During the first half of this year investor psychology and stock indexes have gone from unbridled optimism to a state of pure confusion. At one point in January global equity indexes had advanced nearly 10%, followed by a correction and months of markets being unable to reach or exceed those January highs. In the aftermath of the big January rally, there has been an increasing preponderance of negative media attention about the future of stock prices. As one can imagine much of this is tied to tariffs, rising interest rates and the incorrect view (in our opinion) that this bull market is “long in the tooth.” The most recent commentaries have alluded to an impending global recession and bear market. There is no question that as investors we should be paying close attention to the tariff negotiations, the Federal Reserve and the health of the global economy.  However, when our team views each of these factors, we come to different conclusions than the currently more negative “crowd.”

The fact that global stock indexes rose over 20% in 2017 and another 10% in the first month of this year should send a message to any investors who know market history that a pause in upward trajectory was well overdue. We cannot recall a period in our 25 years running the firm where stocks rose indefinitely for two straight years. The recent trading range of stock prices should not by itself be perceived as a warning of impending doom and investors who believe such should go back and review market history. Often after big run ups in stock prices there are consolidating phases such as this one which allow earnings to “catch up” to stock prices. So long as global economies and corporate profits are strong, these consolidation periods usually end on the upside and markets exceed their old highs. But will the economy and earnings be strong enough to allow for this phase of the market to continue its upward path? We think so.

Global Economic Growth
Global economic growth is running at a pace not seen in 15 years – US growth at nearly 3% annually and global growth exceeding 3.5% annually. Economists and investors have been wishing for these numbers for more than a decade. Our team believes that this robust economic acceleration is based on the fact that we are in a new business cycle, economic expansion and bull market that began in the summer of 2016. It is during the first few years of these recoveries that economies and earnings and stock indexes accelerate rapidly.  The bull market that began in 2009 ended in 2015 when the market declined 20% twice and the economy suffered from a very mild recession. If we are in the second year of the business cycle and bull market it is a far cry from “long in the tooth.”

Corporate Profit Growth
We are experiencing a significant period of robust profit growth here in the US and overseas fueled by healthy economic growth. This past quarter, company’s earnings reports continued to beat expectations on top and bottom lines, surpassing analyst’s upgraded expectations. However, not all sectors of the economy are seeing robust profit growth. These are the usual suspects in a reaccelerating profit cycle: utility companies and consumer staples are good examples of those left behind, as has been the case in past early-stage bull markets. Will tariffs wipe out profit growth? Yes, for some companies. This is why we continue to be passionate about selecting stocks that can benefit from these adjustments and avoid those that may be victimized. However, truth be told, we are still in tariff negotiation mode – not yet war.

Valuation – Are Stocks Overpriced?
If the previous healthy factors we mentioned were in place, but the market was overpriced, the risk of a bear market would be heightened. However, by just about any market valuation metric, stocks are fairly valued, if not cheap, at these levels. The forward price earnings ratio is a mere 16.5 – a level rarely associated with an overvalued market, or a level one would see at the onset of a bear market. In addition to valuation levels being very attractive, more and more investors seem to have a negative bias towards stocks and negative media attention may be fueling this. It is important for all of us as investors to recall that bear markets come very suddenly and unexpectedly – when the crowd is least prepared. If a bear market started today it would go down in history as the best advertised market decline in the history of finance...unlikely!

Interest Rates, Fixed Income and the Yield Curve
The Federal Reserve may slow down their pace of interest rate increases a bit given the confusion about tariffs and investor pessimism – this would be good for equities. However, we believe that the Fed is set on a continuation of raising rates and may do so two more times this year. Though the yield curve – the difference between short and long interest rates – is quite flat, investors would be wise to disregard this until it is well inverted (when long rates are much lower than short rates). Inverted yield curves often proceed recessions and we will be watching this very closely. As we have stated over the past year, this is a great opportunity to own a ladder of individual bonds with short maturities such as we have created for you (dependent upon your asset allocation). As rates rise we will be able to lock in even higher rates at maturity. It’s an awful period to own bond funds or exchange traded funds since they do not have maturity dates and will continue their decline as rates rise – don’t let your friends or family own these investments in this era.

Risk Management
As you know we are quite optimistic in our view of financial markets. However, if we are incorrect in our assessment, or if factors change, we are prepared to manage the risk of your portfolio through its asset allocation, sector management and the use of carefully placed stop loss orders on those companies that are sensitive to the economy.

We hope you find these thoughts helpful. If you have any questions or have experienced a significant change in your financial situation please feel free to contact us and, as always, if you have any friends or colleagues who you feel may benefit from our services, we would be happy to introduce ourselves to them with a no-obligation introductory meeting.

Your Team at Main Street Research