The list of investor concerns is growing by the day. Most recently, we learned that Chinese manufacturing activity contracted in December, US manufacturing activity slowed materially as well, and technology bellwethers Apple and Samsung are experiencing weakening demand. These data points add to a body of evidence that suggests global growth has already peaked and may continue to slow in 2019 and perhaps beyond. In the US, we also have a list of ancillary risk factors, any of which could serve as a negative shock to the economy. Among these risk factors include an extended federal government shut-down, the trade war with China, a Federal Reserve that appears intent on removing accommodation (some would say at any cost), a president who appears intent on influencing the heretofore independent Fed, surging federal budget deficits, plummeting energy prices, and a potential constitutional crisis if/when the Mueller report is released. Apparently there is more to fear than fear itself.
A look back at history can help size up the potential downside risk in the event we have entered a bear market. A December 24th article published on CNBC.com entitled “We are now in a bear market — here’s what that means”, by Kate Rooney, ran some numbers with the help of Goldman Sachs. Here is what she found: “Since World War II, bear markets on average have fallen 30.4 percent and have lasted 13 months, according to analysis by Goldman Sachs and CNBC. When that milestone has been hit, it took stocks an average of 21.9 months to recover.” These numbers suggest we could be in for a long period of weakness, but that doesn’t necessarily have to be the case. We’ve seen lots of head fakes in this 10-year old economic expansion, and there is no reason to definitively declare that this time it’s different.
Also, fortunately, the market is no longer priced for perfection. The price-to-earnings ratio (using forward earnings) for the S&P 500 has dropped to about 14.5x, well below its 18-year average of about 15.7x. The FAANG stocks have seen dramatic corrections, making the overall market far less dependent on those behemoths. The same goes for the economically sensitive Energy, Industrials and Consumer Discretionary sectors, all of which have pulled back at least 18% from their 52-week highs. We’ve also seen a dramatic pullback in long-term interest rates, even as the Fed continues to raise the Fed Funds rate. The yield on the 10-year Treasury has dropped 64 basis points from its high to 2.60% – lower than the dividend yield on many high-quality blue chip stocks. The drop in rates will support activity in the housing market as well as other sectors dependent on low interest rates.
Aside from reasonable valuations, there are other factors that increase the risk of getting out of the market in an effort to avoid the possibility of recession-sized losses. There are clearly some levers that government can pull which could have an important role in stabilizing the investment climate, restoring investor confidence, and perhaps shortening the duration of the market weakness. These policy adjustments might include a definitive trade agreement with China, a pause in the Fed rate-hike cycle, the passage of an infrastructure bill, and bipartisan agreement on immigration policy, to include the political flashpoints that are the border wall and DACA. As long as the potential remains to resolve these issues (or at least provide the illusion of resolution), we think the downside risk to stock prices could be somewhat contained. In other words, we think most would agree that a “policy put” exists.
So, while we are clearly finding more opportunities to put money to work in stocks, we are taking our time. A defensive posture seems most prudent, with an emphasis on high-quality companies with rock-solid balance sheets – the kind we love at Farr, Miller & Washington.