Be Careful What You Wish For
The sharp rebound in U.S. stocks since the Christmas Eve 2018 low has been a welcome development for the bulls, but we are concerned that the pendulum may have swung a bit too far.
The fourth quarter 2018 earnings season has been healthy, but estimates for this year’s first quarter have descended into negative territory. Meanwhile, the Fed has turned more dovish; but why and for how long are relevant questions.
Trade continues to be at the center of investors’ attention—the recent positive news from talks with China may be overplayed and there are other potential trade disputes simmering.
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“Be careful not to compromise what you want most for what you want now.”
- Zig Ziglar
Too much of a good thing?
Equity investors have been cheering the sharp rebound seen since the end of last year, with the S&P 500 up more than 16% since the Christmas Eve low. We don’t want to be buzzkills and we enjoy rallies as much as anybody; but just like you can eat too much cake with bad results, equity gains that come rapidly after sharp corrections can have consequences as well. It didn’t take long for sentiment to move from overly pessimistic to overly optimistic according to the Ned Davis Research (NDR) Crowd Sentiment Poll; somewhat concerning given the contrarian nature of investor sentiment, especially at extremes. We believed that U.S. stocks had gotten to oversold levels and were likely pricing in too great a risk of a near-term recession—so a rebound was to be expected. But some of the declines seen toward the end of last year were justified in our minds as economic growth has been slowing, trade uncertainties remain, government dysfunction persists, and corporate sentiment is deteriorating. In short, we don’t believe we’ll revisit the lows seen late last year if a recession remains a 2020 story, but a retrenchment of some of the recent gains seems likely. If a recession looks to be developing this year—and if there is no trade deal and additional tariffs kick in—those market lows could be retested (and beyond).
Economic growth slowing, while an earnings recession becomes more likely
U.S. economic growth, while remaining in positive territory, has definitely slowed courtesy of tighter financial conditions last year, weak global growth, the trade-related denting of “animal spirits,” and the effects of the government shutdown. Retail sales for December were weaker than expected, truck orders have declined, and auto sales have weakened (with inventories climbing 4% month-over-month according to Wards Auto).
Truck orders have weakened
As have auto sales
Also of note has been the upside breakout in initial unemployment claims; as well as the decline in banks’ willingness to make loans, showing more caution among financial firms and providing reduced capital to business.
Banks are becoming more cautious
The old chicken and egg argument comes into place now. Are businesses becoming more cautious because of weaker economic growth and last year’s market swoon; or is the economy weakening a result of reduced business confidence? Regardless, either scenario presents risks for the stock market in the near-term. The Institute for Supply Management (ISM) Non-Manufacturing Index fell in its latest reading, moving to 56.7 from 58.0, while the forward-looking new order component fell more sharply to 57.7 from 62.7—both still above the 50 mark which denotes expansion versus contraction, but not moving in the right direction.
This slowdown is clearly impacting the earnings story as well. Expectations were relatively subdued coming into the fourth quarter 2018 reporting season, which may have helped companies hurdle the bar. At the same time, companies reporting stronger earnings have been rewarded with higher stock prices—in contrast to the general trends of last year. But stocks tend to focus on the windshield, not the rear-view mirror, and the deterioration in earnings expectations for this year are notable. According to Refinitiv (formerly Thomson Reuters) first quarter estimates are now in slight negative territory, with the subsequent two quarters both in low single-digit territory—making the valuation case less attractive (for more on the earnings story read No Quarter: Could 1Q19 Bring Negative Earnings?).