Market Commentary: "Markets Go in Cycles"

I’ve learned that spring arrives early in Texas. By mid-February, my family and I were greeted by two rows of blooming hyacinths in front of our new Dallas home. In celebration of the new season, we took a trip to the Texas Hill Country where wildflowers are just beginning their annual show. While flower peeping, we also learned that the term “hill” is only appropriate relative to the flat prairies of Dallas. Similarly, February markets were in celebration mode, continuing January’s cadence upward and fully shrugging off the concerns that had plagued the market at the end of 2018. The month ended slightly above where December began.

Equity Markets

Large capitalization stocks, as represented by the S&P 500 Index, rose a respectable 3% for the month of February. Smaller capitalization stocks, as represented by the Russell 2000, fared even better, gaining 5.1% for the month and up 17% since the start of the year. As companies reported earnings for the fourth quarter of 2018, 69% managed to beat analysts’ estimates. While this rate is slower than the five-year average, companies reported top-line sales higher than analyst estimates. Looking forward, analysts estimate that overall earnings for the S&P 500 will grow 5% from last year.

A major weak spot in earnings reports was from business outside the U.S. By one analysis of companies’ public discussions about their earnings, two-thirds of firms mentioned weakness in Europe and half mentioned weakness in China; many mentioned weakness in both geographies. Confirming this pessimism, forward economic indicators such as the Purchasing Managers Index (PMI) turned down in many non-U.S. economies. As a result, non-U.S. stocks lagged their American counterparts, though they managed to close February in positive territory. The MSCI EAFE (Europe, Asia, Far East) gained 2% for the month while the MSCI Emerging Markets Index rose a scant 0.1%.

China, in particular, has been a cause for concern largely because it has been such an important driver of global growth. Last year, the country grew by 6.5%, and, next year, it is expected to grow by 6.0%. This nominal level of growth may be quite impressive compared to the developed world, but it is the slowest pace since 1990. Furthermore, it is less than half of the growth rate the country had been posting just a few years ago. One important advantage that China has over other large economies is its ability to spend. In fact, Chinese officials are already enacting changes to buoy growth: increasing in government spending, enacting new tax cuts, and increasing of lending to small companies.

For the second month in a row, every sector ended February in positive territory. Technology and Industrials led the way, up 7% and 6% respectively. Within the Technology sector, over 80% of companies reported earnings that were stronger than analysts’ estimates, which is the highest number of any sector. This positive indicator was offset by the fact that less than 50% of those same companies beat analysts’ sales estimates. In short: Top-line revenues for tech companies were lower than expected, but companies were effectively wringing out more profits—likely by cutting costs. This trend is in contrast to the rest of the market where, as noted above, fewer companies had positive surprises on earnings and more had surprises on sales.

The Financial sector bounced a respectable 2% in the month, but continued to lag on a longer-term basis, down 6% over the last 12 months. Banks reported that consumers were less interested in new loans for purchases like cars and houses. At the same time, loan officers, worried about the future of the economy, were making it harder for folks to take out loans by increasing their underwriting requirements. Combined, these two forces could mean fewer loans, slower growth for banks, and, in general, slower growth for the broad economy.

Bonds, overall, were about flat for the month, with the Bloomberg Barclays U.S. Fixed Income Aggregate Index returning -0.1%. Bonds that carry more credit risk such as high-yield bonds fared the best, rising 1.7% in February. Bonds that carry more duration risk, such as 10–20 year Treasury bonds dropped 0.7% as long-term rates rose slightly.

In concert with slowing global growth, many benchmark interest rates around the world reached fresh lows. The Japanese 30-year government bond, for instance, dropped below 0.60%, while the German 10-year government bond reached almost 0.10%.

The Economy and the Fed

In February, the Federal Reserve took another meaningful step toward easing off the monetary brake pedal. Recall that, in January, Fed Chairman, Jerome Powell, indicated that he would halt increases in the Fed Funds Rate for the foreseeable future. This announcement was an important driver of the market’s rebound. Then, he indicated that the Fed would likely end the runoff of its $4 trillion portfolio, meaning it would no longer be selling bonds into the open market and putting downward pressure on bond prices. While an official announcement is still pending, the message is clear: the Fed is firmly on hold.

Driving the Fed’s change of heart has been economic data that is decidedly mixed. In response to continuing trade wars and waning confidence, manufacturing has slowed, small businesses have lowered capital spending, and consumers have decreased spending. On the other hand, wages continue to grow, the Federal Reserve’s monetary policy has shifted from a negative to a neutral, and the U.S. remains in better shape than most of the developed world. Most economists would agree that the U.S. is not likely to encounter a recession in 2019. Where they become divided, however, is when one will start. According to one survey from the Wall Street Journal, 25% of economists surveyed expected a recession within the next 12 months, compared with just 13% a year ago. But take these predictions with a hearty grain of salt: as recently as mid-2016, over 22% of economists expected a recession by mid-2017. In short, while recession risks have risen, it is far from a sure thing.

Conclusion

Just like the hyacinths on my lawn that will disappear then sprout again next spring, markets go in cycles—though I’ll admit that my job would be much easier if stocks and bonds moved in as predictable a fashion as the blooming of flowers. Given the unpredictability, the best preparation for these cycles that any investor can benefit from is to have a solid financial plan that is designed to weather market gyrations. And just as a garden needs careful attention in order to thrive, so do your investments.

Live richly and invest well,

Kara Murphy, CFA

Chief Investment Officer

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Definitions

S&P 500 Index: A broad based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It is a capitalization-weighted, unmanaged index that is calculated on a total return basis with dividends reinvested. The S&P 500 represents about 75% of the NYSE market capitalization.

Russell 2000 Index: This index measures the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.

MSCI Europe, Australasia, and Far East (EAFE) Index: This index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

MSCI Emerging Markets Index: This index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009 the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Bloomberg Barclays U.S. Aggregate Bond Index: A market capitalization weighted bond index of investment grade U.S. dollar-denominated fixed- income securities.

Bloomberg Barclays Municipal Bond Index: The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. Gold (spot): Gold price per ounce in US Dollars.

S&P 500 GICS Sectors Level-1: In 1999, MSCI and S&P Global developed the Global Industry Classification Standard (GICS), seeking to offer an efficient investment tool to capture the breadth, depth and evolution of industry sectors. GICS is a four-tiered, hierarchical industry classification system. It consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity. MSCI and S&P Global use revenues as a key factor in determining a firm’s principal business activity. Earnings and market perception, however, are also recognized as important and relevant information for classification purposes, and are taken into account during the annual review process.