The Weekly Summary
If it isn’t the Fed, it’s trade. And if it’s not trade, it’s the yield curve, which really amounts to the Fed not moving fast enough to give edgy investors a smooth enough ride. As far as we’re concerned, the market isn’t about comfort, so we’re more interested in the fundamentals, which remain constructive.
This week, the S&P 500 dropped another 1%. The elite Dow industrials gave back a little more and the Nasdaq held up a little better. BMR stocks charted a similar course. Since the July peak, the market has swung in what we can call a “mini correction” pattern, with losses adding up to 3% to 7% on any given day. Our universe is down 4% over the same period.
People are selling just to get away from whatever fear factor they care to fixate on. Good stocks are falling roughly as far as bad ones, regardless of whether they’re rate-sensitive, recession-resistant, vulnerable to a backlash from China or not. A full 70% of the S&P 500 dropped last week and we suspect the mood will remain fragile until investors receive substantive good news (and not simply a pause in the dread-driven headline cycle) and get off the sidelines.
That good news can take the form of action from the Fed at the Jackson Hole central bank summit this week, although we find it hard to believe that Jay Powell and company will cut rates so soon after the last policy meeting. That’s an admission of desperation. We don’t actually want that. However, the Fed has other tools at its disposal, including the ability to manage interest rates through selective intervention in the bond market. That wouldn’t be bad.
And of course we could see a breakthrough on trade, but that’s unlikely ahead of the G-7 summit in France over the weekend. The head of the European Union might not make it to the meetings due to gallbladder surgery and besides, China isn’t actually invited. Normally we’d look to the earnings calendar, but the main 2Q19 season is over now. (We only have two companies reporting this week. You’ll get our view on them Tuesday morning.)
But if the market as a whole is losing its nerve, we see this as an opportunity. As we mentioned in Thursday’s exclusive News Flash, U.S. stocks look no less attractive now than they did a year ago, the last time the S&P 500 peaked and needed a few months to rest.
While trailing earnings growth hasn’t been great, expectations for the coming year are a little better than they were at the end of last summer. The economy as a whole is expanding at roughly the same rate. And valuations haven’t run any higher ahead of the fundamentals than they were a year ago.
Trade tension is nothing new. Last August, companies like Apple had a pretty good sense of how icy relationships with Chinese partners were getting. Sales to Chinese customers were soft or, in some cases, completely interrupted by government bans. Tariffs on Chinese products were already in the air, forcing alert executives to shift their supply chains to countries like Thailand and Vietnam in order to avoid taking even a temporary hit to their profit margins.
A year ago, all these factors triggered a lot of warnings and ultimately fed into the 4Q18 market decline. Now, however, we’ve lived in that shadow long enough that the reduced outlook is old news. In a few months, the year-over-year comparisons get a whole lot easier. Historically that’s all Wall Street needs to get the wheels turning again.
What’s different is that while short-term interest rates are where they were last September, we now expect them to go down as the absence of inflation gives the Fed more room to relax. A year ago we were looking for higher interest rates and we got them. From here on out, the rate environment gets easier.
In theory, that means corporations find it easier to buy back stock and fund lavish dividends. They can even borrow more cheaply to keep shareholders happy or reinvest in strategic acquisitions or other investments. And if a relaxed rate environment weakens the too-strong dollar, executives will cheer.
If you were in the market a year ago, we see little reason to get out now unless your psychology has shifted. Maybe you’re tired of risk and want an easier ride for a little while. We get that. Otherwise, with Treasury yields falling, stocks remain the best allocation around.
There’s always a bull market here at The Bull Market Report! We’ve de-risked our defensive recommendations for the new environment to cut out as much potential downside as we can on that side. The High Yield Investor has all the details, but that's for subscribers only. Here, The Big Picture takes a frank look at the recession calendar in light of the latest developments in the bond market.
Key Market Indicators
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BMR Companies and Commentary
The Big Picture: Ticks On The Recession Clock
We’ve been weighing each incremental wobble in the Treasury yield curve for months now, keeping you in the loop as signs of stress in the bond market add up. Last week, the rest of the world caught on and suddenly everyone is talking like there’s a recession at the door.
Granted, while most of the curve inverted a long time ago, the closely watched spread between 2-year and 10-year yields took until Wednesday to flip, with debt maturing in 2021 briefly paying more interest than bonds that come due in 2029. Since this is the relationship economists have focused on for decades, a lot of people who thought they could ignore the bond market are having to concede the tough truth.
By the strictest conventional standard, we’re now in an inverted world. You can try to move the goal posts and redefine the terms, but for most of us, the bell has now rung. While interest rates can drift in and out of inversion territory from here, Wednesday’s final break is now a matter of historical record. And that means cutting through the noise to determine what this signal really reveals and how investors need to position ourselves for the future.
