An often voiced refrain on Wall Street is, "Sell in May and Go Away" reflecting a tendency of markets to pause in the summer months. Not this year! The economy and the stock markets were very strong in the U.S. during the third quarter. U.S. economic growth in Q2 and Q3 (likely) was about 4%. Based on this growth and the recently enacted corporate tax cuts, earnings are up almost 20% over last year. Fears of a trade war subsided as deals were reached with Mexico, Canada and others. The Federal Reserve raised short–term interest rates, and the yield on 10–year Treasury bonds rose from 2.87% to 3.06%.
Once again, foreign markets were all weaker than the U.S. The Japanese market did well gaining 4.0% (EWJ). Europe was weaker rising just 0.6% (VGK). China (FXI) and Emerging Markets (VWO) fell 0.4% and 1.7% respectively.
Q3, 2018 Review
We led our letter last quarter with concerns about President Trump’s trade wars. Q3 showed that his bark is worse than his bite. Deals were struck during Q3 with Europe, Mexico, Canada and South Korea, among others. The "trade war" persists with China, but most seem to agree this "war" is justified. Lifting the concern about trade was a major factor in the market’s rally.
Corporate earnings have been very strong. Based on the data we use, earnings are up 19% over the last year. The market as measured by the S&P500 is up 18% in the last 12 months. Sometimes the performance of the markets actually makes sense! The Price–to–Earnings ratio (P/E) rose a bit during the quarter to 17.5 – higher than average but not particularly concerning.
Healthcare stocks paced the rally in the third quarter, gaining 14.5% (XLV). Industrial (XLI) and Technology (XLK) stocks also rose more than the market during the quarter. Energy (XLE) and Materials (XLB) were the worst performing sectors of the market, both gaining less than 0.5%.
Apple and Amazon.com both broke through the $1 trillion valuation level during the quarter – the first time ever. Apple rose 22.4% and Amazon.com rose 17.8% for the quarter. Facebook was notably negative. After being under scrutiny for data privacy and news feed manipulation charges, Facebook decided to rapidly increase spending to address these issues. Higher spending leads to lower growth and lower earnings, and Facebook stock fell 15.4% during the quarter. Google performed roughly in–line with the market.
Banks were generally weaker than the market. JP Morgan had a good quarter gaining 8.9%; Citigroup increased 7.9%; Bank of America gained 5.0%; and Morgan Stanley fell 1.2%.
The disparity between US and foreign markets was large. In a very strong US market, Emerging Markets (VWO) fell 1.7%. Alibaba is the largest Chinese stock, and it fell 11.2% during the third quarter.
In September, interest rates rose quickly. The yield on the 10–year Treasury bond rose from 2.85% to 3.06% during the month. The Federal Reserve raised short-term interest rates to 2.25% during the quarter, and it looks like they will raise rates to 2.5% in December. Although higher, rates remain reasonable for most borrowers. Housing sales are near highs for this cycle and auto production is just below peak levels. Job growth remains strong, and the unemployment rate is low at 3.9%.
After increases in 2016 and 2017, the Goldman Sachs Commodity index rose almost 9% in the second quarter. For most of the third quarter, commodities were falling, but they rose sharply in September, ending the quarter roughly unchanged. Over the last 12 months, commodities are up 22%. The Federal Reserve Bank of Atlanta measures wage growth to be 3.5%. Inflation is now slightly above the Federal Reserve’s targeted rate of 2%. With commodities increasing rapidly and wages growing, we suspect that inflation will increase further.
After a very strong Q2 for the US Dollar, there was not much change in Q3
Q4, 2018 Investment Strategy
We are now nine and a half years into this economic expansion that began in early 2009 –matching the longest expansion in the history of the U.S. Although we remain mostly bullish, we are aware that a downturn is likely to be on the near–term horizon.
Perhaps the best precursor of a recession/market downturn is the yield curve. Most of the time, long–term interest rates are higher than short–term interest rates. When short–term rates are higher than long–term rates, this is called an inverted yield curve. Inverted yield curves are fairly rare, and they have preceded each of the last 5 recessions/bear markets. The yield curve is not currently inverted, but it is getting close. 2–year Treasury yields are now 2.82% and 10–year Treasury yields are now 3.06%. We are watching this closely.
Short–term rates are almost certainly going up. The Federal Reserve will likely increase interest rates once again in December, and the current forecast is for the Fed to increase rates 3 times next year. This would take short–term rates to 3.25%. If longer–term rates don’t rise, the yield curve will invert, and this will be a signal for us to get more conservative.
The market gave investors an opportunity during the third quarter to buy bonds when yields rose (bond prices fell). We’ve been generally underweight bonds for those whose investment objectives call for some conservatism. Now we are more comfortable owning bonds.
We are positive for the fourth quarter, but 2019 will almost certainly be a more challenging year than 2018. Interest rates will be higher, and the impact of the tax cuts will be reduced. After gaining 20% in 2018, earnings growth will likely be less than 10% in 2019.
Healthcare was the best performing sector in the market during the third quarter. The 4 biggest stocks in the sector are: Johnson & Johnson up 14.6%; United Healthcare up 8.8%; Pfizer up 22.5%; and Merck up 17.7%. The big technology stocks, other than Facebook, continue to be among the market’s best performers. Closer to the end, bull markets tend to concentrate their gains in a small group of stocks. It looks to us like this is happening. Where we own them, we are not inclined to sell these stocks outright, but we have been marginal sellers at these levels.
We have been avoiding Industrial stocks – thinking they are expensive. This proved correct in the second quarter as they (XLI) fell 3.2%, but they were strong in Q3. We think they are still too expensive.
After being poor performers for the last couple of years, the energy pipeline stocks have performed well this year. They pay nice dividends, and they make money more on volume shipped than on price.
We have been bullish on the prospects for financial stocks, but they have been poor performers recently (XLF down 3.1% in Q2; up 4.2% in Q3). Despite the weak recent performance, we continue to like select financials.
Emerging markets have been weak this year, but we continue to favor maintaining a position here due to the low valuation and the positive long–term growth profile.
IMPORTANT DISCLOSURE INFORMATION: Historical performance results for investment indices and/or categories are calculated including reinvestment of dividends and other income. These results have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices.
Regent does not hold itself out as providing, nor does it provide, financial planning services. Neither Regent nor any of its representatives serve as an attorney, and no portion of Regent’s services should be construed as same.