Economic and Profit Growth on Solid Ground
Can Recent Stock Market Strength Continue?
After nearly two years of global stock indexes trading sideways, markets have hit new highs in recent months – a welcome change for stock investors! Most of this recent strength is on the heels of better-than-expected corporate profit growth and healthy economic data, two important data points that were missing while the market was “stuck” in an abnormally long trading range. How long can stock prices continue their upward trend? Are stock prices too high in the face of the coronavirus and an election year?
As a team we often remind ourselves that the key to higher stock prices is stronger economic growth and corporate profits above all else. Hence the reason stock markets “take it on the chin” when economic recessions hit (think 2008) and flourish during economic expansions. In recent months we are seeing a resurgence in both economic data and corporate profitability, after a deceleration in both data points over the past two years. Much of this renewed strength can be attributed to an accommodative Federal Reserve and the fact that it’s an election year.
When the economy deteriorated in the second half of 2018 – along with the stock market’s plunge of 20% – it appeared as if the long-overdue recession had finally arrived. However, unlike past cycles, Fed Chairman Jerome Powell was quick to aggressively lower interest rates multiple times throughout 2019, helping the economy narrowly avert recession and allowing the market to “bounce back.” Although stock indexes recovered lost ground, prices were still not able to reach new highs – that is until the election year came closer.
Historically, stock prices rise during election years and for good reason. One of the key components to an incumbent administration’s re-election is the state and health of the economy. It’s no wonder that this current administration, and those preceding, do whatever they can to make the economy look great come November. In this case it would be removing the biggest headwind to better global growth: tariffs. As you may have noticed Phase I of the tariff negotiations was reconciled quickly in December and we believe Phase II will also go smoothly, removing the economy’s biggest obstacle and unleashing better growth ahead. Time is of the essence to improve economic growth and this administration is up to the task.
Some might argue that stock prices have gone too far and too fast, but we disagree. After being stuck in a trading range for almost two years, earnings have grown while stock prices have remained essentially flat – more specifically for sectors such as consumer goods and technology. This has caused price/earnings ratios to become compressed and to a level that would not signify the end of a bull market. Additionally, the future improvement in the economy and earnings makes current stock price levels quite compelling.
On the interest rate front, the 10- and 30-year treasuries have touched down to their historical lows. Once again, it is a great time to own individual bonds – not bond funds. If and when interest rates do rise, today’s bond fund investors will likely suffer losses similar in nature to stock market declines. Investors who own individual bonds that are held to maturity, like those you own, can avoid these declines.
There are always risks to our outlook and the coronavirus is on the top of our current list. It’s a sad situation for those affected and we hope that modern medical science can mitigate its spread sooner rather than later. In the meantime, we will continue to manage your portfolio’s risk and return through your allocation to stocks, exposure to sectors of the economy and the careful placement of stop loss orders to minimize potential catastrophic loss.
All of us on the team hope this update finds you well. If you have experienced any change in your financial situation or would like to discuss your portfolio, please let us know.
Your Team at Main Street Research
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