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.
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