Elvis has left the building
David Nelson, CFA
Elvis fans know the phrase all too well. Hoping for an encore, many would linger long after the concert while announcers gave them the the bad news. Elvis has left the building. Crashing out of the arena Elvis would be whisked away into a fleet of limos with a police escort and entourage in tow.
Dow Jones Industrial Average
Today investors seem to be hanging around hoping for something similar. Just one more encore for the bull market. Just one more day of summer waking up to your favorite news channel as the anchor and guests yuck it up while futures point to a 200+ open confident you won’t get burned if you trade intra-day. It’s been a long show lasting 3,563 days, 17,945 DOW points with 6 encores following 6 corrections of more than 10%.
President’s Trump and Xi at the G-20
Today, smart money does nothing until the last 30 minutes of trading where the real character of the market shows its face. Last week’s performance was disappointing on several levels. On the heels of a monster come back the week before stocks failed to capitalize on what at first glance looked like a very successful G-20 meeting between President Trump and China’s President Xi. Confusion surrounding the arrest of Meng Wanzhou CFO of Huawei, a maker of consumer and enterprise telecommunications equipment added another layer of concern for investors. Without going into the weeds on why she was arrested and all the misdeeds of Huawei which many experts believe is a threat to National Security, questions seemed to center on the President’s knowledge of the arrest. Did he know during the meeting with Xi and if he didn’t why not? Both sides of the political aisle will spin it how they will but for investors the only thing that matters is it became a trigger for another round off selling.
S&P 500 1 Year
Monday’s rally was followed by heavy liquidation Tuesday and successive legs lower Thursday and Friday following Wednesday’s observance of a National Day of Mourning of the death of former President George H. W. Bush.
The political media spent the weekend focused on the Russia investigation and the term “political synergy” as it relates to a Russian national who met with Michael Cohen on or about November 2015. Sunday, the President released a statement saying Chief of Staff John Kelly would leave the administration at the end of the year. Without weighing in on the investigation that is two years and counting all of the above adds to a wave of uncertainty that has gripped the street.
3 Market Challenges for 2019
Economic – It’s true the U.S. economy is still in good shape, but the second quarter 4.2% GDP print may prove to be the high-water mark until several other factors which I’ll speak to shortly improve. We’re seeing a declining trend with 3.5% for Q3 and current consensus at 2.9% for the fourth quarter. Still excellent numbers if we don’t erode much further but the picture in many parts of the world is far from robust. The four most important countries in Europe including France, Germany, Italy and the UK are looking at GDP growth between 1 and 1.5%. Some areas of Europe show significant levels of unemployment in the low double digits.
Japan, with its aging population finds it difficult to stay above zero. China of course is still showing a greater than 6% GDP print but given the opaque nature of their society along with government supporting many industries, the health of the world’s second largest economy is a question at best.
Some economists estimate that more than 40% S&P 500 revenue is off-shore certainly an important factor for large cap U.S. multi-nationals. Again, it’s important to remember these countries are our customers. If they continue to struggle eventually it hits our top and bottom line.
A big part of the economic picture is the ongoing trade discussions with China. We’re at the beginning of a 90-day clock to see whether something meaningful can come out of these negotiations. Secretary of Treasury Steve Mnuchin has said there were 142 specific points discussed in Argentina and now it’s up to Robert Lighthizer and team to bring it home. On Fox News, Mr. Mnuchin said that China would make “additional purchases of $1.2 trillion dollars” and “if that is real, that will close the trade deficit.” According to the Wall Street Journal, last year, the U.S. shipped $188 billion of goods and services to Beijing and ran a $336 billion deficit in total trade.
Today, even the President’s political foes would agree that China’s trade practices including the ongoing theft of intellectual property and forced technology transfer are more than an economic concern. As I’ve pointed out in several articles, one look at China’s J31 fighter jet alongside a Lockheed Martin F-35 Strike Fighter confirms China as a National Security Risk. The obvious espionage is hard to ignore.
Unfortunately, time is on China’s side. While it’s true the trade deficit math doesn’t work for Mr. Xi, he knows full well the United States is a country that thinks, and acts based on election cycles. It was no coincidence that a meeting never materialized between the two world leaders prior to the mid-terms. The gamble hoping for the Democrats to flip the House certainly didn’t hurt from their vantage point. With 2020 and a presidential election only two years away he may choose to drag his feet even if it means China must tough it out hoping for a more traditional voice to make their way to the White House. Until Trump, Xi and is predecessors have tilted the playing field in their favor using the World Trade Organization to their advantage. Today the WTO still classifies China the world’s second largest economy as an emerging market nation with favored nations status.
Market Structure – Smarter minds than yours truly have discussed the chaotic trading of recent years. Hedge Fund legend Leon Cooperman recently pointed out that markets are largely driven by trend following technical systems often on automatic pilot as computers read and trade off key words and data coming from every news source including social media sites like Twitter (TWTR). The proliferation of out of the box trading software like Trade Station is giving even novice investors a basket of technical analysis tools turning them into day trading hedge fund hopefuls.
We seem to forget every 10 years or so that a stock certificate is nothing more than a contract between the holder and the company. As a shareholder, you are entitled to your pro-rata share of earnings and or dividends. Terms like profits and cash flow have been replaced with Linear Regression and Fibonacci Retracement. We’ve moved from using systems defining long-term trends to pattern recognition across 5-minute bars of pricing data. Don’t get me wrong! I love technology and my monthly expenses for data and online services confirm but it’s important to not lose sight of what we’re investing in and why.
Political – The initial positive action by investors following the mid-terms has morphed into something more sinister. There’s been a lot written that gridlock is good for markets in anticipation nothing would get done. I don’t buy it. Maybe that was true during a time when politicians would risk crossing the aisle to get important legislation passed. Today’s Congress resembles the infamous No Man’s Land of World War I. Get caught in the middle and you die. There’s little cooperation between the two political parties and for the next two years key congressional leaders from the Democrat controlled House have all but assured us their focus is to litigate rather than legislate. I’m not politically naive and realize if the situation was reversed, the same would hold.
The Good News
S&P 500 vs FCF Yield vs Price/Earnings
Markets usually die following a wave of euphoria little of which is evident today. Despite a difficult year, markets are near the flat line just above support levels that have survived several tests. Valuations using traditional metrics like Price/Earnings are sitting near the averages of the last 20 years, a time mind you when yields in competitive asset classes like fixed income were significantly higher. Free Cash Flow Yields continue to rise, and current estimates put earnings growth for next year at 8.7%. The press loves to point out that it’s a big drop off from the 22% growth in 2018. Bu let’s drill down a bit. About 9% of the growth on a GAAP basis came from the one-time bump of tax legislation so the real change is from 13% to 8.7%. If markets close the year at or near where we are today stocks will be flat, while most valuation metrics will have come in about 17%. That’s not a terrible setup going into 2019.
Even if the worst happens and we’re hit with a recession or bear market, they don’t last all that long. I can’t tell you whether Elvis is still in the building but like any concert, the limo’s out back have been there since the start of the show. Even if they pull away, fans know eventually the artist can’t resist the stage and will be back for another performance. (The Rolling Stones have announced the dates of their 2019 World Tour)