2018 3rd Quarter Update

Top Headline for Q3: US Equities Dominate, Apple hits $1 Trillion

The US Equity markets followed a strong 2nd quarter with an even more impressive 3rd quarter. All market capitalizations roared ahead with the S&P 500 Index finishing up 7.2%, the Nasdaq 100 Index up 8.5% and the Russell 2000 Index up 3.3%. Big gains occurred in the technology, healthcare and consumer discretionary sectors. The technology sector was boosted by the “Megacaps” as Apple rose a whopping 21.9% in the quarter and gained headlines as it blasted through the $1 trillion valuation mark.

General Market Update

Domestic Equities:  The US Equity markets continued to surge ahead in Q3 on the back of continued positive financial results being reported. As noted in our last update, earnings reports delivered in Q2 (covering Q1 operating results) were spectacular and Q2’s operating results came in just as strong. For example, Factset reported that all twelve major equity sectors reported year-over-year growth in sales and earnings with nine of the fifteen sectors showing earnings growth in excess of 15%. “Projected” year-over-year earnings for Q3 are also very high – sitting at 19.3%.

International and Emerging Market Equities:  The developed international equity markets were mixed in Q2 leading to moderate gains or losses depending on exposure. For example, the Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 1.5% in the quarter though still remains in negative territory year-to-date. Emerging market equities were also mixed in Q3 after a brutal Q2 that sent them deep into negative territory for the year. The Schwab Emerging Markets ETF was down only 0.7% for the quarter but remains down nearly 8% year-to-date. Many analysts have noted the striking, and unusual, divergence between the international market (developed and emerging) and the US equity market. While the US markets are looking a bit stretched relative to the foreign markets, conditions do not seem conducive to a reversal any time soon (e.g., strong US dollar, high energy prices, trade tensions, economic activity slowdown in many areas).

US Bonds: The Federal Reserve continued, as expected, with another 25 basis point interest rate increase in September. Moreover, given strong underlying economics, they projected another increase in December of 2018 and more increases in 2019. Intermediate and longer-term bond prices, along with corresponding ETFs, saw little movement from the news suggesting that the rate trajectory may have already been factored in to pricing by the market. The one exception was long-term government bonds which saw a price drop in the quarter. This change, however, may simply have been an adjustment following this sector outperforming similarly-dated corporate bonds in Q2. Given the stability of bond prices, corporate bond ETFs generally posted a moderate return for Q3 with most of the gain coming from interest payments. US government bond ETFs generally fell into negative territory with interest payments unable to overcome the fall in prices. The “yield curve” remains very flat with only a 27 basis point difference separating the 2 and 10-year government bonds making the shorter-side of the curve a more attractive value. Bank CDs, money-market funds and short-term fixed-income instruments seem to be quickly reflecting the interest-rate changes though bank and brokerage interest-bearing accounts are responding more slowly.

A Look Ahead

The incredible US equity market performance this quarter leaves everyone wondering, “How much longer can this continue?” On the positive side, the corporate financial performance is strikingly good. In recent quarters, on average, companies have been growing earnings by double-digits year-over-year. There is no better justification for a stock price increase than increases in earnings. Moreover, near-term earnings projections remain high. The 19.3% earnings growth projection for Q3 is among the highest in the last 10 years and growth projections are similarly strong for Q4 and into early 2019. So, if the earnings projections are realized, higher prices are likely to follow.

On the negative side, there are some seismic trends that are working as headwinds for the equity market. In our view, the two biggest headwinds are (1) the rising interest-rate environment and (2) an economy that is projected by most economists to begin slowing down. Rising interest rates will hurt liquidity and will adversely affect many industries (e.g., we’re already seeing weakness in housing and automobile purchasing). Corporations, especially companies that rely on high-yield debt, are going to see much tougher conditions in the years ahead. Although a recession may not be an immediate threat, any anticipation of a slowdown would likely lead to an adverse equity market reaction. Moreover, much of the recent market performance has been buoyed by stimulus (i.e., corporate tax cuts and an unprecedented period of low interest rates) along with the perception that more good news is coming (e.g., fewer regulations). It may not take much to trigger a change in outlook and a corresponding short-term sell-off (e.g., the November elections immediately come to mind). Moreover, if economic growth begins to slow, then earnings projections will be adjusted downward and equity prices are likely to follow. Lastly, the expanding US budget deficit is bordering on irresponsible at this stage and creates additional risk. Overall, we see negative conditions ahead and don’t feel that equity or high-yield bond investors are being properly compensated for risk. Our investment allocations will generally continue to trend toward a lower-risk allocation.
Sam Harris – Charlottesville           John Mumper – Richmond
(434) 214-0407                                 (804) 380-1050
Sam@PatinaWealth.com                John@PatinaWealth.com