Mid-Year Update 2018
Clients of the Firm,
Markets
As we begin the third quarter, the domestic markets continue to be range bound with the DJIA down -1.87% YTD and -8.85% off its high and the S&P up +1.56% and -5.45% off its high. The 10-Year Treasury yields 2.85%, which is about 25 bps lower than its recent high. Indeed, in the US, it has been a year of ups and downs so far in 2018, with the net result largely running in place.
Equities
Traditional value investments continue to perform somewhat worse than our growth at a reasonable price ideas. Notably, utilities continue to perform well as bond proxies given low rates. Technology continues to outperform as well. Earnings are projected to be strong for many of our holdings versus prior year results and overall S&P 500 earnings are expected to rise approximately 10% year over year.
The forward P/E level of the S&P 500 is 17.06 while the Dow is 16.58. As we have referenced before the long-term P/E average is 15 times. Elevated P/E ratios tend to indicate both optimism and potential over valuation. We are always cautious not to say, “this time is different”. A reversion to the mean in pricing tends to be an overarching investment principle for our investment philosophy. Our expectation is that this will again be true, the question is whether earnings increases are reaching a plateau or have more room to run. In other words, will earnings grow into valuation or will stock prices shrink to reflect earnings?
Volatility
Volatility has returned to the market and is likely to continue to remain with us given the backdrop of trade tensions, Twitter diplomacy, rising interest rates, mid-term elections and moderating global growth. That said, the US economy and particularly earnings have performed extremely well despite these headwinds. Should this continue, price expansion in domestic stocks may also resume.
The volatility created by the Macro backdrop has created discrete opportunities in individual stocks despite the overall market valuation being on the higher side of the normative range. This dynamic creates more of a case for active management of portfolios particularly in large cap value. As many of you know, domestic large cap value tends to be a specialty of our portfolio management style. Therefore, it is exciting for us to see reasonable valuations and discrete opportunities in our core area of investment.
Bonds
With yields rising, the short end of the bond curve has behaved largely in-line with our expectations, modeling the Fed rate hikes, as expected. Interest rates at the long-end of the curve remain stubbornly low after briefly peaking above 3.10% on the 10 Year Treasury. We believe this is largely resultant of coordinated global Quantitative Easing (QE) particularly by the BOJ and ECB. These QE measures are creating artificial demand for Treasuries which is causing a flatter yield curve than we would otherwise expect given the economic results and Fed tightening in the US. The flatter yield curve has put pressure on bank stocks and has created what we believe is a false narrative of a coming recession near-term. As a result, we are seeing opportunity in this segment of the market.
We continue to like the short-end of the Treasury curve as a place for bond and stable value invested capital. Investing in this area will help avoid downside risk should rates normalize while achieving similar returns to long-dated bonds with far less risk. This approach can be achieved through funds or individual bonds depending on the client portfolio size, liquidity needs and risk appetite.
Politics
The political landscape remains extremely polarizing and has continued to weigh on markets daily. With major looming political decisions ranging from an unexpected SCOTUS appointment to mid-term elections, political uncertainty will remain an above the fold issue for the foreseeable future. Our job is to discern what is relevant to investments and to act accordingly. This task is not made easier by the constant flow of news and the new world of communique by Tweet. This approach has increasingly roiled specific stocks, commodities and markets generally. From an investor perspective, a steady hand approach that is not reactive seems to be the best way to weather this Tweet storm.
Mid-term elections could result in a change in the balance of power in the US. Most polls have indicated this is possible in the House and less likely in the Senate. We have seen in recent years that polling has become quite unreliable. A dramatic shock or change in direction of Congress would likely create significant uncertainty around the future economic agenda and merits watching.
Wall of Worry
It is likely that the 2nd half of 2018 will be accented by several large uncertainties. The most relevant of these likely being the trade disputes, interest rate hikes and the mid-term elections. The presence of this “wall of worry” has helped to keep equity markets from reaching frothy valuations and the resolution of these uncertainties may help the market climb that wall.
Trade
Should the worst-case scenario play out on trade tensions, the market would likely price adjust lower as a result. This case contemplates a scenario of large tit for tat trade tariff escalations resulting in inflation and eventually slack demand for US products overseas. It is possible that a more moderate outcome emerges resulting in certain concessions for exports and a leveling of tariffs in certain industries within the EU or China. This outcome would also include a revised NAFTA with some givebacks to the US and possible auto industry tariff reductions with the EU. A scenario, where trade tensions simply go away does not appear to be a realistic scenario at this point. That said, abandoning this policy would clearly result in a relief rally in equities. Again, we feel that is a remote prospect at this juncture.
The Fed
The Fed is likely to continue its rate hikes given domestic economic performance with the expectation of at least one more hike this year and possibly two. Markets continue to guess what 2019 will bring but the Fed’s guidance is currently at 3 hikes. Since the Fed is data dependent, the prognosis for additional hikes in 2019 remains highly uncertain.
We continue to monitor these and any other emerging issues that impact our investment recommendations and allocations. As always, we are available to discuss your individual portfolios and financial questions as needed. We would like to thank you for your continued confidence in our management of your funds.
Sincerely,
Peter C. Wernau
CEO
Wernau Asset Management
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