“Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major direction.” – Martin Zweig
The stock market continued its upward advance in the second quarter, building on the strong results posted in the first quarter of 2019. After a rough month of May when the S&P 500 Index declined 6.6%, the index surged back with a gain of 6.9% in June, its best performance for the month of June since 1955. Overall, the index was up 17.3% during the first half of 2019, which marked the best first two quarters of a year since 1997. Similarly, the Dow Jones Industrial Average was up 7.2% in June, its best return for the month of June in over 80 years. The Dow gained 14.0% in the first six months, its best performance since 1999. The gains in the stock market were broad based with all eleven S&P 500 Index sectors ending higher for the first six months of the year. Technology and industrial stocks were the best performing sectors, while energy and health care were among the weaker sectors.
The current bull market has now been in place for over a decade, marking the longest stretch in the S&P 500 Index’s more than 90-year-old history. According to Standard & Poor’s, the bull market has now lasted over two times as long as the average bull market. Since the bull market for stocks began in March 2009, the S&P 500 has come close, but has not fallen by a full 20% from a previous high as measured by daily closing values. A 20% decline in the stock market would technically mark the end of the bull market.
The stock market growth over the first six months of 2019 has largely been fueled by a dovish Federal Reserve that appears to be on the verge of lowering interest rates by the end of 2019 due to slowing economic conditions around the globe. In addition, the market has been supported by anticipation that a trade deal with China could be on the horizon.
Over the last six months, the Federal Reserve has pivoted away from its hawkish stance on interest rates. This is reflected in the current Fed Funds futures market forecast of two or three rate cuts of 25 basis points by the end of this year. According to Federal Reserve Chairman Jerome Powell, the Board of Governors of the Fed are now concerned about a downturn in various global growth indicators and a worsening trade environment which has hurt investor confidence around the world. Analysts believe the Federal Reserve will cut interest rates because inflation is below the target rate of 2%, commodity prices are either stable or declining, and the US dollar remains strong. A majority of worldwide central banks are also in an interest rate easing mode due to the slowing pace of global economic activity. Manufacturing activity has markedly slowed in Europe and China, while American manufacturing is slowing as well. Some of this decrease in activity is likely due to the U.S. tariffs on Chinese imports as well as tariff threats on goods from Mexico, Japan and the European Union.
According to various analyst reports there is between $12 and $13 trillion in negative yielding bonds around the globe. Currently, the Federal Reserve’s short-term rate range of 2.25-2.50% is among the highest in the world. For example, Australia cut its rate from 1.50% to 1.25% in June, Canada’s rate is 1.75%, Britain’s rate is at 0.75% and Japan’s rate is a negative 0.1%. The European Union Central Bank’s target rate is negative 0.4%; and Mario Draghi, head of the European Central Bank, has said it may go even lower.
As we noted in our last quarterly report, the yield on the 10-year Treasury note fell below the yield on the three-month Treasury bill in late March, marking what is referred to as an inverted yield curve. An inverted yield curve typically signals falling growth expectations and can precede a recession within the next couple of years. The inverted yield curve condition has remained in place but could unwind in the near term if the Federal Reserve cuts short-term interest rates.
Historically, the stock market has benefitted from the Federal Reserve commencing an interest rate easing phase. According to Sam Stovall, Chief Equity Strategist at CFRA Research, “Looking at the S&P 500’s six and 12 month price performances following the initiation of the Fed’s 16 rate-cutting cycles since WWII, one can easily see why investors get giddy with the prospects of a new cycle. The S&P 500’s average six-month price return following the 16 cuts was a jump of 10.3%, followed by a 14.1% advance for the full 12-month period. In addition, the market rose in two out of every three six-month periods and in 81% of the 12-month periods.”
First quarter U.S. gross domestic product, a measure of economic growth, increased 3.1% according to the Bureau of Economic Analysis. However, second quarter growth slowed as the Atlanta Federal Reserve GDPNow forecast estimated it to have been only 1.5% in its most recent reading. The labor market continues to be tight with many employers reporting difficulties in finding skilled labor. The labor market has added jobs for over 100 consecutive months to notch its longest ever consecutive streak.
Analysts are expecting corporate earnings to grow by approximately 2.5% in 2019 according to S&P Capital, with revenue increasing 4.8% for the year. More optimistically, the same analysts are projecting double digit increases in earnings for 2020, but that could be trimmed as the year progresses if optimism wanes. The forward price-to-earnings (P/E) ratio for the S&P 500 is 17.3 times based on the next 12 months projected earnings. This P/E ratio is at a 5% premium to the 20-year average. Therefore, we believe valuation levels are reasonable even after the out-sized stock market gains in the first six months of this year.
Our overall view of the stock market has not changed since the end of the first quarter. We do not see a recession looming in the near-term as interest rates have trended lower, inflation has been relatively contained and the labor market remains strong. But the same risks to the market remain, notably the ongoing trade talks with China, uncertainty of the resolution of Brexit, and a further weakening in the global economy. Overall, we believe the positives more than offset the negatives. Therefore, we remain generally optimistic for the stock market over the back half of the year and into 2020.
Marietta Wealth Management, LLC