Right out of the gate stocks went into risk on mode with all but one sector finishing the first week of 2018 in the green. Rate sensitive utilities were the lone loser, down almost as much as the S&P 500 (SPY)* was up. It’s easy to get excited when you start off the year this strong but there’s a lot of blocking and tackling ahead not to mention an earnings season that kicks off Friday. Financials are first up with Blackrock (BLK), JPMorgan (JPM), PNC (PNC) & Wells Fargo (WFC) scheduled to report. Expect a lot of one-time charges for deferred tax assets and liabilities on the heels of the tax overhaul.
Investors will likely look through these one-time items and focus on what really matters; organic sales and earnings growth in that order. I put sales at the top of the pyramid because in the end that’s where it all starts. Every accountant and analyst knows there’s a lot you can do to massage the bottom line. Sometimes it comes from the inside as management pushes the accounting envelope and sometimes the outside i.e. a major tax overhaul that dramatically reduces the tax burden and gooses earnings. However, before a company can have earnings it first has to have sales. There isn’t a lot you can do to fudge the top line and if you do its likely fraud.
‘I’m getting worried because I’m running out of things to worry about’
Readers know I made the statement last year but of course therein lies the problem. It’s what we can’t see or forecast that gives us the biggest headaches. Right now markets are on I-95 North and the road is clear but somewhere lurking in the shadows is black ice. Every soldier and for that matter every pilot understands the term situational awareness. Know there are off the radar challenges and risks so be prepared to react. I haven’t met the investor or portfolio manager who hasn’t had to change course or back away from a bad call. Getting it wrong is just part of the journey. Staying wrong is the only unacceptable path.
On the asset side of the balance sheet the soft data is superb with consumer and business confidence at highs. Investors just got a year-end bonus from a tax overhaul that points to $150 in S&P (SPY) earnings or 15% growth year-over-year. All of that is great news but the market knows that. Stocks are a discounting mechanism that look to the road ahead not in the rear view mirror.
No balance sheet is complete without liabilities and first up as I pointed out last week is China. I thought I was the lone voice on what I believe to be a rising threat but Goldman’s Jan Hatzius referred to it in his latest note The 2018 Political Outlook: Mr. Hatzius attacks the issue from the point of view painting the Trump administration as the aggressor expecting a number of trade sanctions in the next several weeks. I see it somewhat differently in that China has already shown their political playbook when they put trade sanctions on U.S. ally South Korea in response to the roll out of our THAAD missile defense program.
Regardless of which direction you view the problem, China and its relationship with the United States is likely problematic for investors in that trade sanctions regardless of how they originate are an economic event. Investors have profited from a buy the dip mentality following most geo-political hiccups but trade sanctions can affect the earnings streams of some of your favorite companies.
The other cloud on the horizon is the Fed and rate policy for 2018 and beyond. The Fed is on a path to normalization but despite rhetoric I don’t see how they can push the short end of the curve beyond 2%. With rates at the long end falling for most of the past year, the danger is forcing an inverted yield curve prompting calls for the dreaded R word.
All in, we’re on this train until it stops or at least slows down. The challenges and risks are real but so are the sales and earnings growth. Despite clouds on the horizon pilots don’t keep the plane on the ground just because there’s some turbulence enroute. After 14 straight months of positive stock returns somewhere along this journey the pilot is going to turn on the seatbelt sign.
*At the time of this article some funds managed by David were long SPY