Third Quarter 2018

Stocks closed the second quarter flat-to-higher.

At quarter-end, the Dow stood at 24,271 (↓ 1.8%), S&P 500 stood at 2,718 ( ↑ 1.7%) and the NASDAQ Composite stood at 7,510 ( ↑ 8.8%).  Again, performance was largely driven by the tech sector.  The Dow posted a negative return with a 14% weighting in tech, the S&P 500 posted a better return with a 26% weighting and the NASDAQ Composite posted the best return with a 46% weighting.  So, performance rose as tech exposure rose.

Much of the tech performance can be traced to four names, dubbed "FANG" by the investment community, and other tech heavy-weights, like Microsoft and Apple.  You did well if you concentrated investments in tech but here's some history to reflect on...

  • In the late 1990s, portfolios concentrated in the hot tech and telecom sectors beat the S&P resoundingly while higher quality and more diversified portfolios lagged behind.
  • In 2000, the bubble burst and portfolios concentrated in tech and telecom suffered catastrophic losses, ranging from 60-80% and more.  In our experience, it is very difficult to recover such losses.  For example, it took the S&P 500 17 years to recover its losses.  By contrast, portfolios with high quality and diversified holdings suffered only moderate losses and recovered shortly.
  • In 2006 and 2007, portfolios concentrated in the hot housing and financial sectors beat the S&P 500 resoundingly. Once again, higher quality and more diversified portfolios lagged behind.
  • In 2008, the bubble burst and portfolios concentrated in housing and financials melted down, suffering catastrophic losses. Once again, portfolios with high quality and diversified holdings suffered moderate losses and recovered shortly.

There is a message here. As stock prices become "richer" and markets become more speculative, participation narrows. Yet, that is when people chase returns, driving prices ever higher and creating bubbles.  Ultimately, bubbles burst.

Is FANG the next bubble?

Maybe. As stock markets and sectors become more speculative, they become more reactive to disappointments.  Witness, on July 25, 2018, Facebook (FB) reported gross revenues up 42%, missing analyst forecasts and warning that revenues would stall near-term.  The following day, it was severely punished by investors, dropping 19% and shedding $119 billion of market value in a single day.  Recent FB performance may or may not represent the first chink in the armor.  But, it's worth noting Amazon (AMZN) and Netflix (NFLX) are trading at around 120 time earnings, leaving little room for disappointment.  Alphabet (GOOGL) remains valued at a more reasonable 28 times earnings.  

The economy is on a roll.

Driven by deregulation, tax cuts and low interest rates, gross domestic product (GDP) grew by an annualized 4.1% in the second quarter.  Importantly, the economy shows no signs of overheating or slowing down.

Overall unemployment stands at 4.0%, as shown in the following Table.  Notably, black and Hispanic unemployment rates hit all-time lows, whereas women's unemployment hit a 65-year low. 















Inflation remains tame. During the first half, it rose by an annualized 2.1%, in line with the Fed's target. But, it should be noted that it rose from an annualized 1.8% in January to 2.4% in June.  Whether or not this reveals an emerging trend bears watching. What does this mean?  Workers can bargain for higher wages and benefits, evidenced by the recent rise in the employment-cost index ( ↑ 2.8%). Coupled with recent tax cuts, it means they have more money in their pockets. Hence, consumer confidence remains high and retail sales remain sound. This is critical as consumer spending represents about 71% of our economy. 

Business investment is still missing and it's critical to productivity. Since the 2008 meltdown, business has used excess cash flow to reward investors with dividends and buybacks, resulting in low capital spending and the oldest plant and equipment on record.  But, this may be changing.  Business is gaining confidence in the economy and recent tax cuts reward capital spending.  Business investment creates productivity, and productivity creates "real" economic growth in excess of inflation.

All eyes are on the Fed.

The Fed remains confident in the economy.  Accordingly, it's hiked its benchmark rate twice this year (current range of 1.75% to 2.00%). Also, it's expressed intent to hike them twice more before year-end (future range of 2.25% to 2.50%).  Even so, this leaves the Fed short of its goal to "normalize" rates, which implies further hikes in 2019.

Clearly, this is not good news for borrowers because they'll pay higher interest for their credit cards, and installment and home loans.  But, it's mixed news for savers. The good news is they'll receive higher current yields on their investments.  And, the bad news is most (if not all) investments will fall in value.  Already, this is showing up longer-term bonds, preferred stocks, and income-oriented common stocks.



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