled back from recent highs. The industrials fell as tariff fears rose.

Thus, we enter a few weeks of relative uncertainty. That uncertainty is compounded by the fact that companies that report earnings on a calendar year basis are now prohibited from buying back their own stock as we are closing in on the end of the quarter. Stock buyback programs are a big lift, especially at the pace of current stock repurchases. Later this week we will get important economic data that starts to pay the picture for June although the employment report won’t be released until next Friday, July 6. All expectations are for strong numbers. Still with so many unresolved issues, mostly centered on tariffs and politics, it seems likely that the trading range we have lived in so far this year will remain in place a while longer. Note that this morning the VIX index that measure option volatility is trading over 15, a sign that we may see more volatility until we get to earnings season. Should the market take a further leg down, it might set up a nice buying opportunity. In the end, interest rates and earnings are what matter. Earnings are going to keep growing and interest rates appear well anchored, at least for now, close to 3% for 10-year Treasuries. That will limit the downside. The upside is limited by valuation and will probably remain limited until closer to the mid-term election season at least.

Today, Carly Simon is 73. Today is National Leon Day. What is that? Well, a hint is that Leon is Noel spelled backwards. Yes, today we are exactly 6-months away from Christmas. For some of us (not me!) it might be time to get your Christmas shopping started.

James M. Meyer, CFA 610-260-2220

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