Capital Formation Group, Inc.

2nd Quarter 2018 Market Commentary

Posted by Capital Formation Group, on Monday, September 17th, 2018

2018 Second Quarter Market Commentary

“Facts do not cease to exist because they are ignored.”

– Aldous Huxley (1894-1963); British author

“The fewer the facts, the stronger the opinion.”

– Arnold H. Glasow (1905-1998); American author

The Narrows

As of last Friday, July 13th, the S&P 500 index of large American companies had returned +4.8% in calendar year 2018. That’s a healthy number for half-a-year’s work so the financial headlines are generally and understandably positive. Yet, that surface calm belies trouble. Seven of the eleven business sectors comprising the S&P 500 showed negative returns as of that same date. Two sectors, Health Care and Energy, posted returns near the overall index number. So, if most sectors are negative, and two are treading water with the benchmark, how are we coming by that 4.8%? Two sectors, Information Technology and Consumer Discretionary, are driving the entire index, booking +15.3% and +14.1% gains, respectively, over the same time frame. Technology is a known story at this point. Companies like Apple, Microsoft, Facebook and Alphabet (read: Google) dominate business headlines and have an ersatz sub-composite complete with the niftily named acronym of FAANG: Facebook, Apple, Amazon, Netflix and Google. Even people with passing market interest know the FAANG stocks have been darlings for several years but how many people know, of that group, Amazon and Netflix are not considered technology stocks? Amazon and Netflix are sorted in the Consumer Discretionary sector, two of the top three stocks by weight in the category, and with gains of +55% and +108% as of July 16th for the year, respectively, you can better understand the overall group return. To be fair, the Consumer Discretionary sector has other strong performers this year, like Nike, TJX Companies, Twenty-First Century Fox, and Target, but, the predominant weightings of Amazon and Netflix after years of strong returns make the two companies the principal determinants of the sector’s performance for the year. Contrast this with the Information Technology sector, where as of July 16th, of the top twenty-five companies in the group, only four were negative for the year. What all the above boils down to is the S&P 500 index is being driven by one sector, Information Technology, and another sector, Consumer Discretionary, subordinate to two companies that we tend to think of as very technology-like.

So, a few stocks dominate the market action. Is that bad? Well, common sense should tell us a deep, diverse collection of companies all doing well at the same time means that a rising economic tide is lifting all boats, a scenario that should be the best backdrop for financial risk assets. However, when markets become increasingly narrow, when an index is being pulled along by merely a handful of companies, particularly a handful of companies that have very similar business models, that gives us pause. Remember the S&P 500, the most-watched stock index in the world, has a value weighted by market capitalization (price x number of shares outstanding) of the companies comprising the index. The bigger the company, the more impact that company’s performance has on the overall index. It can become a bit of a self-fulfilling prophecy. Company A in an index has a price that rises by more than average, so more people buy it by either investing in the whole index or cherry-picking the hottest components attempting to beat the index. Hence, Company A rises even more, Company A receives a higher weight in the index, and the cycle begins anew. As of July 16th, six of the ten largest stocks determining the fate of the S&P 500 are in the above-mentioned Information Technology sector, or are in the FAANG grouping, with a combined market weight of 15.48% of the index, and two of those stocks are Alphabet (again: Google) tracking shares. So, five companies in America from the same industry determine over 15% of the S&P 500 Index’s direction. The Information Technology sector as a unit makes up around 25% of the current index, give or take, and if you add in Amazon and Netflix you’re now hovering right near 30%; that’s significant as the last time the tech sector had this heavy a weight in the S&P 500 was 1999…and I think we all remember what happened next. Therefore, for our portfolios, we have been peeling back on broad passive investments that simply track the S&P 500 and have begun diversifying into other areas and continue to maintain an active management holding in the large company U.S. stock space. The S&P 500, regardless of headlines, is looking more and more like a one-horse bet.

The Economy: We don’t have published numbers yet, but economists estimate the 2nd quarter Gross Domestic Product growth rate in the U.S. may top 4%. Given recent tax reform and the monetary stimulus still being injected into the American economy that number may or may not seem impressive. It has been a broadly held investing tenet for over a decade that the modern U.S. economy is stuck below a 3% annual real growth number, as the yearly growth rate has not topped 4% since 2000. We will see if the upcoming quarterly number can translate to a full year topping that benchmark 4%. It will be surprising, as a declining trend has been in evidence for some time. Taken as a decade, just to deal in round numbers, the 2000’s (“the oughts”) GDP growth rate coming in at +1.88% was by far the lowest number in the post-war environment. That data point is clearly part of a trend by decade: ‘50’s, +4.25%; ‘60’s, +4.53%; ‘70’s, +3.24%; ’80’s, +3.15%, ‘90’s, +3.23%, and we shall see what the full 2010’s decade has to deliver. Again, with renewed concerns over trade wars abroad, achieving long-dormant growth numbers may prove difficult.

