“The real big money in the investment world-the dependable money, the safe money-is not betting that the things that have gone up a lot will continue but on betting that the things that have gone down and become unloved will rebound.”
Howard Marks of Oaktree Capital
Markets recovered from correction territory in the second quarter getting back to about even on the year by the end of June. The Canadian TSX was up 0.40% for the first 6 months, while in US$ terms the S&P500 was up 1.7% and the DOW30 was down 1.80%. The C$ continued to be very volatile, losing a bit of ground during the second quarter which helped the performance of our US holdings and portfolio returns.
The real “action” continues to be in just a few huge technology names (the so-called FAANG stocks or Facebook, Amazon, Apple, Netflix and Google/Alphabet). In fact, just 5 stocks dragged the S&P500 into the green and contributed 85% of the positive S&P500 return in the first 6 months. If it was not for these chosen few, the S&P would have been down slightly just like the DOW30. Breadth is a measure of market health and is positively viewed when there is more stocks moving higher than lower. The last time we had so few names holding up the indices was in 2015 which was a challenging year. Then the global economy found its stride and with it, more stocks joined the advance which lead to very good performance in 2016 and 2017.
Trade concerns and rising interest rates provided the catalysts for the long overdue market correction and consolidation that we have seen so far this year. During this period, money has flowed to a handful of stocks that are thought to be immune from trade concerns. When trade tensions subside, we could see a reversal of sorts and more stocks should begin participating in the advance. And yes, I am in the camp that it is more a question of when and not if trade tensions subside.
President Trump has been quick to link the success of his presidency with the success of the stock market. He inherited an economy that was 8 years into the rather tepid expansion that followed the financial crisis and proceeded to cut years of regulatory red tape and also pass the largest corporate tax cut in decades. This is a pro-business President and if this trade uncertainty causes any substantial market weakness, I think we will see his stance moderate considerably and very rapidly.
As I have said before, almost everybody likes to eat sausages but nobody wants to see them get made and Trump’s sausage-making (negotiating) style is very public with his “no-holds barred” social media presence. Uncertainty is the enemy of decision-making and the longer this negotiation goes on, the more decisions get delayed which could be a large drag on the economy and the stock market will reflect such in advance. So far the gains from the tax cut have been filtering through with very strong earnings (up 20% from last year) and the markets have simply been treading water over trade concerns. Higher earnings have given President Trump a window to keep pushing trade negotiations in favor of the USA but should valuations get a lot cheaper, this window will slam shut.
So in the “positive” column, we have strong US corporate earnings (tax cuts!) and actual sales growth in many parts of the economy. We also have the bond market acting very orderly in spite of steadily increasing short term rates as the US central bank moves to normalize rates. In January markets became fearful that the 10 year US bond yield was going to break above 3% and move steadily higher. Instead, yields have remained anchored under 3% as foreign money flows into the USA, attracted by relatively higher bond yields and the prospect of continued U$ strength. Lastly, we still don’t see a US recession on the horizon and until we see one, stocks should continue to get the “benefit of the doubt”. This expansion is in its 9th year but to use a baseball analogy, we think we have a few more innings left to play!
In the “negative” column, we are obviously concerned about ongoing trade negotiations but it is too early to label it a trade war like many market commentators love to do. We would have to also acknowledge that political tensions have increased between every country and the USA (except of course for Russia!). And we are already seeing some inflationary forces for industries that rely on steel and aluminum as an input (think canned goods, appliances and autos). Should negotiations “sour” further, or worse fail, these pricing pressures will likely spread and run through supply chains as additional products are targeted with new tariffs.
As always, there are reasons to worry and reasons to be optimistic and I continue to remain in the cautiously optimistic camp until I see evidence of a US recession. Of course we are watching the trade situation closely (it is hard not to since that is all that is being discussed!). Unfortunately, the Canadian stock market continues to be challenged due to its reliance on financials (with the housing market risk) and resource companies (fighting a strong U$ headwind). And until we get clarity on the North American Free Trade Agreement negotiations, I just don’t see a lot of interest in our market. So I continue to focus on dividend income in Canada and focus more on fairly priced growth opportunities outside of Canada.