Quarterly Commentary 3rd Quarter 2019

Share this article

Over the past year, the major factors affecting stock market movement—expectations of Federal Reserve policy and administration comments about the China trade disputehave remained largely the same. What has changed is that market reactions are unfolding in an increasingly compressed time frame.

At the long end of a three-year process of Fed interest rate “normalization”, the stock market announced its unwillingness to tolerate any further increase in short-term rates with a decline of 20% from the beginning of 2018’s fourth quarter through Christmas Eve. The decline covered almost the entire three months. The Fed then announced “patience” as a replacement for its “normalization” policy, and the market recovered its fourth quarter loss in just over four months.

A rapid 7.5% decline in May of this year began in response to President Trump’s threat to hike tariffs on $200 billion of Chinese goods. Many investors were surprised, because U.S and China negotiators had previously indicated that a deal was in the works. This decline and a bit more were recovered by late-July, which marked all-time highs for most major U.S. equity indexes.

From that peak, stocks fell by a sharp 6.5% in a single week, beset by a combination of new tariffs on Chinese imports and disappointment when the Fed cut rates by less than investors had expected. Most of that decline was recovered by mid-September.

The sharp ups and downs of the third quarter left major stock market indexes relatively unchanged—some up, some down, but none by much. As I write two weeks into the new quarter, most major averages are down slightly, but the beginning of the fourth quarter has been explosive on a day to day basis. Mixed with some surprisingly weak manufacturing and non-manufacturing data, rumors about reduced expectations on the trade front cost the Dow Jones Industrials 1,300 points from Monday, October 1, through the first hour of trading on Wednesday, October 3. Trade prospects experienced positive revisions, and the Dow rose about 900 points over the next two and a half days through mid-day Monday, October 7, only to fall about 500 points through Tuesday’s close. A handshake agreement on Phase One of a trade agreement produced a 600-point rally into the week’s close. The rally was stronger until trader skepticism about the deal’s lack of specifics cut 200 points off the Dow in the last few minutes of the week.

Clearly, the action of the first two weeks of the quarter does not represent fluctuating opinions of true investors. It is instead the footprint of what has come to dominate markets in recent years—short term traders, often computers programmed with algorithms designed to react to news headlines.

To a firm like Mission that bases investment decisions largely on fundamental conditions, these volatile market gyrations are nothing more than noise that will produce little or no long-term effect. We are far more attuned to the fact that all major international forecasting bodies—IMF, World Bank and OECD—see U.S. and global growth slowing in late-2019 and 2020. The latest Federal Reserve minutes talked about greater risks to economic growth both domestically and internationally. The Fed’s long-term U.S. growth forecast is for a minimal 1.9% GDP growth rate. On top of that, corporate earnings for all U.S. companies have declined from their peak in mid-2018 and are expected to decline on a year over year basis in both this year’s third and fourth quarters.

It’s hard to reconcile a slowing economy and declining earnings growth with equity valuations second only to those in the turn-of-the-century dot.com mania, from which stock prices declined 57% over the next nine years.

On the other hand, the last decade has shown that central bank stimulus can overcome economic weakness as long as the investment community continues to believe that those central bankers will remain both willing and able to keep stock prices above historically normal valuation levels. While the New York Stock Exchange Index, which includes all stocks traded on that exchange, is below its high of January 2018, 21 months ago, it is only a few percent below that high. Investors have largely put their faith in the Fed. Looking at Europe, however, could provide reason for concern. Despite even more aggressive stimulus by the European Central Bank, the Eurostoxx 50 Index, Europe’s leading blue-chip index, is still well below that index’s peak, set almost two decades ago in 2000.

The Fed, ECB and Bank of Japan are all expected to continue providing additional stimulus in their attempts to ward off recession. That prospect leaves investors throughout the developed world in a quandary. Should they trust that central bankers will remain in control, as they have for the past decade? Or will underlying economic fundamentals, as they always have before, lead stock prices to revert to historic valuation means that are far below today’s price levels? How that question is resolved will likely determine investors’ economic well-being for a decade or more.