In news about numbers closer to hitting the target, inflation appears to be running near the Federal Reserve’s stated goal of +2% although we have yet to see if the numbers are sustainable. Unemployment is also at multigenerational lows of less than 4%.

Large Cap Equities: The S&P 500 turned a healthy +3.44% in the 2nd quarter to rebound from a down 1st quarter. Year-to-date through June 30, 2018, the index returned +2.65% and has a +14.38% trailing one-year number. Over the last ten years ending June 30, 2018, the index annually returned +10.2%, including the Great Recession. As of June 30, 2008, a decade ago, the trailing ten-year annual number was merely +2.9%, including the Great Tech Crash. To me, this type of performance rebound shows the power of steady, long-term investing. The U.S. stock market has proven that it does not work for investors steadily, but it does work over time. Since the bottom of the market on March 9, 2009, the S&P 500 has a +404% total return through the end of this most recent quarter. 

Small Cap Equities: The small company U.S. Russell 2000 index returned an impressive +7.75% for the 2nd quarter, following a mildly negative 1st quarter. The index has a +7.66% return year-to-date through the end of the quarter and has a +17% trailing one-year number.

International Developed Equities: The MSCI EAFE sunk, returning (-)1.24% for the 2nd quarter after a down 1st quarter and this has begun to weigh on two strong years of returns. The year-to-date number now stands at (-)2.74% and the trailing one-year number has ratcheted down to +6.85%. Heightened trade war concerns, alluded to above, fueled investor unease. Economic growth in the continental Eurozone performed tepidly in the 1st quarter and economists are no longer optimistic of a strong 2nd quarter rebound. The European Central Bank, given a scenario of moderate growth and low inflation, has signaled it will conclude asset purchases at the end of 2018 but has not tipped its hand regarding imminent rate increases. In this respect, the American and European banks remain out of sync as of this writing. In the United Kingdom, Brexit uncertainty continues to provide a backdrop of fear regarding all investment decisions. The Bank of England appears to understand this, and it is thought the central bank will delay future rate increases until the end of the year at the earliest. In Asia, Japan broke an eight-quarter streak of GDP growth, turning in a slight negative 1st quarter number. Sentiment from both business and the consumer remain strong, but the economy continues to miss inflation targets, so often the bugaboo of the modern Japanese economy. Of course, much of Japanese asset flows can be determined by yen strength in times of crisis, or general fear of the region whenever North Korea rattles its sabre.

Emerging Market Equities: The MSCI Emerging Markets index experienced a rough quarter hanging a (-)7.95% return to bring the year-to-date number negative at (-)6.65% as of June 30. The trailing one-year number stands at +8.21% and the trailing two-year annualized number comes in at +15.72%. Trade tensions between the U.S. and China pose a risk to regional emerging Asian growth, particularly those countries highly integrated into the Chinese supply chain. The trade war had the knock-on effect of slowing growth to the extent Chinese officials had to take stimulus measures by increasing credit access. Overall in the emerging economies, a strong dollar, rising rates, commodity prices and trade tensions made for a difficult quarter. On a technical note, Argentina and Saudi Arabia will be added to the MSCI Emerging Markets index in 2019, elevating their status from frontier economies.

Fixed Income: The Bloomberg Barclays US Aggregate bond index had a mildly negative 2nd quarter given the headwind of another June Federal Reserve rate increases to come in at (-)0.16%. The index stands at (-)1.62% for the year through June 30. The central bank signaled another two rate increases are to be expected for the balance of the year. To little surprise most broad fixed income asset classes were negative over the first two quarters of 2018. The main exception was the bank loan market, featuring floating rate coupons that are forecast to do well in rising rate environments. To some surprise the high yield market, as an asset class, was mildly positive for the first half, a bit of a shock given rising rates and increasing volatility. Otherwise, fixed income was negative, particularly emerging market debt in local currency terms. After a spike in the beginning of the year the benchmark 10-year U.S. treasury note has been range-bound in the 2.80% to 3.00% range, stubbornly persistent regardless of news flow. As the long end of the treasury yield curve remains stagnant and the Fed persists in raising the front end of the curve up, we have watched the yield curve continually flatten and await with great trepidation the onset of an inversion, or short rates higher than long rates. That’s always an omen.

As always, thank you for your continued belief in our investment strategy at Ingalls & Snyder. If there are questions, comments or concerns please contact me at Ingalls, or any member of the Capital Formation Group family.

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