July 21, 2019

Present Your Proof, Please!

Waddell & Associates

Beginning with the Bottom Line:


The US stock markets have produced their best year-to-date returns in over 20 years.  While we should celebrate this stellar first half performance, we must be mindful of the source.  The decline in interest rates has mathematically lofted valuations held high on the hopes of government stimulus followed by economic revival.  For performance in the second half to resemble the performance of the first half, we need proof.  We need rate cuts.  We need trade resolutions.  We need yield curve reversion. We need a lift in leading indicators.  We need upside economic and earnings surprises.  This market now stands at a crossroads. It’s time to put on the proof.



The Full Story:

This market rally needs proof points.  While the Fed has conversationally eased, it has yet to actually loosen policy.  The stock market has already banked at least one rate cut at the July 31st meeting, but would like to see two (as would we).  In advance of that meeting, we would expect some negative trade talk out of the White House and a soggy stock market to help motivate Chairman Powell.  And while the economy has shown some recent bounce, the environment overall remains negatively biased.  To demonstrate, Citigroup compared economic data releases with economists’ expectations to derive its Economic Surprise Index.


image1 17


The most recent tabulation depicts economic data improving….while still disappointing.  That’s encouraging, but less bad isn’t necessarily good.  The 10-year Treasury yield hovering around 2% reflects similar hope and dismay as it has halted its recent decline, but sits well below the 2.8% where it began the year.


image2 19


Our favorite recession indicator, the Conference Board Leading Economic Index, also needs to course-correct or the recession countdown will begin in earnest.


image3 21


The hope remains that monetary easing from the Fed and fiscal easing from the Trump administration in the form of trade resolutions will rekindle economic growth and re-fire earnings.  Markets at new highs reflect conviction in this view, and earnings expectations depend heavily upon it.  According to analyst expectations, S&P 500 earnings will decline 3% this quarter, 1% next quarter, and then jump 6% higher in the 4th quarter, 10% higher in Q1 2020 and 13.5% higher in Q2 2020.  Without economic revival, there will be no earnings revival, making our current highs a misprint in need of correction.

While the market has recently traded at new highs, the uncertainty referenced above resides within the performance figures as well.  Let’s do the data:


image4 23 2


What a year!  The US markets have put in their strongest start in 20 years, with all underlying styles and sectors solidly in the green.  However, in assessing the data, the drivers of return seem less convincing.  In an economically driven market, more cyclical areas like emerging markets, small cap, and value-oriented styles tend to outperform.  As shown above, the leaders of this market advance are the US large companies in the growthy areas like technology that tend to be more economically agnostic.  Remember that markets price off of earnings and interest rates.  The decline in the 10 year Treasury interest rate from 2.8% to 2% amounts to a 28% decline, implying a 28% boost to valuations (it’s not as simple as this, unfortunately, as there are numerous other factors that influence valuation, but you get the point).  Therefore, the sizable advance in the indices this year stems from a rise in valuations rather than better economics.  Yet these valuations would not hold without the hope of better economics to come.  For calendar year 2019, analysts expect earnings growth of 2%.  They expect over 11% growth in 2020.  Probable?  Hmmm.  Possible?  Yes.  But it’s time to put on the proof.


Have a great Sunday!


Sources: Bloomberg, Advisor Perspectives, FactSet, Morningstar, Bespoke Investment Group
David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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