Secular Bull Update: Patience is a virtue

06-19-2018

While we remain bullish on stocks at least through 2019, we have grown more cautious near-term and are advising patience through the summer. Upcoming market positives include a very strong earnings season, nearly upon us; continued positive U.S. economic news; and a growing likelihood the Fed will signal a slightly more dovish stance in the face of the contractionary forces from international tensions, the strong dollar and trade wars.

But the market likely will struggle to escape its present tight range without a big move up in the Financial, Energy, Industrial and Materials sectors, i.e., the “cyclicals.” And that probably won’t come until we exit the present “negotiation phase” of the trade wars and enter the “de-escalation phase.” We have no idea how long this will take; it could be months.

In the meantime, with the consensus also cautious and the fundamental news flow largely positive, we see downside risks as low and continue to recommend an overweight to equities with Technology, Energy, Financials and Industrials favorites at this juncture.

For perspective, consider the following:

  • Earnings to the rescue. Not counting the July 4 holiday week, we are really less than 10 trading days away from the start of the Q2 earnings season. Although much has been made of the second derivative of earnings growth rolling over—that is, a slower growth rate than last quarter’s phenomenal 26.6% year-over-year (y/y) growth—Q2 is still expected to be very good, with almost 20% y/y growth. That would represent the second-best showing since 2011, surpassed only by this year’s first quarter. In the lead-up to the season, rather than pull back their estimates as they normally do, analysts have been hiking them. That’s a very positive sign. Moreover, some of the biggest y/y increases are expected in the very sectors that have fallen back to their secular uptrend support lines over the last three months, including Energy, Materials and Financials.
  • The long cycle. Much of the present concern about the market, and the “second derivative of earnings growth," is rooted in an expectation that we are “late cycle” and that the inevitable recession is just around the corner. We continue to pound against this argument. Most economic indicators we review, especially consumer and business confidence, employment and the ISMs, are at or near cycle highs. Inflation remains in a grind-up mode, with the deflationary forces coming from the digitization of the economy, i.e., robots and iPads, offsetting the inflationary forces coming from the tight labor market and commodity price pressures. Productivity improvements driven by corporate tax reform also are helping and, in reality, are just starting to come into play. As long as growth continues while inflation remains a grind, not a sprint, the expansion should grind on as well … absent a Fed mistake (see below).
  • Trade war drag. Despite the coming positive earnings season, it may be difficult for the market to advance much higher in the face of the uncertainty created around the present very public trade-war negotiations. Today’s latest series of salvos signaled to us that these talks are going poorly and are likely to be more protracted than we had expected. Although we continue to expect a positive outcome with some reasonable concessions from China, Germany and Mexico/Canada, it may take longer to get there than we’d hoped. In the end, however, we think the president is holding a very strong hand and is likely to get the “free-er and fairer” trade he is after. (For example, given the relatively low level of U.S. exports to China, we know it will run out of U.S. goods to slap tariffs on far earlier than the president will! And the idea of China, the European Union and Mexico/Canada forming their own club is interesting as a talking point, but impractical as a way of replacing their massive trade surpluses with the U.S. since all of them would be looking for a partner willing to accept a significant net deficit.) Nevertheless, it will probably take time for the deals to develop and in the meantime uncertainty, never a good thing, will hover over all the key economic players. The tariffs being bandied about, if actually implemented, would just be a modest drag on growth. We are more concerned about the impact on growth of all the uncertainty from these very public negotiations. On the other hand, given the otherwise bullish market backdrop, once investors develop a firmer sense of where these trade negotiations are likely to end up—and this could come slowly or very quickly—stocks are likely to break higher.
  • The Fed: Hawkish or dovish? Markets last week took Fed Chair Powell’s comments and the accompanying dot plot as relatively hawkish, leading some to conclude the Fed is on a fixed hiking path that is unlikely to end before policymakers throw the economy into a major pullback. We think this is highly unlikely. Powell continued to stress in his news conference the symmetry around the Fed’s inflation target and the data dependence of future rate decisions. Providing inflation data continue to behave well as we expect, the Fed is likely to lean on the side of running the economy too hot rather than too cold. And if the trade war, dollar strength and emerging markets/Italy stresses continue, we’d guess the Fed would see these as doing its job for it and would slow its rate-hike path. Net net, we see the Fed leaning dovish, not bearish.

In sum, if we have to deal with some unpleasantness over the next few weeks and months, so be it. Our longer-term bullish perspective hasn’t changed. In fact, we view potential pullbacks as attractive points to possibly add to positions—at the least, not get out. Our fundamental research continues to indicate that the market should be making significant new highs over the next six to 18 months. So when it comes to any near-term hiccups, let patience be a virtue and try to enjoy the summer.