Letter - April 2018

 

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Tumult

After a rip-roaring start to the year in January with the Dow Jones Industrials climbing to new highs, the stock market in February and March was characterized by falling share prices, lower valuations and higher volatility. Market analysts call the recent decline a healthy correction, a decline of 10% from the January high and much anticipated. As share prices significantly declined in the face of rising earnings, valuations came down to more reasonable levels and, as we write, the market seems to have stabilized in April. Though stocks are essentially flat for the year, investors have become more cautious questioning whether the long bull market is sustainable. We are reminded that it takes a certain amount of intestinal fortitude to be a long-term investor. It has been a tumultuous time. Short term sentiment is a fragile thing that can turn on a dime.

During 2017, investors viewed rising valuations with complacency, buying any dip in prices and deferring profit taking. (Revisit on our website, “Where Have All the Sellers Gone?”, our note of October 2017.) Anticipation of and final passage of tax cuts along with regulatory relief promised a surge of corporate profits and, to a lesser extent, middle class take-home pay. Stock valuations continued to soar in January until, at the end of the month, over-extended, the market began to fall.

As market psychology quickly changed, analysts talked about tax reform as baked into the market. Politics, all but ignored last year, started to dominate the market. President Trump’s proposal to place tariffs on foreign imports, for example, sparked fears of a damaging trade war though we suspect that the President’s hard line is a negotiating tactic that will yield to compromise. As we write, the market is sure to struggle with the implications of the weekend military strike against Syria in retaliation for alleged use of poison gas against civilians. Gold and oil have rallied as tension ratchets up.

As is the case during the long bull markets, investors become complacent, if not euphoric, about high valuations. Corrections remind investors that stocks do not go up in a straight line. But now there is something new in the air, an emerging skepticism about how highly stocks should be valued, a sense of vulnerability, that there is a dark side to technology. For example, Facebook stands accused of violating the privacy of its users by selling their data in pursuit of profit. What was once viewed as a unique and highly desirable business model now seems likely to be vulnerable to government regulation which could impact future profitability. Tesla has a market valuation that rivals General Motors though it produces and sells only a small fraction of the cars GM does. Profits?… not for the foreseeable future. The company is now facing a cash flow crunch due to production delays which will probably force it to raise new equity, diluting current shareholders. Is the Tesla car a visionary product of the future deserving an unlimited corporate valuation or is the company just another car company selling at 6 times some future earnings? Some are beginning to wonder. We view such skepticism as healthy for the market.

Good news: the economy is growing nicely. Growth is expected to approach 3% as the year progresses. Unemployment at 4.1% is historically low. Discouraged workers are reentering the jobs market keeping wage growth and inflation in check…for now. First quarter corporate earnings are on track to rise 17% or so year-on-year, an astonishing gain.

The Federal Reserve will continue to raise short-term interest rates this year in a deliberate and methodical manner that should support the equity markets. The risk here is that, aside from geo-political military confrontation, the economy overheats, forcing the Fed to accelerate a rise in interest rates to combat inflation.

As of now, we feel that the correction is just that: a correction, not the start of a bear market. Lower stock prices coupled with higher corporate earnings means lower valuations. This should help support the market. Internationally, growth is picking up in tandem with anticipated higher growth of US GDP. So, we anticipate an OK year for the market, not a great one. In the meantime we will have to get used to the tumult.

 

Tom Herzig

 

As a Registered Investment Advisor regulated by the Securities and Exchange Commission, P.R. Herzig & Co. is required annually to offer our clients copies of our form ADV Part 2. This form describes in plain English our business and how we operate. The form can be found on our website, prherzig.com. Hard copies are available upon request.


 

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