Balancing the Positives

The first quarter saw volatility return to the United States equity market. At long last, the indexes had their first 10% decline since 2016 and the VIX index of volatility soared to 50 before settling back to around 20. The VIX had been mostly at 10 for the past year. Stock pickers found themselves in an environment where they could demonstrate their ability to add value, but the market remained narrow, with, according to Bianco Research, the ten largest capitalization companies in the Standard & Poor’s 500 accounting for 45% of the year-to-date performance of the index. Technology stocks were at the top of the pack, with Amazon, the standout, contributing 16.5 percentage points, followed by Microsoft at 9.3, Google at 6.6 and Apple at 6.3. These companies are indeed impressive, but you have to wonder if their stock market leadership can continue indefinitely.

The current bull market marked its ninth anniversary in March, and last year, with a total return of 22%, was one of its best. You would expect an aging bull to be showing signs of weariness, but 2018 began with a strong performance before the February decline that was triggered by the January employment report and renewed apprehension about inflation and higher interest rates. With the market having done so well for so long, you would think stocks would have reached a point of overvaluation, but that does not seem to be the case. We are estimating S&P 500 earnings at $160 for 2018, so the multiple is about 17. This does not seem unreasonable considering earnings for the index are expected to grow in double digits this year. Although investors are not as dangerously euphoric as they were at the end of January, they are not yet at the level of concern or pessimism that would provide a platform for a significant rise in the market. My current year-end target is 3000, less than 10% above present levels.

Because we are in a rising interest rate period, big returns should not be expected anyway. At the beginning of the year, most observers were expecting the Federal Reserve to raise the funds rate two or three times this year. Many now believe (and I agree) that we may see four increases, as evidence shows that the economy is strengthening, and worries about rising inflation are renewed. Intermediate and longer-term rates have risen as well, making bonds more attractive in comparison with equities. Rising rates alone may not be enough to cause a retest of the February lows. There are many instances of the market rising during periods of Fed tightening, but the yield curve inverting would be a warning signal that trouble is ahead. Even if that occurs, we should have a one-year lead time and we’re not at the point of inversion yet.

We have had no shortage of major developments recently, and any one of them could have caused a further market decline. The most notable was the decision by the Trump administration to place tariffs on steel and aluminum. This raised fears among investors that a trade war with China may be starting. The president has always leaned toward a nationalistic stance on trade, so the current policy move is not surprising. My view has always been that free trade is a positive for the world economy, but I also believe in fairness and there is no question that some countries have trade practices that are harmful to American exporters. Unfortunately, however, the countries most hurt by the new tariffs are among those that are fairest in their trade policies with the United States. As a result, the initially announced tariffs are likely to be modified. Canada and Mexico have already been granted exemptions. There are several studies that argue for a softening of the steel and aluminum tariffs. According to one, only 140,000 people are employed in the steel industry in the U.S. today, while 6.5 million are working in steel-consuming industries. Another study, by the Council on Foreign Relations, shows that 45,000 auto workers could lose their jobs because of the tariffs; that is one third of the number of workers in the steel industry. If the principal target were China, that country accounts for only 5% of our steel imports and 10% of our aluminum, according to the Peterson Institute.