Posted on OCT 11, 2018
Investment Commentary | Thursday, October 11
This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
Black Wednesday? We don't think so.
Everyone loves a headline, and the financial media love nothing more than to put a large, ominous number into them. Yesterday's 800+ point drop in the Dow Jones Industrial Average (DJIA) made for riveting headlines this morning. Then today, the DJIA declined another 545 points.
It's important to keep in mind that with the DJIA near 27,000 points when this started, the two‐day drop represents less than 5% of the index value. Profit taking for sure. In 1987, Black Monday represented more than a 20% drop. Here is our take on what is transpiring in the equity markets.
Top 5 Names
The top five stocks in the S&P 500 Index, by market capitalization, represented over 15% of the index at the beginning of the month, or more than $4 trillion. The bottom 250 stocks represented less than 13%, or less than $3.5 trillion. Among the top 10 stocks are the technology darlings of the last several years — Amazon, Netflix, Google (Alphabet), Facebook and Apple. These stocks have had a phenomenal run as they've made their way into every part of our lives. Who hasn't Facebooked, binge watched or bought something in the last week, likely using an iPhone for all three? If you haven't, you were probably off the grid, climbing a mountain or something.
These stocks represent the growth part of the equity market, and it has been on a tear. Meanwhile, the more mundane value stocks have been languishing. Over the last two weeks, we've begun to see these growth names underperform other parts of the market, particularly utilities and industrial stocks. Given their long run and being priced for perfection, this comes as no surprise. Even well‐run companies producing enormous amounts of free cash flow are questioned by investors once in a while. Or investors are willing to take some profits to reduce their out‐sized positions in these companies.
The other thing affecting stocks recently is the headline news that intermediate‐ and long‐term interest rates have been rising at a faster clip. The Federal Reserve last raised the Fed Funds interest rate several weeks ago. Since then, Fed Chairman Jay Powell has made comments about how comfortable it is with that move and its future forecast for another four hikes between now and the end of next year.
This isn't news. The Fed has been publishing a long‐range forecast for quite some time that highlighted these rate increases. As noted in last week's commentary, as long as it has cover from a strong economy, labor market and low inflation, the Fed is probably right to distance itself from the zero percent interest rate we had for the better part of the last decade.
Even President Trump got in on the act, referring to the Fed policy of raising rates as “crazy.” His administration's policies are meant to create growth, and he knows that higher interest rates will eventually create a headwind for that growth.
Bond investors are a stubborn bunch and usually a glass‐half‐empty crowd. While the Fed may control short‐term interest rates, those investors are in charge of how intermediate‐ and longer‐ term rates are set. They haven't been convinced that the Fed would follow through on its promise. And more recently, they view the stronger economy as giving the Fed cover. However, because they are stubborn, they won't continue to demand higher interest rates if they see any potential weakness in the economic outlook in the next 12 months.
Some believe that weakness could come from the tariffs already imposed and a prolonged trade war with China. China represents not only the largest part of our trade deficit, nearly $400 billion, but also is our largest trading partner, representing nearly $700 billion. A good portion of that trade deficit comes from consumer goods sold here in the U.S. As the trade tiff heats up, it is expected that it could become a headwind to consumption growth, reducing economic activity and ultimately reducing corporate earnings. Because stocks are trading based on expected earnings growth of nearly 25%, anything that suggests a faster slowdown than currently expected will hamper stocks' ability to continue to rally.
We believe it is simply an overstatement to suggest that yesterday's 800‐plus point drop is anything like a Black Monday event. (Keep in mind that the stock market finished positive for all of 1987 despite that big October drop.) Rather, we are seeing those stocks that have performed extraordinarily well come off their highs as investors take profits. We're also seeing bond investors wrestle with the potential for future rate hikes and a better economic picture than they were willing to assume.
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.
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