Once again, stocks set new record highs on Friday despite poor earnings reports and outlooks from Dow components Exxon Mobil# and Intel.
The ideal for stocks is a combination of good earnings, low interest rates and a stable dollar. Friday’s GDP report was a surprise in two aspects. Growth of 3.2% was higher than expected and inflation of barely more than 1% surprised to the downside, a neat combination if you are an equity investor. But the GDP number wasn’t quite as good as the headline numbers suggest. A sharp jump in inventories and a reduction in the trade deficit related to Chinese tariffs, helped to boost GDP by about 1.5%. The excess inventory will have to be worked off in ensuing quarters, and if a Chinese trade deal is reached, look for Chinese exports to the U.S. to increase.
As for inflation, the continued downward pressure, despite an economy creeping ever closer to its full potential, points to the power of technology to drive prices lower. This includes the continuing and building impact of the Internet on price discovery.
Earning so far for the first quarter have been better than expected despite some high profile misses, including Friday’s reports from Exxon and Intel. Exxon’s weakness was largely related to very soft refining margins, another indication of a weak pricing environment despite solid demand. Intel’s weak outlook (the company actually did fine in Q1; it was the poor outlook that clobbered the stock) was mostly related to a buildup of inventory. In addition, migration to the cloud worked to slow data center demand, a key market for Intel.
Overseas, China also has started to show signs that government efforts to stimulate demand are working. Japan and Europe remain soft, but a turnaround in China and ongoing strength in places like India and Brazil more than offset weakness in traditional developed markets.
Valuation could become a concern once again, as it was in 2018, should stock prices continue to rise at the same pace as Q1 or if interest rates rebound with any vigor. But Friday’s GDP report and the attendant PCE inflation data sent rates lower, not higher. Futures markets actually suggested the odds of a rate cut in the second half of 2019 have actually increased.
Thus, the near term risks are more tied to valuation than to any fear that the economy is going to suddenly deteriorate or that interest rates are set to spike. While valuations are nowhere near as high as they were last fall, they are certainly close to fair value. A double digit increase in stock prices clearly isn’t justified every three months. Stocks could move sideways in a fairly narrow range for several months or they could move materially higher in the short run, setting investors up for a more than modest correction sometime later this year. Without any near term storm clouds, there doesn’t seem to be anything to stop the rally at the moment.
There is one more heavy week of earnings reports. After that, obvious catalysts to move stocks in either direction aren’t clear unless there is a surprising good trade deal with China to be announced over the next month or two. The new issue market will command a lot of attention with Uber likely to be the name that gets the most consideration. A solid reception for Uber could set the stage for an extended rally. A poor reception could slow the advance, at least for the short term. While some high profile new issues have done very well lately, valuations in the IPO market are starting to get extended. Hot IPO markets can be euphoric or they could lead to heightened volatility. That shouldn’t infect the rest of the market but it bears watching.
Today, Uma Thurman is 49. Jerry Seinfeld is 65. Willie Nelson turns 86.
James M. Meyer, CFA 610-260-2220