Investors enjoyed strong returns across the board in the both the stock and bond markets in the second quarter. The milestone marking this as the longest economic expansion in US history was also crossed at 120 months (July 2009-2019). For perspective, the average length of expansions since 1900 is 48 months and recessions average about 15 months.
Again, for perspective, while the major stock indices are at highs, they are only about 3% above January 2018 levels. We are concerned potential good news may be already be reflected in stock prices, while the markets seem to be ignoring any potential bad news. Investor sentiment has reached the extreme optimism zone; a contrarian indicator according to the Ned Davis Research Crowd Sentiment Poll.
Q2 earnings season has started with reduced expectations. Factset reports Q2 2019 estimates for the S&P 500 are expected to decline by 3% on a year/year basis, leading to the possibility of upside surprises in the near term. However, if the index reports earnings growth of 1.0% or lower for Q2, it will mark the second lowest earnings growth reported by the index since Q2 2016.
With lower earnings, recent returns in the stock market aren’t likely being generated by earnings growth, but by expanding valuations (P/E ratios). It seems the extension of valuation is being driven by three focus points: Federal Reserve monetary policy (rates up/down), Congressional fiscal policy (spend, tax, deregulate) and trade / political concerns across the globe.
It does look like the Fed will cut rates, but the impact may be diminished. Fed Chair Powell has commented several times that much of the economic uncertainty is due largely to trade & tariffs rather than interest rates being too high. Assuming he is correct, a quarter point cut in rates is probably not a panacea for the economy. It’s also probably not enough to offset the trade-related uncertainty. These days the market seems to be rising on bad economic news as this would likely signal lower interest rates from the Fed. However, we believe an economic decline to the point that the Fed has to cut rates multiple times would likely be a signal of a recession and not a good backdrop for stocks.
Conflicting signals from stock and bond markets suggest markets are uncertain about the current environment. Investors in the stock market seem to have their hopes pinned on lower rates from dovish central banks to buoy asset prices, even though underlying fundamentals have weakened further causing bonds to rally and yields to fall.
In our opinion, while upside to the stock market is still likely, with the markets near all-time highs, risks remain skewed to the downside. We still believe the US and major global economies will continue to grow in the months to come, however growth is slowing. Our focus is on the November 2020 election and we believe volatility will increase as that date nears.
Because of this we continue to elect to take a more conservative route as it aligns with our long-term investment objective of achieving a more consistent rate of return over full economic cycles. For those in withdraw phase we continue to hold / increase cash while receiving 2%+ yields. For assets targeting longer term growth we haven’t seen a technical reason to sell, and until we do we will stay the course in our already risk-reduced allocation. We have positioned portfolio assets to both participate and defend in the current unique market environment.