January 29, 2018

As we near the close of January, the S&P 500 is up more than 7%, the best start since 1987.  Obviously, the confluence of sharply higher earnings, reduced taxes and rising investor confidence are working to drive stocks higher.

This week, over 20% of the S&P 500 will report earnings.  Based on reports to date, revenues are set to rise over 7% and earnings per share over 13% for the fourth quarter, by far the best showing in years.  That clearly hasn’t been lost on investors given the 25%+ rise in stock prices over the past 12 months.  This week the five biggest tech firms who together comprise 14% of the market value of the S&P 500 and about 40% of the market value of the NASDAQ Composite are due to report.  They are Apple#, Alphabet#, Facebook#, Amazon, and Microsoft#.   Judging purely by recent price performance, expectations are extremely high for Alphabet, Amazon and Microsoft.  All three are benefiting from rising consumer demand, the economies of scale, and the rapid growth of the cloud.  Facebook and Apple face more challenges.  Apple’s new iPhone launches appear to have been less stellar than previously expected, while Facebook and other social media stocks have come under attack for either their inability or lack of effort to police and scrub their websites to reduce fraud and various forms of undesirable content.  It appears that some of the sites that have built their revenue base on advertising and eyeballs have been overcounting and therefore overstating their effectiveness.  While the errors may be inadvertent and more related to faulty algorithms than any intent to deceive, clearly Facebook and others need to spend more time, money and effort to improve accuracy and quality or face increased government scrutiny and regulation.  In Facebook’s case, in particular, I think management is highly concerned and wants to do the right thing.  The ultimate question, however, is whether it proves willing to move aggressively enough on its own to hold off onerous government regulation.

In the case of Apple, perhaps introducing two new phone lines while maintaining previous models has created more confusion than demand.  I have little doubt that, ultimately, the advances now built into the iPhoneX will come to dominate future phone generations.  Even if the technological transformation is undergoing some hiccups short term, there are few signs that Apple is losing its place in the smartphone race.  Some argue that there are other phones made by Asian manufacturers that have beaten Apple to the punch technologically.  That may be true.  It is also true that Apple has been late with a lot of its recent new products, including not only the iPhoneX, but also the newer models of its watch.  But, in the end, Apple gets the products right.  Moreover, one can’t look at individual phone models as standalone devices.  If you are an Apple customer or fan, you know that all Apple products tie together.  That is key, because Apple service revenues are growing fast.  These services are the glue that create the ecosystem.  Apple adherents are willing to wait for the next model of a particular device even if a competitor can beat it feature-for-feature because they value the ecosystem so highly.  To date, every Apple stumble has proven to be a better buying point than a sale, and I suspect, should Apple disappoint this week in its forward looking guidance, that may prove to be the case again.

The option prices of all five stocks suggest that there is a probability of a 5% move around earnings.  Thus, this could be a very volatile week.  While good earnings are expected from Amazon, Alphabet and Microsoft, the recent moves in their stock prices reflect that.  Only blowout numbers are likely to send their shares immediately higher as they report results.

This week will also feature President Trump’s first State of the Union Address.  It will come tomorrow evening.   I expect it will be very carefully scripted.  As we saw in Davos at last week’s economic forum as well as many times in the past, when Mr. Trump stays on message and keeps the fireworks to a minimum, he gets high grades and a favorable reception.  It is when he speaks extemporaneously and off the cuff that he is prone to creating controversy.  Thus, despite the fact that a handful of Democrats are choosing to boycott the speech and the liberal press will make a mountain out of a mole hill to that point, the focus on the speech will be and should be on its content.  Clearly, part of the speech will be looking backward, and no doubt, the President will be patting himself on the back multiple times, citing the tax cuts, job creation, reduced regulation and record stock prices.  But investors will be looking forward.

This being a big election year, very little, if anything, is likely to get done.  Mr. Trump will talk about immigration and probably repeat his laundry list of wishes to accompany an accommodation for the dreamers.  That will be posturing.  The deadline is March 5, and I suspect that while he will continue to press for a comprehensive package that adheres to the wishes of conservatives up until that deadline, if he can’t get the necessary votes to get that done, which at the moment seems unlikely, he will have to settle for a narrower package focused on funding for his border wall and call it a win.  Politically, it would almost certainly be suicide for the Republicans to pursue massive deportation of law abiding and productive dreamers and their families.  The other piece to focus on is infrastructure.  The issue here isn’t the need; all sides agree on that.  It is the funding mechanisms.  The government portion has to be funded, given that deficits for the next two years are already expected to rise to at least $1 trillion each year.  While the Federal government only accounts for a small portion of infrastructure spending, it is a crucial and necessary part.   Simply said, our airports, roads and bridges are no longer world class.  In many cases, we are not much better than some lesser-developed nations.  The needs are critical.  This point wasn’t lost on prior administrations, but to date, government hasn’t found a common path to get infrastructure going.  If there is going to be a serious infrastructure bill this year, it will have to evolve soon.  Nothing major is going to get passed after the 4th of July, and if Democrats succeed in winning either or both chambers of Congress (still an uphill battle but quite doable) the odds of getting anything substantive done after the election will go down rapidly.

But even if nothing is done, the impact of the tax cuts and less regulation are sufficient to keep the economy going.  What is in question is the stock market itself.  A 7%+ gain in January is a healthy full year’s performance quite often.  I noted earlier that this January is the best since 1987.  In 1987, lest anyone forget, stocks went on a tear through mid-summer and then fell about 40% from August through late October, declining 22% in one session alone.  For the first 7 months stocks went straight up as bond prices went straight down.  This morning, the 10-year Treasury yield is over 2.7%, the highest in several years, rising about 25 basis points in January alone.  Some question how high the rate has to be before stocks respond.  The answer is that nothing happens in a vacuum.  Stock and bonds trade against each other all the time.  The fact that stocks don’t appear to consider the January rise in rates, only suggests that the influence of earnings increasing and rising speculative fever, for the moment, are overwhelming the negative impact of higher rates.  There is a lot of anecdotal evidence suggesting that millennials and investors that have stayed out of the market since the Great Recession are coming in.  Not only are they putting their toes in the water, they are buying some of the most speculative instruments.  Cannabis-related stocks and anything related to cryptocurrencies are particularly hot.  This reminds us of prior speculative booms.  There may be several weeks, months or even years left to this phase.  But if the market keeps up January’s pace for long, it won’t be years for sure.

Investment decisions aren’t black and white.  It is never all in or all out.  Stay with your asset allocation for now.  Letting profits run a little isn’t wrong but don’t get too far out over your skies.  Eventually, the facts win.  Stocks may be a bit ahead of themselves and in need of some correction, but rarely have the economics been as good as they are today.  Years like 2008 happen because of severe economic or financial dislocations.  That isn’t upon us.  Stay sober and stay calm.

Today Oprah is 64.  Tom Selleck is 73.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request.  This report is not a complete analysis of every material fact representing company, industry or security mentioned herein.  This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned.  This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities.  The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed.  This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report.  Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized.  Opinions are subject to change without notice.

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