"V" is a Victory
US stocks were strong in the first quarter of 2019, reclaiming much of the lost ground from the previous quarter. The S&P 500 had dropped 13.5% in the fourth quarter of 2018 after investors reassessed the risks overhanging US stocks. Concerns over the trade war with China, rising interest rates, the Federal Reserve’s ("the Fed's") plan and other geopolitical issues crushed stocks. Around mid-December these fears were exhausted and the market began a steady reclamation of lost territory. By the end of the first quarter 2019, the S&P 500 had recovered 80%+ of its Q4 decline and posted a gain of 13.6% for the quarter and 20.6% from the December low. Large V-shaped recoveries are rare, as big market losses tend to be reclaimed over time. The larger the decline, the more damage to investor sentiment and trader psychology that needs repaired with time and distance. The market’s recovery should be considered a solid victory since the risks which reared their ugly heads still exist. The remainder of the year is likely to experience additional volatility and we at Oak Associates Funds are preparing for this inevitability. However, we remain optimistic towards US equities due to the fundamentally favorable environment of low interest rates, slow growth, and sound capital discipline.
S&P 500 Index - The V-Shaped Recovery
The Fed’s Catch 22
One fact that investors cannot dismiss is that interest rates have risen and might go higher still if the Fed has its way. During the quarter, the Fed made softer comments regarding the path to higher rates, which may have allowed equities to experience a relief rally. While a more wait-and-see approach into 2020 is welcomed, the reality is that a Catch-22 has been created. If stocks remain strong, the Fed may resume the course to rearm its toolkit (in preparation for the next recession) while also reducing its balance sheet. The balance sheet has fallen more than 10% since its peak following the subprime crisis and significant amounts of stimulus are targeted for withdrawal. Thus, equity market strength simply opens the door to Fed action, which hurts stocks. The Fed Funds Target rate currently stands at 2.5%.
The outcome of the Chinese Trade War is also uncertain. Reporting on its progress is schizophrenic at best. There certainly are areas where the US could make inroads in Chinese trade relations, such as eliminating state-sponsored support of certain industries or the required joint ventures that lead to intellectual property pilfering. But China’s perspective regarding trade is very different than ours and pundits should recognize the intellectual and cultural differences. China views their economic model as a comparative advantage which the rest of the world accesses/exploits. They need to protect the model to ensure social stability and prosperity. To access this advantage, its price is joint ventures and intellectual property transfers. Many countries, even the US, support certain industries China considers vital to its national security and economic independence. Hopefully progress can be made to lower trade barriers, eliminate tariffs and protect intellectual property better, but the Trump administration is unlikely to get all it desires.
The Yield Curve
During the quarter, the yield curve, measured as the spread between short-term bills and long-term bonds, inverted. This is a well-documented precursor to an economic recession, but not a true predictor of a recession. As usual, some try to explain away its warnings by analyzing the term premium, Fed’s actions, or claiming it’s simply expected. But it would be Pollyannaish to dismiss its occurrence. Certainly we can see the economy is slowing as higher rates hamper economic activity. But for now, there are many positive signs in the economy and the yield curve’s inversions shouldn’t be considered the last call to exit equities. In fact, it is historically several quarters between yield curve inversion and an actual recession. In the interim, stocks usually do well. Additionally, it isn’t warning of something we don't already know. To state the obvious, at some point in the future, the economy will experience a recession. But the yield curve inversion event shouldn’t be dismissed.
Q4 Risks May Return
The risks facing the US equity market are abundant. Interest rates are up and the tighter monetary environment takes 12-18 months to work its way through the economy. Higher rates put downward pressure on earnings and also lower the present value of future cash flows, hurting valuation multiples, such as PEs. Meanwhile, global economies are also slowing. There’s the Brexit debacle, other geopolitical risks and, oh, the trade war. For now, these risks have abated, but could reemerge and a correction similar to the November-December 2018 decline could occur.
That said, bull markets usually go on a lot higher and a lot longer than people expect. Risk to equities always exist and second guessing a recession isn’t an investment strategy. As this bull market ages, we may lower the risk profile and shift exposures, but exiting prematurely would also be financially damaging. In general, the investment climate is still supported by a favorable low interest rate, slow growth environment. Unemployment is low and likely to fuel productivity gains as business can’t rely on manpower to ramp activity as easily. Corporate profitability remains high and the fruits of tax cuts and deregulation are likely to persist. At this stage of the economic cycle, growth companies tend to outperform and we have a healthy exposure to technology stocks. Our process also tends to favor companies with strong cash production abilities, which stand to benefit from the trend of returning capital to shareholders. On balance, the outlook for equities remains positive.
We remain vigilant and will take any victory the market offers.
Thank you for reading.
Robert Stimpson, CFA, CMT
Co-Chief Investment Officer & Portfolio Manager
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