Steady as She Goes!

July 2018

The second quarter of 2018 was less eventful than the first quarter.  As a reminder, U.S. stock markets began the year quite strong with the S&P 500 gaining 5.7% in January.  Then starting in late January through mid-February it suffered a sharp 10% correction. The S&P 500 recovered to end the 1st quarter down 0.8%.  From there the market has continued to recover posting positive returns each subsequent month with the S&P 500 ending the second quarter up 3.4% turning the year-to-date number positive – up 2.7%.

The S&P 500 is a market cap weighted index however with the largest companies having the greatest impact on the index.  The four largest companies in the S&P 500 (Apple, Microsoft, Google, Amazon) have accounted for most of the index’s gains.  The Dow Jones Industrial, which in the past had been thought of as the Blue Chip index is down 0.7% for the first six months of the year.  Apple and Microsoft are in the Dow, Amazon and Google are not.

The United States economy is currently very strong.  Perhaps the best indication of this strength is the 3.8% unemployment rate.  The last time the unemployment rate was this low was in April of 2000 and prior to that it was December of 1969.  Job openings are at record levels and exceed the number of unemployed workers.

Energy prices have risen considerably from the low levels of early 2016 of roughly $28 per barrel to the current level of $70 per barrel.  This is still well below the $110 per barrel just five years ago and the $130 level before the financial crisis.  The United States is now the world’s largest oil producer.  Consumers are negatively impacted by moderately higher gas prices but higher energy prices have also benefited many U.S. companies and have created many jobs in the sector.

The Federal Reserve is working to return interest rate policy to normal (pre-financial crisis) levels.  The Fed raised the Fed Fund Rate off of zero in December of 2016 and has raised rates seven additional times since bringing the Fed Funds Rate up to the current level of 2%.  This rate is expected to be raised to 2.5% by year-end.  Higher interest rates are a sign that the economy is healthy and the Fed is doing its part to prevent the economy from overheating.

Corporate profits were very strong in the first quarter with the companies in the S&P 500 reporting EPS up 24% with revenue up 11%.  We are just starting the reporting season for the second quarter, consensus estimates are for them to come in up roughly another 25%.  S&P 500 earnings are expect to be about $161 this year (up 22%), with the index currently trading at 2,800 the market is trading at 17.4 times this year’s earnings.  Earnings are expected to increase another 10% in 2019.  Stocks will follow earnings over time.

The environment for stocks is seemingly very good, what can go wrong?  Inflation could accelerate causing the Fed is to raise interest rates faster than expected.  This would cause the economy to decelerate, corporate profits growth would slow or turn negative and the multiple investors pay for stocks would contract.

The other major near term concern is an escalation of the trade war.  Investors have absorbed the administration actions to date but there is a breaking point.  Hopefully, as we expect, negotiators can come to some resolution before the breaking point is reached.


Michael Kane