Mid-Quarter Update: A Setback for Stocks

While the third quarter of 2018 was uneventful but quite profitable as U.S. stocks drifted up to their all-time highs in September, the first half of the fourth quarter has proven to be the opposite: plenty going on in politics and in the markets and the major stock indexes solidly in the red as compared to October 1.

As we approach the end of 2018, the U.S. economy remains in solid shape.  Consumer confidence is high going into the holiday season and the job market is robust. Corporate earnings for the third quarter, reported in recent weeks, were strong on the whole, rising 15%-20% over last year’s third quarter. So why the abrupt change of heart for investors?

Because investors look forward, not back, stocks have declined in recent weeks due to a growing list of factors have been negatively impacting investor confidence.

Rising Interest Rates

First, interest rates have continued to rise, and the Federal Reserve seems to be on track for a 25 basis point hike in December and a few more hikes in 2019. Many investors think this pace of increases is too fast, as already higher interest rates this year have contributed to a significant deceleration in the housing market—a very important segment of the overall economy. Homebuilders in particular have felt the pinch as their order books have dwindled while home values are softening across the country.  On the other hand, a strong labor market along with higher labor and production costs would argue for the Fed to continue its campaign of rate hikes to get ahead of a surge in inflation in 2019 and beyond. 

Continuing Trade Worries

Second, trade tensions around the world seem to finally be causing a slowdown in the global economy. In the quarter just ended, both Japan and Germany reported an economic contraction.  China’s economy is also struggling under the yoke of U.S. tariffs, which are set to intensify on January 1st, when they go from the current 10% to 25%.  While the U.S. economy expanded at a robust 3.5% annual rate in the third quarter, it is just a matter of time before the global weakness arrives on U.S. shores if the trade/tariff situation does not brighten.

Wary Tech Forecasts

Third, the giant technology companies that have led the market for the last few years have stumbled. The stocks of Amazon, Alphabet (Google), Apple and Facebook have declined meaningfully from their all-time highs and their managements mostly struck a more cautious tone during their recent earnings conference calls.  Because tech and the tech supply chain are an important and fast-growing segment of the global economy, any slowdown is sure to impact markets.

What could happen in the near term to turn sentiment around?  Two things in particular would likely cheer investors. 

  • First, if the Fed were to prominently acknowledge the potentially detrimental effects of the global slowdown and trade spat on the U.S. economy, investors might come to believe the path to rate tightening would become slower and longer.
  • Second, an accommodation with China on trade would certainly be well-received in the markets. It is in the interests of both the U.S. and China to work hard to find common ground, and if negotiators can hammer out a deal then global markets would likely respond well.

As it stands, the valuations of U.S. stocks have become more attractive now as earnings have grown more strongly this year than stock prices.  The S&P 500 Index currently trades at 16.8 times next year’s consensus earnings estimate of $160, a slightly higher-than-average valuation.  With the 10-year Treasury note yield at 3.12%, stocks seem to be reasonably valued.

Please don’t hesitate to get in touch with me if you would like to discuss your portfolio or the markets.

 

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Peter Thoms

About the author

Peter Thoms founded Orion Capital Management LLC in April 2002. Peter has an extensive background in crafting investment solutions for high-income clients in a wide variety of circumstances.