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Greatly Exaggerated? In 1897, Mark Twain was on a speaking tour in London, seeking as he often did to raise funds to pay off his debts, when the English press first reported him ill and soon after reported him dead. The American author responded with his famous line that, “reports of my death have been greatly exaggerated.” If fact, Twain may have said the report of his death was “an exaggeration,” but that is not nearly as piquant as the popular version of the timeless phrase.
Over time, “greatly exaggerated” has become the go-to sarcastic rejoinder for any person or entity perceived to be in decline, but that is in fact still robust and wants the world to know it. In mid-summer 2019, the U.S. economy was widely perceived to be heading into a downturn. The clamor for more accommodative Fed policy rose from a murmur to a roar. In terms of specific market action, equity investors rapidly rotated from risk-on sectors into more defensive areas, favoring long-neglected themes such as minimum volatility.
Yet as summer 2019 approached its inevitable end, the swing to defensive had already begun to unwind. That is at least partly because the demise in U.S. economic activity has been, well, greatly exaggerated. The consumer remains in good shape, as demonstrated by recent retail sales data and sentiment. And the industrial economy, though dinged by the trade war, stubbornly refuses to roll over. A pair of “Goldilocks” inflation readings sent positive signals to the fixed-income markets, where yields bounced higher from multiyear lows.
In this politically fraught time, geopolitics always has the potential to disrupt the prevailing economic trend.
The attack on Saudi Arabian oil infrastructure temporarily disabled half of Saudi output and sent oil prices soaring. Stocks weakened on fears that spiking oil prices would further slow the trade-impacted global economy. One thing terrorists don’t seem to understand is that in a capitalist economy, attacks on physical infrastructure are ultimately rebuilding opportunities: where once stood the World Trade Center now stands the Freedom Tower. Saudi output will take some time to recover but will ultimately return. Risks of a deeper military confrontation are of course heightened. This region has been volatile not just for years or decades, but for centuries.
For U.S. investors, the stock market is about to enter its historically strongest quarter. Stocks could be positioned for further gains, given that they tend to do better than average in 4Q following a strong nine-month performance. The earnings environment is in a “no news is good news” phase, as earnings warnings have quieted down. The final piece of the puzzle would be a confirmation from economic data that the U.S. economy is at no risk of tipping into recession.
Consumer Remains Solid
U.S. retail sales rose moderately but more than expected in August. Retail sales rose 0.4% for the month, a tick better than expected. Sales had been expected to cool off after July’s strong 0.8% gain. The August gain was driven by a jump in auto sales, as carmakers priced aggressively to move 2019 models off lots before promoting the 2020 lineup. Excluding auto sales, retail sales were about flat in August. The weakness in retail sales ex-autos is pushing down 3Q19 GDP expectations. The GDPNow model from the Atlanta Fed has slipped below 2.0% for third-quarter GDP. Still, the overall trend in retail activity is positive, as retail sales in August 2019 were 4.1% higher than they were in August 2018.
In another positive sign, online sales rose 1.6% in August, matching the July level. Economists had been expecting that metric to slow given the impact of Amazon’s “Prime Day” in July. Consumer spending is being supported by rising wages, even though they are not rising as fast as consumers wish. According to the Commerce Department’s Bureau of Economic Analysis (BEA), personal income rose 0.1% in July after rising 0.5% in June. Behind the headline numbers, however, July income trends were positive. Real disposable personal income (DPI), reflecting after-tax income, rose 0.3% in July after rising 0.4% in June. Consumers have shown resiliency throughout the decade-long economic expansion. While August showed trade fears gnawing at confidence, September provided signs that consumers are getting “used to” the trade war. At the end of August, the University of Michigan’s consumer sentiment index fell to 89.8, missing the 92.1 consensus and declining 860 basis points from the final July reading. That decline was the largest since 2012. Consumers have been largely insulated from tariffs, which previously were assessed on industrial products such as steel and lumber.
Escalating accusations from Chinese and U.S. government officials may have alerted consumers that consumer goods were at risk of higher tariffs just in time for the holiday shopping season. Just a few weeks later, however, consumers sent a different message. The preliminary consumer sentiment reading for September rebounded to 92.0 from 89.8 in August. Although consumers are feeling a bit better than they did a month earlier, more than one-third (38%) expressed concerns about the negative impact of tariffs.
Consumers and the Federal Reserve are ultimately pulling for the same thing – the health of the U.S. economy – but they obviously have different priorities. The Federal Reserve has been worried that inflation has been rising too slowly. Consumers are happy when prices don’t rise, or even pull back. The consumer price index (CPI) for August has something for everyone. The all-items CPI rose just 0.1% in August, pulled down by declining gasoline prices – music to consumers’ ears. Core CPI, which excludes food and fuel, rose 0.3% month-over-month and 2.4% year-over-year. That annual gain serves one-half of the Fed’s mandate of supporting moderate (2%) annual inflation. The core CPI number, with its trendline annual inflation, was one of the key drivers of the reversal in bond yields, which rose on the perception that pricing was sufficiently strong to indicate sound underlying demand.
With just two weeks of trading remaining in September, fundamental investors tired of tariff talk can be forgiven for turning into technical traders. That’s because 2019’s strong nine-month performance could be harbinger of a better-than-average fourth quarter. Since 1980, the S&P 500 has averaged capital appreciation of 5.5% for the first nine months of the year and 9.7% capital appreciation for the full year. For all years since 1980, that means the S&P 500 has averaged 4Q capital appreciation of 4.2%.
For years in which the S&P 500 delivered double-digit appreciation as of the nine-month mark, fourth-quarter performance is better than average – with an asterisk. The simple average gain of 3.2% for those years is distorted by the 30.1% decline in 1987. Excluding 1987, fourth-quarter performance for double-digit nine-month years averages a gain of 5.9%. Just since the turn of the millennium in 2000, fourth-quarter performance for double-digit nine-month years averages a heady 7.4%. Much as in 1987, the year 2018 served as a sobering reminder that technical indicators can turn to dust in a fundamental world. The S&P 500 concluded September 2018 with a 9% gain – not quite double-digits though close. But as the fourth quarter got underway, the dialog between the U.S. and China deteriorated markedly. Stocks declined 14% in 4Q18, resulting in a fullyear 2018 decline (excluding dividends) of 6.2%.
We won’t pretend to be able to predict the next step in the trade war. What we can see is that the S&P 500 as of midSeptember 2019 is only a few percentage points above where it was in September 2018. Meanwhile, corporate earnings have continued to grow, and our normalized (five-year & centered) EPS calculation used for market valuation has also moved higher. Based on normalized earnings and the current index level, the S&P 500 at mid-September 2019 was trading a few percentage points below fair value, which we peg at 3,030. Our 12-month target price for the S&P 500 is 3,200, representing a 5% premium to fair value.
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