Stocks fell as concerns rose that the coronavirus, now emerging in China, will spread and inhibit global travel. In addition, new management at Boeing# warned that the 737 Max may remain grounded until mid-year or later. That not only impacts Boeing, which took the biggest hit in the Dow Industrials yesterday, but a raft of suppliers. With all that said, it was time for some profit taking anyway. After the bell, two high profile companies reported earnings. Both IBM# and Netflix rose in afterhours trading. There will be several more high profile earnings reports this morning including Dow component Johnson & Johnson#.
I generally don’t like to use technical jargon in these letters but today I will to make a point. Traders watch 50 and 200 day trendlines. They do so for several reasons. First, over a relatively long period, and 200 days of trading is pretty close to a year if you exclude weekends and holidays, stocks with rising trends tend to reflect good results and expectations. You want to own stocks that move up over time commiserate with their growth rates. On the other hand, there is an old expression that it is dangerous to stand in the kitchen and try to catch falling knives. Buying stocks that are going straight down for an extended period is about as dangerous as standing in that proverbial kitchen. But in a year like 2019 when stocks rose 30%, there haven’t been many stocks in such steep downtrends. Rather, the opposite has been true. There are many stocks rising in meteoric fashion. They have been rising so fast, that they are now priced far ahead of both their 50-day and 200-day trendlines.
History says that should be taken as a warning sign. Like so many other trends in our life, there tends to be revergence to the mean over time. Lately, charts of many leadership names now show stocks priced well above all their trendlines suggesting some sort of reversion lies in the not-too-distant future. That doesn’t mean a correction has to occur tomorrow. In fact, stocks could move sideways for a period of time and revert back to their longer term moving averages. Or they can stay above trend as long as there are enough momentum traders out there willing to try and hitch a ride on a fast moving train. But when stocks rise much faster than the fundamentals might suggest, it does mean that despite all the good news, stocks sometimes get a bit ahead of themselves. Reversion to an upward sloping line suggests only a pause and that is all I am suggesting is staring us in the face. It doesn’t mean long term positions should be sold nor does it mean asset allocations should be changed. But it does mean that if your equity holdings are a bit ahead of what your asset allocation suggests, some rebalancing is OK.
With that said, the economic backdrop today is almost ideal. Growth of 2.0-2.5% is sustainable. The pressure of rising tariffs is lessened today and probably will stay low through the election season. The Fed is keeping interest rates low and has expanded its balance sheet to avert a liquidity squeeze for very short term paper. Europe is starting to grow again. So is China. Inflation remains low. Less tariff pressure and less dollar strength will also help to mute inflationary pressures. While the election season poses risks, right now investors are betting that either President Trump will be reelected or progressive agenda items like Medicare-for-all or sharply higher taxes simply won’t be passed into law. Against this backdrop, earnings are reaccelerating, the dollar remains stable, interest rates are low, and productivity is slowly rising.
There have been seven times since World War II when the stock market rose by 30% or more in a single year. Each year following, the markets rose again, albeit by a smaller percentage. Right now, I see no reason not to assume the same. An 18x forward earnings estimates appears high by historic standards, but it is consistent with 2% inflation and 2% long bond rates. As long as rates stay near current levels and profits reaccelerate, stocks can move higher. There can be, and probably will be, an interim correction or two after stocks move too far too fast but that is the normal course of events and not to be feared.
To me the biggest risk this year is that interest rates move up faster than anyone expects despite muted inflation. What could cause that? An explosion of debt. More demand for debt and a constant supply of funds to buy new debt issues could trigger an upside surprise to rates. The laws of supply and demand suggest that if supply rises faster than demand. In bond terms, that means lower prices and higher interest rates. In addition, foreign governments, like China, that have been historic buyers of U.S. debt, may hesitate adding to already large holdings, especially if geopolitical tensions stay high. A 3% 10-year Treasury yield is not inconsistent with a 2% inflation rate. I worry about that more than I worry about the outcome of the election next fall. But for now, rates remain contained. It pays to concentrate on the facts and not speculate on something that may not happen.
Today, Guy Fieri is 52. Diane Lane turns 55. Steve Perry, lead singer of Journey, is 71. Don’t stop believing.
James M. Meyer, CFA 610-260-2220