July 28, 2017

After many calm sessions, mostly to the upside, stock market volatility reappeared yesterday sending share prices on a wild ride. Most of the leading averages were up in the morning, once again responding to good earnings reports from such varied companies as Procter & Gamble#, Facebook# and Comcast#. But around midday, comments from well noted traders that prices were extended sent many of the high flyers lower. The whole market followed. While a late session rally rescued the Dow, which finished higher, the NASDAQ was a solid loser.

There is little question that the market leadership this year has once again centered around the FANG stocks, Facebook, Amazon, Netflix and Google# (now Alphabet). This week all four companies reported strong earnings growth. But any student of the market knows that it isn’t absolute earnings that count; it’s how earnings match up to expectations. Simply put, based on stock movements post earnings, Netflix and Facebook reported even better numbers than expected, while Alphabet and Amazon came up a bit short. Other companies did the same. Some beat forecasts and some missed. But the attention was focused on these four leaders. However, now that the news is out, one wonders what thrust is left in the engine to push these shares higher. All trade rather lofty P/E multiples. Some of them may be justified and, over the long term, any of the four that match or exceed expectations are likely to reward shareholders. But as July rolls into August and the news quiets down, who is left to jump on the bandwagon of these four horsemen who have been market leaders for so long?

If they lose momentum, something that is quite possible at any moment in time, which sectors are going to take over? In a market at record highs with P/E ratios the highest in a decade, that is a tough question to answer.

Yesterday’s trading action wasn’t very good. Stocks opened higher, only to sharply reverse. And the reversal was led by the FANG stocks. It didn’t help that after the close, Amazon disappointed investors with an earnings report that wasn’t as good as expected. There are more technical clouds. The old Dow Theory says that transportation stocks should lead and forecast market direction. The fundamental support for this argument is that a good economy means more movement of goods, the foundation for good earnings from transportation related stocks. Lately the transports have been weakening, and yesterday the weakness was notable. It didn’t help that UPS missed its target for Q2. The pain was also felt by railroad and trucking issues.

So far this year we have barely witnessed any correction. There is nothing wrong with a 5-10% correction to reset prices and create a buying opportunity. In the retail world, discounts create sales. The same is true in the stock market.

While fundamentals are good and low interest rates dictate higher than normal P/E ratios, it is hard to argue that this market is cheap. August and September together, historically, is the weakest period for stocks. That doesn’t mean every August is weak, but it does raise concerns that what lies ahead may not be as friendly as the immediate past.

So what are the possibilities? First, stocks could flutter for a day or two and simply keep on going. Second quarter earnings are growing at close to 10% annualized, and the outlook ahead is for more of the same. The recent dollar weakness will help Q3 earnings and maybe beyond. Low interest rates will keep P/Es high. The second alternative is that something seriously spooks the market. The Fed is about to start reducing its balance sheet, probably in September. That could unsettle investors and lead to a rise in long term rates. If that happens, some short term P/E contraction is possible, and that would mean lower stock prices. Then there is the risk of the complete unknown. Possible examples would be a debt crisis in China, a sudden change in currency rates, a spike in interest rates, or some government crisis. The market isn’t predicting any of the above. If it were, prices would already reflect such an event. Obviously, I could make a list of hypothetical risks at any moment. That’s not the point. What is relevant is that as prices and P/Es rise, the risk associated with outlier events also rises.

All the above suggests some trading uneasiness entering August. But nothing suggests fear to the level that one should move to the sidelines in a meaningful fashion. Short term corrections of 5-10% are quickly reversed. The core fundamentals of this economy, strong earnings and low inflation, remain intact. As long as that is the case, a correction won’t morph into a bear market of consequence.

The conclusion is the following. Don’t be complacent. Make sure you are true to your asset allocation. Don’t chase a stock you like. Rather, set a buy point and hope it comes back to your price. Bonds and cash are not very attractive alternatives other than to tamp down volatility. Volatility has been noticeably absent, but it won’t stay absent forever. Tomorrow’s leaders aren’t likely to be very different than the leaders to date. Stocks follow earnings growth. Sectors like technology, health care, industrials and financials have been leaders because they sport the best earnings growth. Until that changes, they will be the leaders, correction or no correction.

Garfield cartoonist Jim Davis is 72 today.

James M. Meyer, CFA 610-260-2220

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

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