Market Commentary Q2 2019

On April 14^th, German Marquez, starting pitcher for the Colorado Rockies, had a no hitter going against the Giants.  When you’re watching baseball and a pitcher has a no hitter going there’s an evolvement as to how you react to the game.  After a few innings you start to take notice of what’s going on.  Around the 5^th you start asking if someone can get a hit.  Later you start wondering how long he can last.  At some point you assume someone has to get a hit.  Nervousness by the viewer starts to increase more and more.  German entered the 8^th inning unhittable, only for everyone’s questions to be answered by Evan Longoria who had the only hit in the game, a one out single, that ended German Marquez’s bid.

The current bull market feels the same.  We are 117 months into the current bull market and it is the second longest bull market in U.S. history.[1]  We’ve taken notice of the bull market and the questions from investors have started to increase.  How long can this last?  Will the market continue to rise, or will our bid for the longest bull market end like Mr. Marquez’s bid for a no hitter?

There’s no possible way to time the end of a market.  We can however look at the current characteristics of our market, relate them to past economic cycles and try to understand what is currently going on in our economy as well as international economies.

U.S. Market

Earnings Growth

In the U.S., Earnings estimates have moderated, but single digit growth seems possible for many sectors[2].  This is much like driving down the highway.  If you must stop and go in reverse, that would be a recession.  This is when earnings would be negative.  Right now, you’re going about 30 miles per hour.  If you should slow down to 20 miles per hour, you still haven’t gone in reverse.  We are still moving forward, just at a slower pace.  The U.S. economy is still expanding, but it’s expected to be at a slower pace.

Aggressive Fed Tightening

One of the characteristics of a recession is an aggressive Fed1.  This means when the Fed raises rates too high, too rapidly the economy can go into a recession.  In October of 2018, we started a correction and the main culprit was due to fears over interest rates as the ten-year treasury yield hit a 7 year high[3].  On March 20^th, the Fed left its key interest rate unchanged and projected no rate hikes in 2019[4].  What this means is that the Fed was increasing rates in October and treasury yields hit new highs.  This led to market fear which was considered as one of the factors of the correction in October.  As of March, the Fed mentioned that they were no longer projecting to raise rates for the rest of 2019.  Since an aggressive fed is considered a fed that raises rates too high, too quickly this means the Fed is reducing its aggression towards rates.

Historically, an aggressive Fed has been evident from a negative correlation between the market and Fed rate hikes when the ten-year treasury yield is 5% or more1.  What this is telling us is that, historically, when the Fed raises rates and the ten-year treasury yield is less than 5%, we have a positive correlation between the market having positive returns and the Fed’s decision to increase rates. The 10-year treasury yield was 2.56% as of April 12[5].  This is less than the 5% historical threshold.

Inverted Treasury Yield

The treasury yield inverted from March 22^nd to March 28^th of 20195.  An inverted yield curve happens when short term rates become higher than long-term rates[6].  The inverted yield curve is important because there have been 7 instances where a recession took place, on average, 14 months later1. That being said, we’ve seen an inverted yield curve nine times1.  While the yield curve inversion is not a direct cause of past recessions, we do have it on our radar.  However, there generally should be a bubble for there to be a bust.  When the GDP goes up, or it goes down, 66% of that change to GDP has historically been associated with 4 sectors:  Housing, Cars, Change In Private Inventories and Business Fixed Investments1.  As of today, these are close to historical averages, not showing wild extremes1.  In other words, they’ve not grown rapidly beyond historical averages.  They haven’t created extreme, abnormal bubbles.  Historically, they’re outputting at an average pace.

International Markets

Valuation Disparity

Price to Earnings is the ratio for valuing a company that measures its current share price relative to its per-share earnings[7].  It’s a way to value markets or companies and then compare them to other markets or companies.  The price to earnings of the S&P 500 was 16.40 as of March 31^st, 20191.  This means that you currently pay $16.40 in price for every $1 of earnings for owning shares of a S&P 500 index fund.  Internationally, the MSCI All Country World Index ex U.S. has a price to earnings ratio of 13.0 as of March 31^st, 20191.  This means it only costs $13 for that $1 of earnings to be the MSCI All Country World ex US Index Fund.  The valuation gap between the U.S. and International stocks shows that International stocks are favored in terms of valuation relative to the U.S. at an extreme that we last saw in 2001[8].  In short, we are seeing a better value for investments outside of the U.S. that we haven’t seen in a while.

Discount to Trend

MSCI EAFE stocks have a long term real return of 6.40% since 1970 and they are currently at a discount to that trend by 40.90%8. When MSCI EAFE has been 40.90% below their trend line, average returns are about 16% over a ten-year time period8.  This is saying that, as of January, 2019, the ACWI ex U.S., which is an index that represents international markets, has been performing subpar compared to its historical average and the average return needed over the next 10 years would be 16% to get back to its long term averages.  This, combined with the valuation disparity, shows that international investments look attractive

Conclusion

Once again, no one can time markets.  We don’t know quite when this no-hit bid will end.  That being said, the U.S. economy is still expanding. The Federal Reserve doesn’t look aggressive at the moment and has signaled a current stoppage of rising rates.  The treasury yield curve did invert, but only 77% of the time did a recession follow and it precedes a recession by an average of 14 months.  International equities still seem attractive and have some significant growth to catch up to their long term trends.