Market Commentary – First Quarter 2019
“First Quarter 2019”
If you have children as I do (Basketball Team and counting) you’ve probably been to an amusement park of one sort or the other… Legoland, Disneyland, Universal Studios or Knotts Berry Farm. If you’ve been fortunate enough to have visited all four here in Southern California, you know that all four of them have roller coasters with Legoland being the most benign and Knotts Berry Farm arguably being the most aggressive. What we’ve seen in the US Equity Market of late can be very much categorized as a roller coaster ride… and not of the Legoland variety.
With a nearly 20% drop in the S&P 500 (2,930.75 close on Sept 2oth / 2,351.10 close on Dec 24th) in the twilight of 2018, who would have guessed we’d be at 2,892.74 as of the close on April 5th? Certainly not I! I’ve been much more surprised by the rally in 2019 than I was by the sell-off in 2018. You might be reading that comment and say, “Souz, I thought you were a glass half full kind of guy?!”. It’s not about optimism, pessimism or any other “ism”, It’s about Rate Of Change – or what we will refer here as ROC. When the US economy printed a GDP number of 4.2% in the second quarter of 2018, our feeling here at Koa was “That’s going to be a hard number to comp – quarter over quarter and year over year”. Looking back now we know with certainty that it was a near term peak in the ROC of our economy. “But Mike the economy continues to grow, just slower – we’re not in a recession, we’re fine”. I agree, yes, we are still in positive growth mode, however as we ride the “Roller Coaster” that is the Business/Economic Cycle, it’s clear we are on a downward slope and the deceleration that started in Q3 of 2018 has yet to find its bottom.
So… if the economy has been decelerating for 3 straight quarters the sell-off in Q4 2018 may have made sense… but then why this sharp rally in Q1 2019? We believe the catalyst for the recent flip in market sentiment was primarily brought about by the total 180 degree change in communication from the US Federal Reserve to the markets. Back in September of 2018, Chairman Powell was clear that future rate hikes where in the cards for 2019 and the Quantitative Tightening (QT) was on auto pilot with the Fed reducing its balance sheet by 50 billion every month. The market in response to a belief that the Fed was “Deaf, dumb and blind”, continuing to hike interest rates and restricting liquidity in the system into a slowing economy… a classic recipe for causing a recession – expressed its discontent with some of the worst selling pressure I’ve seen since 2008. Yes, 2008 – that’s how violent some of the trading action was – to the downside – during the most recent 4thquarter. Chairman Powell in a speech on January 4thduring the American Economic Association effectively delivered a message that investors wanted to hear sparking a huge stock rally. Not only would the Fed be on sidelines in regards to rate hikes in 2019, but the Fed was also going to wind down QT and cease the reduction of the balance sheet by September 2019.
If we’ve learned anything over the last decade with the rally that began in March 2009, it’s that you don’t want to fight the Fed or frankly global central banks. While we were very concerned with the trading action in the market in Q4 of 2018, we have become more constructive here in 2019. Yes, the economy is still slowing, but interest rates have adjusted lower to reflect that reality. Lower interest rates directly affect how equities are to be valued by reducing the risk free or discount rate. Just as we saw a contraction in the Price to Earnings (P/E) ratio in 2018, we are starting to see an expansion of that ratio here in 2019. What’s even more interesting is the Fed Funds Futures market beginning to price in a possible Fed Funds rate cut here in 2019! While that’s not our baseline opinion, if we were to see a 50 basis point cut in the Fed Funds rate here in 2019, we would refer investors to 1998. In 1998, there was an Asian Currency Crisis which sparked the failure of a huge hedge fund (Long Term Capital Management). The Fed performed an emergency rate cut which helped to reflate the markets and created a final blow off top in the equity markets that resulted in almost tripling of the Nasdaq from the point of the rate cut until it finally topped out in March of 2000. While we don’t see that kind of parabolic move in the cards, it is instructive – if Central Banks want to extend the current expansionary cycle this late in the game – you better own stocks, because they are going higher, potentially A LOT HIGHER! The other side of that climb of the roller coaster may be awful… but that will be a problem for another day.
What’s been most interesting to observe of late is the leadership in the market – with the S&P 500 back near its old highs, one would expect the usual suspects (FAANG Stocks) to be leading the charge – yet that’s not the case. Amazon, Apple, Google, Netflix, Facebook are well off their highs – instead it’s utility stocks, REITs and software/cloud computing stocks making new highs… strange bed fellows to say the least! The leadership in Utility stocks and REITs speak directly the drop in interest rates and the continued slowing in the economic growth globally. Cloud computing/software stocks speaks to the markets chase for growth at a time when growth is again becoming more scarce. When we have a market like this… where recessionary stocks and high growth/often marginally profitable companies are leading the way, we like to take a step back from the fray to check on the quality of our holdings.
When we are so late in an economic expansion where the threat of a recession and the possibility of one final push higher in stock prices is a 50/50 proposition, we like to focus on high quality stocks. Why? Because under either of the scenarios – recession or an aggressive move to all-time highs, they are apt to outperform the general market. As we exit Q1 of 2019, we are very happy with our current portfolio – all of our companies sport investment grade debt ratings and solid balance sheets… this will come in handy in the event of recession. They also sport very profitable businesses with pricing power which should also serve them well if inflation starts moving higher due to the late cycle pressure of full employment and wage pressures that tend to accompany a final boom in an economic cycle.
We start Q2 earnings shortly with reports from some of the largest financial institutions. Over the next 6 weeks we’ll get more insight into whether the global economy continues to slow, what the central banks may decide to do about it and if investors will push markets to new all time highs or send stocks back down into our almost 20% high to low trading range established between September of 2018 and December of 2019. No matter what happens next we suggest investors buckle up, the roller coaster stops for no one!
Securities offered through M.S. Howells & Co. Member FINRA/SIPC. Advisory services offered through Koa Wealth Management. M.S. Howells & Co. is not affiliated with Koa Wealth Management.
Koa Wealth Management
11260 El Camino Real, Unit 220, San Diego, CA 92130