Stocks closed mixed once again yesterday. While the Dow Jones Industrials posted nice gains, the S&P 500 rose just 0.2%, and the NASDAQ Composite was down slightly. Most of the leading averages have now recovered to within 2% of their all-time highs. They could all make a run to new records over the next couple of weeks, their success will depend on the outcome of trade talks with China and investor reactions to first quarter earnings.
While we all know that the economy slowed through much of the first quarter, and international companies will feel the impact of a strong dollar on earnings, it is hard to make the case that much of the negative news is built into a market that is up close to 15% since the start of the year. Most companies have fiscal years ending in December and report at the end of calendar quarters. There are more than a handful of companies that report on off months. For instance, those with quarters ending in February have already reported, and investors have voted with mixed reactions. Some, like Accenture#, reported better than expected earnings, and raised guidance. Wall Street calls this a “beat and raise” quarter. Its stock jumped sharply. Others missed and saw their share prices drop sharply. We expect the same behavior as the major banks begin reporting at the end of next week. There will be winners and losers plus a lot of companies that report within the range of expectations. But as noted above, the recent rally has placed the margin of error on the downside meaning that understanding how the weakness in Q1 could hurt earnings, any miss or lowering of estimates will put any company reporting disappointments in the penalty box.
Today there will be two pieces of news to digest. First, since this is the first Friday of the month, is the March employment report. We are looking at two numbers. First, of course, is the total number of new employees. After February’s dismal performance, one could fear a repeat. Any number of net jobs created materially below 100,000 would create shivers in the market. On the flip side, gains over 100,000 would be taken in stride, even outsized gains beyond expectations of 150,000-175,000 new jobs created. The second is the gain in wages. We want wages gains to be robust but not too robust. Any acute acceleration in the rate of wage increases will spook markets that the Fed might consider raising interest rates.
But the Fed doesn’t rely on any one data point. At the moment, it is in no mood to do anything. And, frankly, there is no reason why it should. The economic growth outlook is for real growth in excess of 2% this year (some hope for well in excess) with inflation about 2%, more if you include food and energy, less if you just look at the core rate. The Fed, having lived through several years of inflation a bit below 2%, is more than willing to live with some inflation, using whatever measure one chooses, a bit above 2%. A bit above doesn’t mean 3% or 4%. It means something less than 2.5%.
If I were a Fed Governor (and no one asked me; it appears Herman Cain and Steve Moore are first on the list), I would sit back and do absolutely nothing right now. An economy growing too fast risks lighting the fires of inflation. An economy growing too slow risks setting off recession. Right now, we are spectacularly in between which is precisely why markets are approaching all-time highs. From a Fed standpoint, it is a perfect world. Yes, the Fed probably got too aggressive last fall and it has spent the last six months walking back that hawkish stance. Are rates a quarter point too low or high today? Really? Is there anyone who can tell precisely, within 25 basis points the perfect rate? I doubt it. But what I do know is that we are living in an economy growing 2%+ with an inflation rate of 2%-. That is as close to perfection as possible. Putting all politics and rhetoric aside, the primary drivers of growth are population and productivity. Our population growth isn’t accelerating and, if we make immigration more difficult, the outlook isn’t positive. As for productivity, getting to 2% in an economy dominated by services, is going to be difficult, especially when investment spending is constrained by all the uncertainties related to trade, Brexit, and the overall political environment.
We might learn more about trade soon. Chinese Vice Premier Liu He and President Trump met last night. Mr. Liu has to present any agreement back to Chinese leadership. Hopefully, something can be signed by this summer’s G-20 meeting. At the moment, the key issues are enforcement and the status of existing U.S. tariffs. Clearly markets are poised for an agreement, and any breakdown in talks will set off a correction. Conversely, any success could spark a rally to or through previous highs. But I suspect some degree of success is already priced in, and any blow-off rally should probably be sold. A 17x multiple on forward earnings takes us to just under 2900 on the S&P 500. That is almost where we are today, suggesting stocks are fairly priced right here. Said in a different way, don’t expect the “salad days” of Q1 to continue unabated. As noted, Q1 earnings reports could be a catalyst for a bit of uneven trading, up on days when key companies report favorable results and down on days when they don’t. Markets never move in a straight line forever, and they certainly don’t move up or down by 10-15% per quarter. Look at the last six months in context. Q1 gains pretty much offset the losses of last year’s fourth quarter. Call it relatively even since September despite an overall rise in earnings and a decline in interest rates. But for those Q1 gains to continue, at least at the same pace, expectations have to rise. That probably is more than one could ask for.
Therefore, the obvious strategy is to sell what is fully priced relative to rational expectations and to buy what gets beaten down to the extreme during earnings season. Longer term, with no recession in sight, the key is to stay to one’s asset allocation and stay focused on companies that can continue to grow in a slow growing economy.
Today, Pharrell Williams is 46.
James M. Meyer, CFA 610-260-2220