In the twilight of the holiday season, Charles Dickens came to mind; “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair”. Our references here are not only to the fourth quarter (worst of times and despair), but the earlier twelve months (best of times, epoch of belief), and maybe the entire preceding decade of Fed driven zero interest rates (an age of foolishness?).
Lots of ink and breathless commentary accompanied the fourth quarter decline that started the very first trading week of the new quarter, e.g. “The Worst December Since the Great Depression”, etc. Our take, simplistically, is that when the new Fed Chair Powell indicated on October 3rd, that after 8 (with 9 priced-in) interest rate hikes, there were many more increases to come, in combination with a contraction of economic activity because of China tariffs (higher prices -tariffs- equals lower demand), the markets and the economy reached some tipping point. Clumsy language and delivery by Chair Powell scared investors into thinking that the Fed possessed an unalterable course of action, markets and the economy be damned. In a strange synchronization, everything reacted negatively. The stock market started its decline, aided in part by mindless electronic trading which on some days amounted to 85% of the activity, oil prices collapsed, bond yields retreated at a furious rate (the U S 10 Year Treasury fell from an August high of 3.25% to 2.70% [Source: Factset Research]), and other commodities fell apart. Of course, fear begets fear and trend following took over. We were due for some sort of reset.
But what of the future? We could rattle off many sleep depriving concerns. They mostly center around debt, Federal and corporate, accumulated over a decade of low-to-zero interest rates, and the numbing acceptance of that condition after a benign 10 years. The possibility for an “accident” and related contagion is real. However, let us also focus other real conditions. The market’s decline has now priced the S&P 500 at approximately 14x price-to-earnings ratio for this year, down from 22x last summer [Source: Factset Research]. Earnings will likely slow from last year’s 20% growth, but would 5% or 6 % growth, on top of 2018’s growth, at a much-lowered price, be so bad? We pay careful attention to the earnings yield, the inverse of P/E. We view it a gauge to determine if economic conditions favor stocks over bonds or vice versa. The earnings yield using trailing four quarters is a P/E of 13.5x making the earnings yield 7.4% or a significant 470 basis point advantage to stocks over bonds (over the past 10 years it has averaged 2.3%) [Source: Factset Research]. The rate of unemployment is near a 50-year low. Core inflation, the silent thief, is steady at a tame 2%. The real economy appears to be growing at 3%, the best rate in well over a decade. The Fed, now, seems to be acutely sensitive to making a “policy mistake” and we believe will back off its march toward higher rates –or tightening. The same holds true for the European Central Bank’s monetary outlook as their member countries have hardly mended. We think that the domestic reflux from the China tariffs and the real risk of a recession to China will cause the negotiating parties to declare some sort of victory, shake hands, and go home. Many have described the anniversary of the tax cuts as the end of a “sugar high”, but I tend to associate that “high” with Keynesian programs (remember cash-for-clunkers?); this is a supply-side activity which tends to have more durable effects. Our disappointment is that much of the initial benefit of the tax cuts has gone toward corporate share repurchases, the “investment” of which went poof in Q4, and not into capital spending projects. Let’s see how that plays out if we can attain calm from the Fed and the administration. The U. S. consumer accounts for about 2/3rd of domestic production. In a December 4, 2018 interview on CNBC, Jamie Dimon of J P Morgan expressed that consumer balance sheets are in “terrific” shape. Wages are rising at ~3.1%. Financing costs have fallen along with interest rates. Much lower gasoline and other fuel prices are the equivalent to another consumer tax cut. The consumer is good shape.
We always remind investors that Radnor Capital makes investment decisions based on individual security valuations, not the top down assessments as referenced above (much of it paraphrased, with permission, from our friends at Strategas Research Partners). That does not mean we don’t think about these things.
There may be some blue skies in the year ahead.
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