US Market Viewpoints: First Quarter 2019Submitted by Castlebar Asset Management on April 5th, 2019
Stocks brushed off the frantic sell-off of the fourth quarter to post its best first quarter performance since I was in college (1998). This was the best single quarter since 2014 and the S&P 500 recovered most of its losses from last year sitting about 3% away from all time highs. The stock market rebounded from the Christmas Eve lows on the back of new optimism that US and China are close to reaching a trade deal, the Federal Reserve (Fed) making a significant change in their policy stance and the resolution of the government shutdown. This was a broad based rally as all 11 sectors posted gains for the first time since 2014.
The market rebound from last year is surprising but not shocking. As we discussed in our Viewpoints from the fourth quarter, stocks are generally higher 12 months after a major market sell-off. The swiftness of this rally did catch us off guard, but several events stimulated the market. The most significant change was the shift from the Fed. The Fed’s policy stance went from one of tightening monetary to a more accommodative stance. In December, the thought was the Fed’s next move would be to increase interest rates in 2019. Now, the market is pricing in a cut to interest rates in the second half of the year. Fears also relented that the US economy was going to be significantly impacted by decelerating global growth. The data in March shows that the US economy is holding up better than expected after a severe winter and the impact of the government shutdown.
The top performing sectors this quarter were technology, real estate and industrials. Investors went hunting for growth in the quarter. The tech sector still has the best growth prospects in the market. This sector rallied 21.1%. Real estate is not a sector we discuss often. Lower interest rates are making REITs and other real estate related investments more attractive. Real estate gained a strong 18.2%. Industrials added 19.4% in the quarter. The anticipation of a US-China trade deal and better economic data helped lift this group. The “weakest” sector was healthcare. This sector gained only 6%, but was the top performing sector last year. Several high-profile pharma companies saw drugs in their pipeline not meet expectation during development studies which lead to 20% or more declines in several large cap companies.
After the rally this quarter, the logical question is what is next for stocks? The market is trading at 16.3 times forward earnings. This is slightly above the historical average of 14.9 times. It is easy to think that the gains seen have outpaced the fundamentals, but the market looks fairly valued at current levels. Valuations are slightly above average but given inflation and interest rates are both stable it is normal to see valuations expand in this environment. Corporate earnings growth is also expected to be up again in 2019, but not as strong as 2018. The tax cuts which came into effect last year provided a strong tailwind so year over year comparisons could be difficult.
There are few indicators that are reliable in predicting a recession. The yield curve is one data point that bucks this trend. It is a graph that charts US Treasury bond rates starting from 3 months to 30 years. Normally it is pointed in an upward fashion where long-term rates are higher than short term rates. In the past month, the yield curve became inverted which means that short term rates are higher than long term rates. This is a signal that bond investors believe that economic growth is slowing and short-term interest rates will be cut. The reason why this indicator is important is it has a strong track record predicting when the US might see its next recession. An inversion has preceded every US recession over the past 50 years to the yield curve. The one caveat is an inverted yield curve is not a timing tool. It generally will invert a few months to two years before a recession starts. Generally speaking stocks rally, sometimes considerable, after the yield curve inverts. The yield curve needs to be inverted for at least three months to produce a reliable signal. This is an early warning signal that this economic expansion could be ending in the medium term.
There are several catalysts we think will lift shares in the near term. The Fed’s 180 degree turn from restrictive monetary policy to accommodative is supportive for stocks. If interest rates continue to decline investors will have few other places to invest other than stocks to get an acceptable rate of return. A deal on trade between the US and China will likely be completed sooner than later. This will remove uncertainty for industrials, autos and tech companies. The IPO market is expected to remain strong this year with firms like Airbnb, Pinterest and Slack, all coming to market. Lyft recently went public and was a modest success. For a large amount of these “unicorns” to go public, there will have to be favorable market conditions to support IPO activity. Lastly, stock buybacks are expected to be as strong as ever. Companies made record profits last year and they are not reinvesting at records levels in their business. Most of these are shorter term catalysts but positive for stocks.
If you take a look back at history to see how markets perform after quarters with a 10% or better gain, the numbers might surprise you. Since 1950, the performance in the following three months after a big move, the gain was over 4%. This is a full 1.5% better than an average market return. It is also positive 85% of the time which is better than all market periods. Over the next year and three years, stocks tend to do much better as well. There are a wide range of outcomes but a big move usually leads to additional gains.
Our bias is there is further upside to stocks. The sell-off we experienced at the end of last year is still in our memories. We are putting new money to work, but are remaining diligent because we are late in this economic cycle. Your portfolio is being built to invest in lower volatility investments which should keep pace if the market continues to rally but will offer some protection if we see a pullback. During the sell-off last year we stuck to our investment strategies and only made small adjustments in your portfolios. Having confidence that we are invested in the right portfolio for your goals allowed us to stay invested and see your portfolios recover this year.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.