Capital Market Comment
January 23, 2019
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The precipitous market decline in December and the trough reached on December 24th marked what appears to be the end of a capitulation phase and the beginning of a new market cycle. Many stocks and sectors completed a “correction/bear market”. As we have suggested in the past, the quant models, computer algorithms, trend and momentum strategies, and the major deleveraging of hedge funds produced trading havoc. These developments created major selling regardless of company/sector fundamentals: simply – a need for cash. According to Bloomberg, investors fled hedge funds, pulling out $22.5 billion in Q4. Consequently, a confluence of forces came together to set the stage for a change in the direction of the stock market. Fear (trade conflict, recession, Brexit, and the Fed), capitulation (indiscriminate selling induced by “crowd psychology” with the help of the media), and deleveraging (excess borrowing created a need for cash) combined to generate irrational transactions (for the sellers).
For those with the where-with-all to focus upon the intermediate and long-term, value opportunities were abundant. Most importantly, the forces that set the rising interest rate cycle in full motion were/are changing, and the Fed’s rate increase on December 19, 2019, may prove not only to be the last one for some time, but the last one for this cycle. Central Banks around the globe are reassessing their policies. The divergent nature of monetary policy in the U.S., Europe, Japan, and China, complicated by trade tensions over the last year, is bringing about the revisiting of the degree of monetary accommodation that is necessary to sustain world economic growth. A move toward synchronized monetary accommodations may be underway.
Economic growth in Europe has slowed significantly, particularly in Germany. The European Central Bank has made it clear that downside risk is increasing. China is wrestling with both fiscal and monetary policies to stimulate growth which has slowed and is projected to slow further. These growth pressures appear to be playing a part in the movement toward a trade agreement.
The International Monetary Fund has once again lowered the estimate for world economic growth with the advanced economies slowing more rapidly than anticipated. The dialogue and the monetary landscape have changed significantly and shifted to a posture that suggest caution, flexibility, and patience.
What is likely to emerge in the coming months is evidence that the Fed has failed to meet its inflation target, despite successfully achieving its employment goal. During this entire cycle, they have overestimated inflation and are struggling to understand “Why?”, particularly in the face of an unemployment rate that in the past produced significant inflation. The digital economy and the major deleveraging that has taken place since the financial crisis are worthy of note.
Currently, several indicators of liquidity conditions have improved and rates around the world provide impetus to move money to the U.S. The 10-year Germany bond rate has fallen 24 basis points to 0.25% and Japan’s 10-year rate is essentially zero. The U.S. 10-year rate at 2.75% is a compelling investment option for foreign investors. Furthermore, a 15.6 forward price/earnings ratio for the S&P 500 (or 6%+ earnings yield) is very attractive and stands in stark contrast to the 19 times price/earnings multiple in early 2018 (5% earnings yield). Moreover, the yield curve has moved further away from inversion – a concern just several months ago. Additionally, the yield differential between high-yield bonds (junk) and the 10-year Treasury has fallen precipitously over the last several weeks from 5.24% to 4.14%. Although, in our opinion, a recession was not likely, even over a reasonable investment horizon, the fear of recession was evident in this yield spread. The change is welcome and constructive. Under this scenario, a shift in strategy should be considered. In an interest rate environment in which the risk of rising short-term rates is reduced, an emphasis upon growth becomes a viable option. With the rate at which earnings are discounted is not likely to rise, growth has greater appeal. Moreover, with prices having fallen significantly for many growth stocks, valuations have become more attractive. Focusing upon secular growth themes that are proliferating, may offer some relief from the short-term volatility created by failed algorithms and media maniacs while producing successful investment results. Artificial intelligence, cloud computing, cybersecurity, digital retailing, the internet of things, advances in biotechnology, medical devices, and the tools that accelerate such advancement are some of the important ones.
Improving liquidity, reduced financial stress, and rising money supply growth offer an improving backdrop to the financial markets over the intermediate and long-term. In the short-term, volatility is likely to continue with the ebb and flow of news out of Washington, thus providing opportunities for “buyers”.
If you have a question or need further information, please contact:
Don Keeney, CFA, CFP, Principal & Portfolio Manager in Nashville at 615-866-0882, or email@example.com
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or firstname.lastname@example.org
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors.
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The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.