Q2 2018 Market Update

August 1, 2018
  • Equity Markets rebounded in the second quarter, propelled by economic (GDP) growth of 4.1%
  • Companies continued a strong run of solid earnings
  • The valuation bar and expectations for the market remain high, which seems to have provided a pause in price growth
  • There is growing concern around interest rates and trade tariffs tipping the economy into recession, which leads to cautious optimism of current numbers
  • Broad equity markets rebounded nicely in the second quarter, bringing the Wilshire 5000 and S&P 500 slightly positive for the year, up 2.16% and 1.67% respectively. We are pleased to see investment strategies and client accounts have also rebounded back to more normal levels from the recent decline. As we write this article, most accounts are within 5% or closer of all time high water marks and continue to remain in line or above long-term planning objectives.

We are pleased to see a nice acceleration in economic growth, represented by a 4.10% increase in the real Gross Domestic Product (GDP) during the second quarter.

This represents a 2.8% real economic growth in the past year. The combination of tight labor markets, strong market returns, low-interest rates, increasing home values, tax reductions, and de-regulation have served as tailwinds for continued economic growth. After 9 years of positive movement from the 2008 recession, we continue to see the economy and markets move forward.

But to be clear, the market is not the economy. The economy often provides the wind that drives the market forward…but the market is a forward-looking creature, constantly looking for the balance between historical reality, valuation of companies and future possibilities. It is a never-ending scale attempting to weigh all information…factual and irrational information at the same time. So what has this factual information looked like as of recent past? Well, downright amazing! As of this writing, roughly 60% of S&P 500 companies have reported earnings. 72% of them have beaten sales expectations. Even more have beaten on very demanding bottom-line estimates. Operating margins continue to break out higher into record territory. Stock buybacks continue. Dividends increase.

So why has the market not moved forward to ever higher levels?

In our prior updates, we have shown concern for a bar that is getting very high to clear for many parts of the market to move forward. Even when companies deliver on promises and expectations we are seeing very little overall market movement. January 2018 was beyond exceptional as far as returns in the market go. The market ran ahead of even rosy projections….. and set an amazingly high bar. So the price returns we’ve experienced as of late, can’t help but underwhelm a bit. Going forward the market is also wrestling with a question…. Where can new growth come from? If unemployment is at record lows…what new employees can be hired to add productivity…to receive a paycheck to add to consumption. If interest rates are not declining how can we get more wealth from our homes, refinance debt or take on added debt for growth? These changes do not mean growth will not occur…but Mr. Market seems justified in taking a breather from fast growth as we await some clarity.

Naturally, these thoughts have prompted investors to continue asking, “when will the next recession and major market decline occur?”

In Q1 the National Association for Business Economics found that among its members, there’s a growing concern about the impact tariffs and a trade war could have on the gross domestic product. Two-thirds of the NABE’s economists believe that a recession could show its head as early as 2020, while 18% of its economists think it will hit as early as 2019. So what does this mean? Likely very little. Economist and Analyst do not generally have a predictive ability any better than you or I. I am reminded of a funny joke from my graduate study days:

Three econometricians went out hunting and came across a large deer. The first econometrician fired, but missed, by a meter to the left. The second econometrician fired but also missed, by a meter to the right. The third econometrician didn’t fire, but shouted in triumph, “We got it! We got it!”

Economist and analyst are all over the map. Perhaps in aggregate, the average will end up correct. But it remains challenging to draw any positive investment decisions from such inaccurate economic predictions. The variables are almost infinite and any action would be counterproductive to long-term goals. We cannot predict the effects of Fed actions, political tariff policy, elections, geopolitical actions any more than I can predict what my 2-year-old daughter will do next.

I will simply state the obvious….we are 1 day closer to a recession today than yesterday! Are we 1 year removed, 2 years removed or longer can be altered by many variables. We find it much more important to focus our energy on understanding the investments we own or may own, the business models they run, the financial statement conditions and the manner in which these investments can compound capital long term. If these investments and represented companies continue to compound capital long term we can rest assured that the finicky Mr. Market will eventually reflect this compounded interest and move prices forward. When and how Mr. Market will react is difficult to predict. Will a recession interrupt this process from time to time?… .certainly. But if we own solid investments, with solid business models that can produce solid cash flows, we stand to make a very adequate return relative to our financial goals with a high level of long-term safety.

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return – Benjamin Graham

Final Takeaway

The economy and markets remain healthy and strong. The market is justified in taking a breather and slowing down price growth as companies produce earnings to catch up to the lofty valuations set forth in January. Uninterrupted, we believe the market will eventually move to new highwater marks in coming years as prices will reflect compounding capital and the strength of companies long term.

However, we are cautiously optimistic given the wealth-stripping effects of higher rates and increased tension around trade. Left unchecked and at the current pace, these could turn the economic tide. Regardless of what transpires, we remain confident in our companies and investments to provide long-term returns relative to investor needs with a certain level of safety. And we remain steadfast in our analysis of these investments to verify sustainability over the next 10 years to provide returns commiserate with planning needs and absorb any turbulence that may come by way of recession or economic surprises.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.