With Earnings Season Around the Corner...
On a recent trip to Niagara Falls, my family and I crossed the border to visit the Canadian side and experience the semi-famous Maid of the Mist, the boat that takes you in, around, and under, North America’s most powerful falls.
As we waited in line for our turn, enjoying the beauty of the horseshoe falls, we were handed ponchos by staff. But when we watched the returning passengers exiting the ship they all looked quite dry. Perhaps the staff were being overzealous - clearly, today was a sunnier day than they were expecting. However, since they were provided, we slipped the ponchos over our heads and got on board.
As we were among the first on the ship, we managed to secure one of the best viewing points on the second deck just under the captain. The falls were stunning, with birds flying everywhere, and rainbows reflected in the rushing waters. The Maid took us closer and closer to the falls, which were utterly awe-inspiring, and yet still we were dry.
Until, suddenly, we were not. At a certain point in the ride, we were pelted with water, and shaken from side to side by the thunder of - as advertised - the most powerful falls on our continent, which gave us a beating we will not soon forget.
On our return from the heavy waters, the sun shone and the wind blew. Much like the passengers we saw before we boarded, we were entirely dry when we disembarked.
The 2018 markets got off to a similarly sunny start, with equities and commodities rallying significantly in January. As market sentiment reached a record high, we saw the return of volatility - something we had not experienced for the better part of two years - and the waters raged throughout the rest of the quarter, until markets finally regained their footing towards the end of March.
As the second quarter began, the sun broke out again, and equity assets continued to rebound from their first correction in about 500 days. However, lack of broad participation, the rising spector of tariffs, and privacy issues with Facebook brought back rough waters, and we re-tested the lows we had experienced in February.
The winds turned out to be less extreme in Q2, and markets found support as geopolitical concerns subsided. Equities and commodities began to rally. The rally proved to be short lived as concerns over global trade and doubts surrounding the collapse of a planned summit with North Korea put markets under pressure. Small-Cap stocks performed particularly well this quarter as fears surrounding global geopolitical issues were perceived to affect these companies to a much lesser extent, when compared to their large multinational and international counterparts.
While the overbought conditions that concerned us at the beginning of 2017 have been relieved, there remain a few unresolved concerns hanging over the market as we move into the back half of 2018.
Unlike the Maid of the Mist, which travels the same waters again and again, we cannot predict when volatility will appear. At present, we see the three biggest risks as:
Rising Interest Rates
Our first concern throughout 2018 has been whether earnings momentum has peaked. Tax cuts, solid economic growth, and the recovery in oil prices had combined to prolong the earnings recovery that began in early 2016 and strengthened throughout 2017. Current consensus estimates are assuming that earnings will accelerate, but consensus estimates such as these are typically optimistic, and tend to trend lower in the latter part of the calendar year. Growth in earnings, while still expected to be solid, is not likely to be quite as strong as last year.
Rising Interest Rates
Our second concern is whether interest rates will throw another tantrum, after the spike in yields we saw early in the year. Historically, interest rates start to be a drag on the economy when they hit around 5-6% on 10 Year Treasuries. It’s likely that since we are coming off of historic lows, we’ll feel this drag long before reaching that traditional pain point.
The speed of interest rate increases can also heavily impact returns. In the past, when yields have risen quickly, the S&P 500 has struggled versus those periods when rates have either fallen, or risen at modest speeds. The recent drop in the 10-year yield has provided a few rays of sunshine and relief from earlier this year.
Since the lows of 2009, polls have implied that the market has been climbing a wall of worry. Even small drops in the market have resulted in rapid drops in optimism. After our very long run of positive months with record low volatility, investor optimism reached a record high in early 2018 - implying that the wall of worry has been climbed. The correction in late January/early February briefly brought sentiment back into the pessimism zone, but pessimism has yet to approach the levels that corresponded with major bottoms in previous years. Sentiment may need to fall in order to have the market return to a sustained upward trend. It has already rebounded into “extreme” optimism, which historically has limited the higher returns in the market.
Extreme optimism such as this can entice some investors to make out of character decisions, such as selling everything that has been “a drag” on performance to load up on those parts of the portfolio that have been basking in the sunshine.
Back to the Maid of the Mist...
After disembarking, we took a walk up the steps on the U.S. side of the falls. My poncho caught on a pole and ripped and so, to entertain my sons, I tore it up like I was the Hulk, and threw it in the trash. The sun was shining, so my sons and I joined the many other tourists who had removed their ponchos to bask in the heat.
When we reached the top of the steps, I stopped to take a photo with my sons, with our backs to the falls.
Out of nowhere, a huge gust of wind suddenly formed, and gathering mist from the falls, soaked us completely from head to toe.
When the drenching had ended, my wife, who chose to keep her poncho, made fun of us for our poor decision.
You never know when the wind is going to change. Extreme optimism can leave us unprotected in volatile times, and dropping your guard can leave you soaking wet.
Investment decisions are best driven by data, rather than noise. In volatile times, keeping an eye on both winds and water, and using that information to carefully choose your opportunities, is more important than ever.
- Greg Stewart, CIO