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Looking for New Market Leadership

Risks are rising, but economic fundamentals are strong; there is likely upside ahead. 

The first quarter of 2018 was disappointing and now the second quarter is off to a poor start.

I’ve been writing for a while about increased market risk due to factors like rising interest rates, trade protectionism and inflation fears. More recently, controversies around customer privacy at social media companies have sparked concern about new restrictions on some of the darlings of the tech sector.

At this point, however, I believe the market’s negative reaction is overdone. Economic growth remains strong and earnings could surprise to the upside. A potential policy mistake from the White House, the Federal Reserve or regulators may be avoided.

Let’s consider some positives:

Growth is robust. Most economic readings remain extraordinarily strong, running at or close to multi-decade highs. Business and consumer confidence are near record highs. The labor market is healthy, personal income is growing and tax refunds start arriving later this month. Consumers have money to spend and so do businesses. Spending on capital goods is rising. Companies in the S&P 500 are forecast to grow earnings more than 18% in 2018.

Stock valuations are more attractive. The price/earnings ratio of the S&P 500 is 16 and the 10-year U.S. Treasury yield has drifted lower (stocks are often valued in comparison to a risk-free Treasury rate). Some technical indicators are more positive. For example, the share of stocks trading above their 50-day moving average has plummeted, which often signals a buying opportunity.

Risks may not be as bad as they seem. Damage from aggressive trade talk may be overestimated. While tech leaders may be facing new regulation and restrictions, the broader market may still be able to advance.

New market leadership could emerge. Recovery in prices and production should boost the energy sector, deregulation could lift financial stocks and new capital spending and infrastructure projects may help heavy machinery and industrial stocks. These sectors could experience double-digit profit growth yet the stocks are currently priced for recession.

I also see potential for “old tech” firms, which emphasize software and services as opposed to social media, to prosper as companies spend more to boost their productivity.

Bottom Line: This is a good time to use active portfolio managers rather than passive index funds in your portfolio. Indexes may emphasize former market leaders. I think the market will end 2018 higher than it is today and expect a new group of companies and sectors to lead the way.

Risk Considerations 

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

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