On Monday, I laid out a case that the concentration in leadership for the S&P 500 might be a precursor to some sort of market correction. I noted that it was possible that the trigger for such a correction could be just about anything, including spreading concern that the coronavirus could impact economic growth to some extent. But readers of my comments on a regular basis also know my two-day rule which says any trend reversal must follow at least two bad (or good) days in a row. Over the past several years, we have seen many one-day hiccups that moved markets 1-3%, only to see them end as one-day wonders. Yesterday’s rebound suggests that Monday wasn’t the start of a correction, but rather the crescendo of near-term fear related to the coronavirus that began last week.
The virus is going to spread, it is going to result in many thousands of deaths, and it will create some near-term economic mischief before it flames out in a couple of months as winter morphs into spring. Fortunately, it doesn’t seem to be as fatal as SARS, but it is nasty and scary to those living near its epicenter. I have little doubt that we will see more than a handful of cases reach this country, and it will be a big story on the evening news for a while. For companies like Disney#, that have closed theme parks temporarily, or airlines that will cancel flights, there will be a short-term impact. But the long-term value of Shanghai Disneyland won’t change, nor will the value of any airline that has to cancel a few flights. Thus, while the coronavirus fears may have a short-term impact on markets, unless it explodes far beyond current rational expectations, it won’t be a long-term factor in determining equity values.
What will determine values will be earnings. As always, stocks react to expectations, not to the actual numbers themselves. Yesterday, for instance, Dow component 3M# reported a stinker of a quarter. How much of that is due to a weak macro environment for manufacturing globally, and how much is self-inflicted, is up for debate. But what isn’t up for debate is that markets expected better. 3M clearly missed expectations and its stock fell over 5%. Conversely, after the market closed, Apple# reported a much better than expected quarter. It is hard to believe that a company whose stock doubled in the previous 12 months could still report results that exceeded expectations, but Apple did. The key was better than expected iPhone sales. Because the iPhone 11 does not have a 5G chip, many felt the 11 series would be an interim improvement that wouldn’t stimulate a lot of demand. But a great camera, better battery life and a good price point made a difference. Apple’s shares are likely to rise 1-2% this morning.
And that is the way earnings season is going. There are some hits and some misses. In technology, it is encouraging that two “old tech” names, IBM# and Intel#, both exceeded expectations. Banks have generally reported pretty good numbers with the notable exception of Wells Fargo. Another Dow component, United Technologies#, had good results yesterday. Boeing and McDonald’s, among others, are on deck this morning. Boeing will disclose details of the pain caused by the 737 Max grounding. It is unlikely to have much further to say about when it will return to the skies. McDonald’s had a decent third quarter that was short of expectations. We will see later this morning whether it was able to regain any momentum.
The real question this earnings season is whether companies share a brighter outlook for 2020 or not. On the positive side, there are many economic indicators showing some economic improvement worldwide. On the other hand, there are uncertainties surrounding the election, tariffs, capital spending, and the impact of the coronavirus. As with most earnings seasons, it is likely to be a mixed picture. Actual results will almost certainly beat estimates. They always do. What matters is the direction of future expectations. Will estimates looking ahead stay where they are, or will managements collectively pull them back? That will be the key to the near-term direction of stock prices.
Yes, the sharp rally in stocks has caused many to become overextended. That was my point on Monday. Yes, if stocks can move higher, the heavy lifting has to be done by companies other than Apple#, Microsoft#, Alphabet#, and Facebook#. But if improving economic conditions can spread joy to other companies and industries, that could happen. Whether it does or not, we will have a better picture in the next two weeks.
Today and tomorrow is a Federal Reserve FOMC meeting. Rates will not be changed. Investors will be watching direction as to how the Fed wants to manage its balance sheet going forward. Lately, it has needed to expand it to inject more liquidity into short-term markets. That has helped support rising markets. But injecting liquidity isn’t a long-term event. Once it is done, it’s over. The Fed still may have to grow its balance sheet a little, but not at the rate of the past few months. The Fed has done its job, three rate cuts in 2019 and some balance sheet accommodation. Now it is up to natural economic forces, demographics, fiscal policy, and better productivity to keep the economy growing. Governments, especially ours, are increasing spending and supporting that spending with more debt, not the best long-term solution, but one that will support the economy right now. It is a good backdrop for stocks.
The bottom line is that the economic news is good at the same time equity values are a bit stretched. That should mean a higher market this year, but with more volatility than we have seen over recent months. Long-term investors should be able to live with that. I would look at stocks that have significant hiccups in Q4 earnings season for opportunities. But be careful. Potholes give you a quick jolt, but sinkholes have very nasty consequences. You are looking for value, not value traps.
Today, former House Speaker Paul Ryan is 50. Oprah is 66. Tom Selleck turns 75.
James M. Meyer, CFA 610-260-2220