What a Strange Half a Year It's Been

If you look just at the strength of companies in the S&P 500, earnings growth is looking to be above 19% and this is following over 24% in the 1st qtr. Consumer sentiment remains high, the Small Business Optimism index hit its 6th highest reading in history, the job market is robust, wages are starting to increase-things are looking pretty rosy. What hasn’t been fun is the market itself. The first quarter saw the resurrection of volatility and for the first time in a while, we got to experience that the market can go both up and down. The aggravating part is that instead of companies driving their own fortune, it is being driven by politics.

For the most part, we have seen recent policy changes be extremely good for markets. With the lowering of corporate taxes and lowering the burden of over-regulation, it should be a huge tailwind for the markets. Recently though, policy is what has been markets around the globe jittery.

Inflation has been stubbornly low since the experiment of the zero interest policy. According to academia, this is the opposite of what should have happened. Zero cost money should have pushed prices up and inflation should have taken off. What actually happened is technology has changed our productivity model and has pushed down prices. Left alone, inflation would have a hard time of elevating to its historical norms. Technology has crept into every aspect of our lives. Just as individuals, we can listen to music, order groceries, check on mom and adjust our home thermostat just with our silly phone. If we can do that, think of what corporations can do. Technology is bringing down the cost of goods organically.

One thing fighting against this downward inflation pressure is the government. Before I even get to obvious, think about corn. We have to use it in our fuel now, right? There is now a floor on the price of corn. Animals eat corn. Pork, beef, poultry, etc. all eat corn. Guess who gets to pay extra at the grocery store because some politicians pushed ethanol into our fuel? It tears up our motors, eats through our small engine carbonators, and decreases fuel efficiency. Why would we do this? It sure isn’t because it’s good for the public or good for the environment. This is just a simple example of how governments can affect pricing or inflationary pressures inorganically.

Now the biggie: Tariffs! Globalization has been a huge driver of keeping costs down around the world. Capital (money) should flow to where ever in the world it can be put to use in the most efficient manner. It should. The problem is governments slap these tariffs or taxes on goods to support their own homegrown products. It does raise prices to the consumer, but domestic companies can be competitive. On the global scale, most countries haven’t played fair with us. They have slapped tariffs on our goods and we have basically let it slide. Now it seems we are trying to right all wrongs and make it an even playing field. If it works, then it will benefit all of us. If we have an all-out trade war that drags on then we can all expect higher prices. All the wonderful technology and effects of globalization will be tossed out the window and inflation will be knocking on our door.

So why does this even matter? The fed fights inflation by increasing interest rates. Interest rates are the “cost” of money. When the cost of money gets high, the economy slows down. We don’t want that. Nobody wants to go back to 18% mortgage rates. It’s painful. Hopefully, everyone starts to play fair and we can get on with our wonderful low inflationary lives.

The fed has been raising interest rates pretty significantly. The chart below is how significantly the FED has been raising interest rates recently. This has been putting a lot of pressure on any security that pays out a dividend. Utilities, real estate, and dividend stocks have all struggled. Most of these securities are “defensive stocks.” They don’t feel so defensive right now. It’s not the case that these types of stocks are bad companies or that they are losing money. It’s just that they are unpopular right now. If people as a whole (the market) sell a stock, it goes down. It doesn’t matter about earnings today or tomorrow. It’s simply a case of supply and demand of stocks. Instead of thinking that this is a broken way to invest, think that it is more of a wonderful time to start picking up shares at wonderful prices. If we can do that at the top of the market or close to the top of the market it’s probably not a bad idea.

Momentum investing is still the clear-cut leader in investing. People are still chasing stocks that are working price wise. Momentum is buying what has been working and selling what has not. This is simply chasing the winners. It’s a great way to invest long term but we need to be careful when it is the dominating investing factor. We humans tend to chase prices until they are ridiculously high and then watch reality settle back in. Does anybody remember tulip mania, beanie babies, dot-com stocks, bitcoin, etc.? Here is a chart comparing momentum (light blue) to the S&P 500 (red), utilities (yellow), consumer staples (dark blue), and real estate (green) over a one-year time frame. My question is “what is driving markets today?” We can see it is NOT cereal, soap, soft drinks, real estate, or our electric companies. These are all considered defensive sectors and they are all in the red.

If you have a little contrarian in you, it’s a good time to look at things that are not broken (no blockbuster video) and on the cheap side. International investing, smaller companies, consumer staples, real estate, and utilities all are on the cheap side right now. I have heard somewhere that buying low and selling high is a good thing. It is just so hard to do it.

Written By: Aaron Kennedy, CFA