In our message of February 7th, we noted that a sharp sell-off in the stock market is typically followed by a relief rally in the broad market averages off the “Benchmark Low.” This rally is nearly always followed by a retest of that initial level to establish a so-called “Confirmation Low” in order for the secular bull market to resume. This time the initial low occurred on February 9th at 2533 on the S&P 500. We also noted that the emergence of a “Confirmation Low” can take anywhere from a few weeks to a few months. It typically occurs on lighter volume than the heavy selling that accompanies the forced liquidation that established the initial low. Once again, this script seems to be unfolding at present. There are multiple triggers for a renewed downtrend, including fears of a global trade war (which we discuss below), the chaos and staff turnover in the White House, the recent rise in interest rates, albeit very gradual, and for good measure, the fiasco at Facebook. There seems to be no end to the supply of bricks in this “Wall of Worry.”
We strongly believe that a serious trade war is a very low probability outcome. Note how badly the steel stocks were clobbered over the past few days as it became evident that almost every steel producing exporter, save China, has been exempted. The threat is simply toothless, to say the least. Yesterday Trump indicated that a list of $50-$60 billion of Chinese exports to the US will be hit by tariffs. A list of these will be released shortly, to be followed by a 30-day comment period. The Chinese response was to place tariffs on only $3 billion of American exports, divided among 128 products. China is not in a position of great leverage, since they desperately need many American exports, among them commercial airliners and agricultural products. They have no alternative suppliers of these. To us, all of this is a negotiating ploy, which sadly, is likely to fail since Trump’s go-it-alone policy will be far less effective than if he were to marshal a coalition representing Canada, the EU, Japan, Korea and Australia. The Chinese do not like to be seen as outsiders. In the end, this whole thing is nothing more than a sop to Trump’s base.
In the meantime, the US economy is continuing to grow at an increasing pace, as both consumer and business spending are on the rise, as are wages and corporate profits. At today’s level of 2630 on the S&P 500, the Index is selling at less than 17X projected 2018 profits of $155, implying an earnings yield of 5.8%, which is well above a 4.3% BBB bond yield. In his first press conference, Fed Chairman Powell allayed fears of a rapid increase in the Federal Funds Rate, implying clearly that the Fed has no need to precipitate a recession in order to curb inflation, which is still running well below its 2% target rate, due to globalization, technology and other disruptive changes.
In short, we are patiently sitting on the sidelines as this highly volatile correction plays out. As long as corporate profits are rising and as long as interest rate increases are gradual, equities will continue to rise although, as we have noted earlier, price earnings multiples are likely to be gradually compressed as excess financial system liquidity is absorbed by the real economy as well as the need to finance a huge Federal deficit, all while the Fed is shrinking its balance sheet. Nevertheless, worthwhile returns over the next year or two are still a good bet. Once again, we thank each of you for your confidence and trust.