July 23, 2019
Dow Jones Average: 27,172
S&P 500 Index: 2,985
The Fed Reverses Course
It became increasingly evident over the Spring and early Summer that the Federal Reserve planned to lower interest rates by cutting the Fed funds rate. While the Fed has not formally made that move yet, the changing language of the Central Bank members signaled to investors their future intentions and the yield on previously issued bonds fell sharply. As interest rates fell, stock prices rose. Investors then started to anticipate multiple interest rate cuts by the Fed and stock prices rose even further. The relationship between interest rates and stock prices dominated all else during the quarter.
The direction of stocks over the course of months and quarters can often be hard to understand. To an outside observer it may seem like a random walk, and there are times when it feels that way to more seasoned investors as well. However, as we wrote several years ago, over a longer time frame, there are only a few variables that matter to long-term stock investors. The pace of economic growth and, more importantly, how that growth impacts corporate earnings is of primary importance. Stock prices typically follow the underlying company earnings higher and lower. A second critical input is the level of interest rates worldwide. High interest rates mean investors earn a substantial level of income from bonds. Some investors will sell stocks in favor of bonds when interest rates are higher. Low interest rates result in the opposite effect, with certain investors selling their bonds and piling into stocks in search of higher yields.
While lower interest rates have buoyed stocks in recent months, the reason for lower rates is troubling and presents a headwind for further stock market gains. It is widely anticipated that the Federal Reserve will cut interest rates in an attempt to underpin a flagging global economy. There has been a spate of worsening global economic news and reduced profit outlooks for companies as of late. The Chinese economy is now undoubtedly slowing and most European economies are hovering at a standstill once again. The proportion of companies warning investors about disappointing results this year has reached a level that matches early 2016, the last time that the global economy teetered on the edge of a recession.
Once again, as in 2016, the last pillar of economic strength appears to be the U.S. consumer. Employment is strong and, despite muted wage growth, people are still spending. Resilient consumers may keep the U.S. economy from tipping into a recession. A full-blown recession never materialized in 2016 and stock prices were supported by a large corporate tax cut later in that year. Investors now face the possibility of recession once more, with no dramatic fiscal stimulus likely from a politically divided government. Lower interest rates from the Fed can prop things up for awhile, but if earnings begin to erode we think that stock prices will begin to wilt as well. At current levels it seems to us that the balance of risk and reward for investors is starting to tilt in a negative direction.
Many investors are aware of the risks posed by high stock prices and a slowing economy. Recessions have a way of exposing all the economic dirt that gets swept under the rug during good times. Investors have already started to move away from economically sensitive stocks to those that are more immune to difficult macroeconomic conditions. Staying heavily invested in a high market facing recessionary trends is a tricky proposition. If and when a recession eventually takes place the major market indices will almost surely decline, taking down stocks that currently seem impervious to economic forces. Over the past few months we decided to sell a number of our most economically sensitive investments. The prices we received on the sales look good in retrospect. Some of the proceeds went into smaller, domestically focused, growth companies. And the remainder went into the money market fund which still yields over two percent. We expect stock prices to react, in some cases quite strongly, to earnings reports this month and in the fall. We are ready to redeploy some of the cash reserves if certain stocks become more attractively priced.
The sharp drop in interest rates last quarter interrupted our strategy of rolling maturing notes into new, somewhat longer-dated Treasury notes. Bond investors have come to the conclusion that the Fed is going to cut interest rates in a dramatic fashion. If the expected cut is somewhat smaller than anticipated, we may have a better opportunity to lock in some yields in coming months.