Canary in the Coal Mine?

It’s an understatement to say that the Great Financial Crisis of 2008/2009 has not easily been forgotten by US equity investors. It looms large in peoples’ psyche even today—eleven years later and well into the second longest economic expansion in US history. Investors and market pundits are extremely busy predicting the arrival of the next US recession.

Volatility is good! Volatility is bad! And other lessons that 2018 has taught us.

An apt description for 2018 might be “Be careful what you wish for.” It was a year that began with great promise and optimism but ended with disappointment along with a healthy dose of anxiety. In January, the change in the tax law was expected to generate higher economic growth than had been experienced over the prior several years. In fact, GDP growth did accelerate, wages, especially for lower income households, began to rise meaningfully, unemployment is now at a 50-year low, the Federal Reserve continued its normalization of monetary policy, and the outlook for corporate profits is strong. So, why is the stock market behaving so badly?

Context for the Correction

Since reaching a peak on September 24th, the stock market (S&P 500) has lost 9.6% of its value as of Friday, November 23rd, taking us back to where we started the year.  Losses have been greatest in the technology sector among previous high fliers, but the selloff has been broad based.  Even though it’s impossible to explain any market movements given the infinite number of factors that influence security prices, following is a list of potential explanations: 

Everything is Connected

The stock market continued to grind higher as an expanding economy and strong earnings growth outweighed concerns about trade wars and fragile politics both here and abroad. During the second quarter, the Gross Domestic Product in the US grew at a rate of 4% while corporate earnings surged by 25%. This economic expansion is predicted to continue for the remainder of the year.

Up in Smoke

There are sectors of speculation in every market that defy reasonable valuations. In the late 1990s, many Internet stocks with flimsy business models were bid up to stratospheric levels. One dozen years ago, speculation in the housing market reached historic proportions as the banks provided easy credit to risky borrowers. Housing prices in many markets are still way below the highs reached during the bubble. Last year, Bitcoin and other crypto currencies exploded higher only to deflate by 50% this year to date.

The latest craze is the cannabis market.

Tax Update

Fall is typically an opportune time to take stock of one’s finances in preparation for the upcoming income tax preparation season. For many taxpayers, income taxes for the 2018 calendar year may prove to be a much simpler process due to the passage of the Tax Cuts and Jobs Act late last year. However, that doesn’t mean that there aren’t any opportunities to take some strategic steps now to save on income taxes come April 2019.

A Balancing Act

The second quarter has been in many respects a continuation of the first quarter wherein financial markets have provided investors with little or no return on their investments. Today’s markets appear bewildered and subject to relatively sharp moves based on news stories and political maneuvering. Rising interest rates, potential trade wars, geopolitical concerns (populism, EU difficulties, sanctions) and a growing fear that the end is near for the long, but weak, economic expansion in the US all bear some responsibility for the confusion. Markets are driven by fundamentals and by emotions.

Auditors and our Research Process

Our research process starts with a screen to narrow down our investable universe to a more manageable number of names. As the screen is reviewed, more names are removed from consideration due to unattractive qualitative factors, such as extreme cyclicality of revenues or earnings. A few names are targeted at a time for a deep qualitative dive, which includes a checklist of characteristics we want the company to demonstrate, such as sustainable margins and shareholder friendly management.