The month of October came to an end this week, and even though it ended with a 673-point rally Tuesday and Wednesday, it was still the worst month for the market since September 2011 (you should see what the market did in the three months after September 2011, but I digress). The Dow ended down 1,700 points (-6.3%) from its October 3 all-time high of 26,828. The S&P ended down 7.3% from the same high point. And the Nasdaq is down 9% since October 3 (its worst month since 2008, by the way). So besides the first couple days of the month, it was a nasty month in equity markets all over the world. We've been unpacking that all month, but have much more to say in this week's Dividend Café, so let's not hold anything back. Come on in...
Trade war turmoil
The evidence I see is more and more pointing out to the direct consequences and the second and third derivative consequences of the present trade war being in the middle of much of what is plaguing markets. As I have laid out over the last couple of weeks, U.S markets have faced downward pressure on valuation (see very next section in this commentary) as investors weigh the realities of vulnerable global conditions in the context of a normalizing U.S. monetary policy. At the heart of these global conditions is the impact of the trade war, and investors clearly are seeing now how that impact is not limited to the counter-party countries (most notably, China). The market's big reversal Monday came after the Trump administration announced intentions to add tariffs in December on $267 billion of imports if the Nov. 30 meeting with Xi Jinping does not go well. As has been the case throughout the year, separating the facts from bluster is not easy (for individuals, or markets), but the fact remains: the trade war is a headwind to a U.S. market filled with tailwinds.
Earnings, or Price-to-Earnings?
The following chart shows a whole bunch of stuff, but let me unpack a few of the better nuggets:
- Most significantly, you should note that if the market were only a reflection of earnings, this would be the biggest year for stocks in five years. Dividend level in the S&P 500 is about the same. Earnings are dramatically higher than any of the last five years (are any other year for that matter), and yet you see returns are currently dead flat (the worst of the last five years)
- How can this be? The chart answers that too. All that has happened is that the P/E multiple (the multiplier investors pay for the earnings) was subtracted.
- There is an ash heap in investor history for those who have attempted to drive an investment policy out of forecasting what P/E ratios have done.
- Dividend growth, though, has been forward moving, not downside volatile, and outside of the tension of wild price movements (but this requires a focus on the companies actually growing their dividends, and not the entire broad-based index)
Capex alert - or, How Is the Economy?
The 3.5% growth in real GDP for Q3 was strong, even stronger than the 3,3% most were expecting. But the category within GDP we find most important - "investment" (a reference to private, non-residential fixed investment in the economy) was only up 0.8% quarter-over-quarter. This sub-category to GDP is the one I find most important because it is the one I believe will be needed to drive productivity and enhance the business cycle we have been in. The Q1 and Q2 numbers were huge, and to come down to 0.8% is quite mysterious. Core capital goods orders were flat in September, with overwhelming evidence that fear of the impact of the trade war and tariffs is behind the muted activity. Trade subtracted 1.8% from GDP in Q3. If it had just been what it has been on average for the last three years, it would have subtracted .3% from Q3 GDP - meaning, we would be talking about a 5% GDP growth number on the quarter (net of inflation). The need for ongoing business investment is the story on which the continuance of this bull market will sink or swim. And right now, it is a completely unforced, voluntary policy decision that is holding that business investment back.
So what next?
I do not have much doubt that lowering the cost of capital (which the tax cuts did) increases capital spending, and I have no doubt at all that increased capital spending/business investment/etc. drives productivity, and therefore profits. The question is whether or not the trade war fear overhang offsets the supple-side benefits of the tax reform. I have far less doubt about whether or not capex will lead to what I have projected than I do whether or not said capex itself will materialize. It is way too early to throw in the towel, but this quarter's tepid business investment was a disappointment and the evidence is overwhelming that it is global trade/tariff nerves that are suppressing it.
Did someone say earnings?
With 67% of companies having reported, 77% have beaten their quarterly profit expectations, and 59% have beaten their top-line revenue expectations. Q3 profits appear headed towards a 22.5% year-over-year profit growth, the highest in eight years. So all of these things are stunningly good. The bad news? Stock prices have had their worst response to positive earnings surprises in years.
The S&P 500 is now down to a 15.5x P/E ratio on its next 12 months of earnings, compared to a 16.5 five-year average. S&P prices being below their median valuation? Who would have thought that possible with all the bemoaning the 18.3 multiple we had at the beginning of the year.
The Fed giveth too
With all the focus on Federal Reserve policy normalization, it may be easy to forget they are also the regulator-in-chief out of Dodd-Frank of the nation's financial institutions. This week they provided significant regulatory relief (long overdue) to a significant batch of regional banks and such who had been lumped in with behemoths like Goldman Sachs and Wells Fargo in such matters as capital requirements, etc. The response from the left was that it does too much to help these banks and the response from the banks was that it does not go far enough. So there you go.
Politics & Money: Beltway Bulls and Bears
- The midterms are just a few days away and by this time next week we will know if indeed the House switched to the Democrats (I think it will, but by much lower a margin than had been previously predicted), and if the Democrats will flip the Senate (I not only do not think they will but think the Republicans will add to their majority by 2-3 seats). I am expecting little to no market impact unless the Republicans hold the House, or the Democrats flip the Senate.
- One of the huge political stories that heavily juxtaposes with markets will be where the trade war sits with voters now that its impact in business investment, economic confidence, and the stock market is more visible. It has largely been seen as a slight net benefit (politically) to the Trump administration so far, as the Canada, Mexico, and European Union hassles have mostly been resolved favorably (or at least optically so). But the China matter is many multiples larger than all those combined, and there is no clarity as to what it will mean economically or politically.
- I think this section is supposed to be U.S.-centric, but perhaps the biggest political event of the week did not happen in the United States. The Brazil election is a big deal, with Jair Bolsonaro winning in a huge rebut of the socialist-leftist, Fernando Haddad. Bolsonaro ran on a platform of cutting taxes, selling state-owned enterprises, and repudiating crony capitalism
Chart of the Week
Two things have to be said about market downside volatility, whether of the correction variety or not: (1) It is not something regular human investors every enjoy emotionally, and (2) It is extraordinarily common.
Quote of the Week
"Never take cooking advice from a waiter."
-- Nassim Taleb
This week's "quote of the week" is one of my favorites ever, and is extremely timely for a lot of reasons, but I do suspect some will wonder what it means in the context of the Dividend Café commentary. I can only say that I think it has more application for today's investors than almost anything I have said in the Quote of the Week section in years.
I leave you with these permanent realities in investing: No matter how it feels at the time, volatility is always and forever the friend of the equity investor. And investment in asset classes that hide the volatility is not the same thing as investing in asset classes that do not have volatility.
Enjoy your weekends, and welcome to the final two months of 2018.