10/19/2018

Looking Backward and Forward on The Market

Below is a market commentary excerpt from the quarterly review of our flagship strategy, The AFG50.  The AFG50 is a large core, sector neutral, low turnover strategy that has consistently delivered strong performance vs. the S&P500 with less than 20% turnover.   Firms that implement this strategy also receive written research support on each stock, updates that reflect the overall outlook/attractiveness, and detailed proforma models with target prices.  If you would like to learn more about the AFG50 please fill out the web form below and we can schedule a brief conversation.

18Q1 is probably the phase one of a likely lengthy battle between two opposite forces. On the one hand, the Fed in mid-March lowered its unemployment rate expectation for the US to 3.8% by the end of 2018 and to 3.6% by the end of 2019, down from the prior forecast of 4.1%. The Fed also projected U.S. economic growth of 2.7% in 2018, up from the previous 2.5% forecast, and raised GDP growth for 2019 from 2.1% to 2.4%. At the same time, the global economy is growing at its fastest pace since 2010, with global GDP growth projected to be 3.5% in 2017, strengthening further to 3.75% in 2018 before easing slightly in 2019, according to OECD Economic Outlook provided in November of 2017. The S&P500 ended 2017 with adjusted EPS up ~11%, revenue up ~6.4%, and the index’s growth is expected to accelerate in 2018, with EPS growing at 18.4% and revenues up 6.6%, according to Factset. Consumer confidence remains at very high levels, at 130 in February, the highest since 2000, and 127.7 in March. On the other hand, headline CPI rose 2.1% on an annualized basis in January, against expectations of 1.9%, and the consumer price index rose 0.5% against projections of a 0.3% increase. Worries about rising inflation, and therefore potentially faster interest rate hikes by the Fed, provided some investors the perfect fodder to sell stocks. From January 26 to February 8, the S&P500 lost 10% of its value. Then February CPI growth retreated to only 0.2%, which eased some inflation fears. The S&P500 rallied back nearly 8% in the month following the February trough, until external factors hit the market. In mid-March, President Trump fired Secretary of States Rex Tillerson, and later replaced National Security Advisor McMaster on March 22. Those important cabinet shuffling were taking place when the Trump administration also announced plans to impose tariffs on steel and aluminum, and to impose tariff on up to $60 billion worth of Chinese imports. So far, the US has granted temporary exemptions to most countries on the steel and aluminum tariffs so negotiations could continue. For tariffs on Chinese goods, specific actions won’t occur for at least one month, and our belief is despite heated rhetoric, the two sides will work actively in the coming weeks to reach concessions and avoid a trade war.  It is also important to note, $60 billion is only ~0.3% of the US GDP. As a result any trade friction with China, if limited to the current scope, will have very small impact on the US economy, though some spill-over effect could happen. Regardless, the S&P500 closed Q1 down nearly 1%, as the negative force which fear inflation, dread higher interest rates, and detest any negative events whether big or small, won.

It is important to note that we welcomed a possible breakthrough on North Korea in the first quarter. In early March, North Korea says it is willing to discuss denuclearizing the Korean Peninsula with the United States, a key requirement laid out by the Trump administration as a precondition for talks with NK. This extended olive branch was followed by a visit to NK by a South Korea delegation, then a surprise visit by Kim Jong-un to Beijing. The latest is Trump would meet with Kim by late May. Should denuclearization of the Korean peninsula become a reality, it would remove a long overhang to the market and be a very positive contributor to the world peace in the long run.

From a valuation perspective, many holdings in the AFG50 saw their intrinsic value estimates increase, due to the holding companies maintaining or increasing their operational outlook in the near to mid term, partially helped by lower corporate tax rates, as a result of the US corporate tax reform. Many companies announced well balanced plans to utilize their tax savings, including: accelerating capital investment, boosting employee wages and benefits, and returning capital to shareholders. The first quarter gave us a good taste as how the stock market might behave differently from a healthy overall economy and good earnings growth prospect. While broad economic data on unemployment and GDP deserve cheers, investors chose to focus on the interest rate implications from those rosy economic indicators, and decided the resulting higher interest rates would overwhelm any positive upside on corporate cash flows. “Where are we in the cycle?”, investors ask. The consensus seems to be, we are late in the mid cycle, but, odds of a recession in the next two years are still very low, in the 20s, according to some estimates. What should an equity investor do in a late mid economic cycle, is currently a popular topic for pundits and strategists. Some say exit now, despite the risk of exiting too early, while others say, exit later despite the risk of exiting too late. The truth is nobody knows what the perfect timing is in any cycle to enter, exit, add, or trim equity positions. We continue to believe for equity investments, especially with equity investment being a critical part of long term financial planning, the best strategy is to invest in undervalued stocks (not the index) and let the cycles take care of themselves, which would allow investors the luxury to reap the benefits of time arbitrage.

We understand that investors’ memories of the last two bear markets are still very fresh. From August 2000 to Sep 2002, the S&P500 lost nearly 50% of its value, and from late 2007 to early 2009, the S&P500 was halved again. We want to reiterate our view that we don’t think the current situations bare much similarity to the conditions preceding those two crashes. The 12 months forward P/E for the S&P500 is currently ~16 times including the tax cut benefit, which suggests an attractive earnings yield of ~ 6% relative to the ~2.8% yield of the 10-Yr US treasury. Back in 1999/2000, the earnings yield of the SP500 was ~3% relative to the ~6% yield for the 10-Yr Treasury. Financial institutions have largely deleveraged since 2008 and their capital positions are strong. For consumers, household debt service payment as a percentage of disposable income is around 10%, down from 13.2% in late 2007 and is the lowest in the past ~30 years. In addition, wage gains are accelerating with average pay rose by more than 3% in at least half of U.S. states in 2017, up sharply from previous years.

2018 will likely be an eventful year, and we already experienced a quarter packed with an impressive stock market rally and a big correction. Moving to the rest of the year, the outcome of tariff negotiations, NAFTA renegotiations, denuclearization talk with North Korea, and the mid-term election could create more challenges and opportunities for the US stock market. We will sit tight, observe and assess keenly, and keep our focus on the long term.


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