During my early days as a newspaper reporter, mentors were few and far between. Whenever I needed help, the attitude of my managers was: “Look, kid, just figure it out.” As a journalist, I was raised by wolves.
Which gives me insights into the wolves of Wall Street. Forget the homilies of avuncular gurus. The stock market boils down to one thing: a daily wager on the future profitability of corporations.
Optimism over corporate profitability has been one of the key factors keeping stocks afloat. That optimism is dissipating.
To be sure, stocks got a big boost Tuesday from renewed hopes that the trade war is on pause. Yesterday’s gains for the three main U.S. stock market indices were 1.44% for the Dow Jones Industrial Average, 1.48% for the S&P 500, and 1.95% for the tech-heavy Nasdaq.
However, trade war hopes are illusory and market momentum should prove temporary, as recession signals intensify. Notably, the benchmark 10-year Treasury note today broke below the 2-year rate, a red flag for an imminent economic downturn.
As of this writing on Wednesday morning, the three main indices were trading deeply in the red, with the Dow down by more than 400 points.
The slump in corporate earnings is probably a harbinger of woes to come. To date, more than 90% of the companies in the S&P 500 have reported actual results for the second quarter of 2019. The blended earnings decline for the second quarter is -0.7%. (Blended combines actual results for companies that have reported and estimated results for companies that have yet to report.)
If -0.7% turns out to be the actual final number, it will represent the first time the S&P 500 has posted two consecutive quarters of year-over-year declines in earnings since Q1 2016 and Q2 2016.
Don’t expect salvation in the third quarter. The analyst consensus calls for a decline in earnings for Q3 as well, followed by low-single-digit earnings growth in Q4. And yet, equity valuations remain historically high.
Read This Story: Do The Math! The Numbers Don’t Add Up
A recent study by the research firm FactSet is instructive. FactSet searched for the term “tariff” in the conference call transcripts of the 438 S&P 500 companies that had conducted earnings conference calls between June 15 and August 8.
The number of S&P 500 companies discussing tariffs on Q2 2019 earnings calls during this period is well above the number through the same point in time in the first quarter (see chart).
The chart shows a more than 40% increase in S&P 500 companies citing tariffs on earnings calls in Q2 versus Q1. Corporate managers this earnings season are increasingly complaining that tariffs are raising input costs, undermining supply chains, dampening demand, making it difficult to plan, and squeezing profit margins.
Goldman Sachs (NYSE: GS) said Monday that the U.S.-China trade war is increasing the risk of a recession. Many analysts concur and warn that the economic downturn could strike before the 2020 presidential election.
Here’s what analysts at Bank of America (NYSE: BAC) had to say in a note released last Friday:
“We are worried. We now have a number of early indicators starting to signal heightened risk of recession. Our official model has the probability of a recession over the next 12 months only pegged at about 20 percent, but our subjective call based on the slew of data and events leads us to believe it is closer to a 1-in-3 chance.”
The recession could be particularly harsh. Interest rates already are low (although not low enough to suit President Trump) and the federal government is grappling with a massive budget deficit caused by tax cuts. The traditional tools to mitigate an economic slump are stretched thin.
During previous bouts of investor anxiety, strong corporate earnings have calmed investor fears. That pillar of the bull market is now missing.
After a blockbuster corporate earnings performance in 2018, expectations for earnings growth this year plummeted. Some of that pessimism was born of basic math. Year-over-year comparisons became more problematic, after the temporary boost provided to 2018’s earnings from the U.S. tax overhaul bill signed in December 2017.
Meanwhile, inflation is stirring (albeit only modestly). The Labor Department reported Tuesday that the consumer price index (CPI) rose 0.3% in July, driven higher by energy and a broad range of goods. On an annualized basis, the core inflation rate (excluding volatile food and energy prices) rose 2.2%, while the headline number was up 1.8%.
The following chart shows the 12-month percentage of change in the CPI for urban consumers in the U.S. in July 2019, by selected expenditure categories.
Inflation came in a bit hotter than expected, which raises questions as to whether the Fed will cut rates again this year. The Federal Reserve targets inflation at 2%. However, some analysts contend that the inflation numbers aren’t dire enough to dissuade the Fed from further easing.
Regardless, you should emphasize sectors appropriate for the late stage of economic recovery, such as energy, utilities and health care. Especially appealing right now are utility stocks.
With interest rates still at low levels and growth stocks overvalued, high-dividend utilities are an attractive hedge. The utility sector has been on a tear so far this year and it’s poised to continue outperforming.
Utilities exchange-traded funds (ETFs) can be accurate barometers regarding overall risk appetite in various market climates. As risks mount this year, investors have been fleeing to the traditional safe haven of utilities.
As of the market’s close on Tuesday, the benchmark Utilities Select Sector SPDR (XLU), the largest utilities ETF by assets, had returned 16.7% year to date, compared to a YTD return of 17.7% for the SPDR S&P 500 ETF (SPY). The XLU’s performance is all the more impressive, when you consider that utilities are dividend payers and less risky than the more growth-oriented broader market.
The rigged casino…
Utilities are a bulwark against trade war-induced volatility. Trade tensions have buffeted stocks this year, sending markets sharply higher or lower depending on the latest presidential tweet or government press release. Incessant volatility is keeping investors on edge.
Stocks soared Tuesday, after the U.S. Trade Representative (USTR) announced that “certain products are being removed from the tariff list based on health, safety, national security and other factors and will not face additional tariffs of 10 percent.”
The USTR also noted that the remaining tariffs on “cell phones, laptop computers, video game consoles, certain toys, computer monitors, and certain items of footwear and clothing,” will be delayed until December 15. In the immediate wake of the USTR announcement yesterday, stocks took off like a rocket. But after the opening bell today, stocks started to plunge as investors confronted weak economic data.
In my mind, this Pavlovian pattern in the stock market begs the question: are certain insiders benefiting from the advance knowledge of trade and economic announcements? For example, if you knew ahead of time that the USTR would make that statement on Tuesday, you could have made a killing from the predictable jump in share prices.
President Trump’s tweets are moving the entire stock market up or down in routine fashion, which makes the market ripe for exploitation. It shouldn’t come as a shock to you that in many ways, Wall Street is a rigged game. Here at Investing Daily, our investment strategists strive to tip the odds back in your favor.
It’s time to elevate cash levels and turn to safe havens. Reduce your allocations to large-cap growth stocks that are exposed to trade uncertainty. In this chaotic investing environment, a “Lehman moment” could be lurking around the corner. Don’t get thrown to the wolves.
Got something to say about the trade war? Give me a shout: email@example.com
John Persinos is the managing editor of Investing Daily.