First, because the 2-to-10-year spread is so closely watched, we know a lot about where markets go from here. The curve generally inverts when an economic expansion is entering its final stage before a contraction resets the cycle. Sometimes, of course, the Fed and other factors delay that recession for so long that there’s practically no connection, but in general we’ve now got about 22 months before government economists call the top.
That’s a practically luxurious amount of time in the stock market, so there’s no urgency to liquidate vulnerable positions ahead of the storm. A typical economic expansion only runs 60 months anyway, which means investors who tap out 22 months before the end evade all the recession periods but cheat themselves out of 35% of the good times as well. Follow that strategy and you’re going to spend almost half your life on the sidelines, locked out of opportunities as well as the cyclical threat.
And while stocks generally track the economic cycle, there’s usually a three-month lag at the end where the S&P 500 keeps going after the recession starts. We saw this in 2008 and the statistics say that it’s played out the same way after other yield curve inversions. In general, the S&P 500 keeps moving up in the year after the 2-to-10-year spread flips. It’s only when you look two and three years out that the market tends to hit a wall.
We admit that a recession can be gruesome, especially if you’re still nursing psychological bruises from the last one a decade ago. But dwelling on historical trauma is a sure way to cheat yourself out of the benefits of investing across the cycle. The goal is to hang in there as long as you can while the market is moving up, whether that rate of wealth creation is fast or slow. Then, when it’s clear that the economy has stalled, you can cash out well before the downswing takes you to the bottom.
Statistically, the S&P 500 has a pretty good chance of earning investors another 13% over the next year. That’s not so bad . . . in fact it’s a little better than average. And as dynamic as BMR stocks are, we’re fairly confident you’ll do at least that well, even in an inverted world. After all, since the first whiff of trouble on the yield curve about a year ago, our universe is up 11% counting stocks we’ve cut along the way. The market as a whole hasn’t gone anywhere.
So if our stocks keep outperforming at this rate, it’s going to take a lot of pain on Wall Street to make it worth retreating to the sidelines. More likely, subscribers have the chance to attract significant wealth before the party finally shifts into reverse.
Timing is always uncertain, which is why we don’t spend a lot of effort trying to second-guess the market twists. But unless we’re looking at the shortest delay in history between inversion and recession, the rally has about 11 months left to go. More likely, the bulls will keep running well into 2021.
Either way, the last time this part of the curve inverted was in 2005, which gave investors 21 months to squeeze what they could out of growth stocks and shift into more defensive positions. Think about how far some of our recommendations have come in a fraction of that time. If you’re more concerned about risk than missing out on that level of return, it’s time to start making that defensive shift. We’d rather you feel confident now than push you beyond your emotional comfort zone.
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Apple (AAPL: $206.50, up 3%)
Like most companies (deserving or not), Apple was dinged during the recent tough talk that took place between the Trump administration and the Chinese government. Even though things have cooled off a bit, the market is still roiling given the inverted yield curve situation. That’s less of an issue for Apple, which is why the stock has held up very well (up 28% YTD).
Apple does have exposure to China via the iPhone, but the company is rapidly diversifying away from its core product. 3Q19 was the first time since 2012 that the iPhone made up less than 50% of revenue (48%). The quarter also produced a 1% YoY revenue bump to $54 billion, even though iPhone sales were down 12% YoY. That comes by way of a growing Services segment (up 13% YoY), as well as resurgent sales of both Macs and iPads. Macs were up 10% YoY, and iPads up 8%. 3Q18 saw both products produce 5% YoY losses. So that’s a big swing in just 12-months time.
Apple’s Wearables segment is also growing. 3Q19 Wearables grew an astounding 48%, and this is rapidly becoming a core feature of the underlying business. All of this diversification is coming at just the right time, because China revenue is down 20% YoY, which makes sense given the trade war implications. It seems 4Q18’s poor iPhone performance was a blessing in disguise, as it spurred management to accelerate the diversification strategy, which is now paying dividends.
BMR Take: Even though Apple has exposure to China, that exposure is rapidly being mitigated by the diversifying product base. Also the growth of high-margin Services (which is location-independent) is a strong plus. The concern at the moment isn’t just China, it’s the yield curve, and Apple isn’t vulnerable there. We expect the stock to hold up nicely throughout the rest of the year, and the long-term is looking even rosier given the multiple revenue streams.
NOTE: In our weekly paid subscription Newsletter, we do between 5 and 7 SnapShots and also support regular Research Reports. The last three stocks we recommended are already up 5% apiece. Plus, we have the Weekly High Yield Investor, whereby we discuss the 17 stocks in our High Yield and REIT Portfolios.
And to top it all off, we send News Flashes each day during the week. Got a question about any stock on the market? We'll answer. So if your favorite stock reports earnings or there is significant news, you will hear about it here first. If you want the whole picture, join the thousands of Bull Market Report readers who are making money in the stock market and subscribe here:
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Todd Shaver, Founder and CEO
The Bull Market Report
Since 1998
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