“Never be afraid to sit awhile and think”
The end of 2018 was one of the more tumultuous periods for the markets in the last decade as equities swooned and the New Year has opened with a stiff dose of volatility. The easiest response for a long term investor is “buy the dip” but before venturing down that path we think it is important to review the factors driving the treacherous markets and we’ll highlight the issues we’re watching most closely in this quarterly update.
While President Trump blames the Federal Reserve and Chairman Powell for destabilizing the markets by raising interest rates, we believe the risk presented by a trade war with China is more troublesome. China’s restrictive trade policies and intellectual property theft have been valid problems for American companies for many years. However, the imposition of tariffs on goods entering the USA from China has disrupted supply chains and complicated operations for many businesses in America and China. Apple pre-announced disappointing results and cited trade tension with China for weak iPhone sales in that market. The Institute for Supply Management (ISM) released its monthly measure of manufacturing activity and it declined 5.2 percentage points to 54.1 and we believe that much of the weakness is attributable to the tariffs that were implemented this fall. We suspect that other businesses will identify China trade issues as a source of weakness in the upcoming earnings season. American and Chinese negotiators are working to resolve the trade conflict by a March deadline. Should no progress be made the US has stated it will increase tariffs from 10% to 25% on all goods imported from China. We believe it is in the best interest of both countries to compromise and settle the trade dispute.
Although the noise from the trade war is spilling into the real economy there is a point at which fundamental valuation matters. Currently algorithmic traders, which represent 90% of the daily trading volume according to a study by JP Morgan, are causing violent swings in the market as trading programs issue orders based upon technical market factors, economic data, and code words such as “tariff”, “China”, and “interest rates”. The valuation of the S&P 500 is currently at 17.3X trailing earnings and 14.8x forward estimates. Over the last 20 years the average trailing price/earnings ratio of the S&P 500 has been 23.5x, ranging between 14x and 46x trailing earnings. Additionally, the yield on the S&P 500 is 2.1% and it has ranged over the last 20 years between 1.2% and 3.2%. By both measures the market appears to be reasonably valued. While we expect downward earnings revisions to serve as a headwind for near term equity appreciation, we think at current valuation levels it would be unwise to aggressively sell stocks, incur capital gains, and then try to guess when the storm clouds will clear. We prefer to mitigate risk by keeping funds that clients will need in the short term in money markets or treasury bills, and invest longer term assets accordingly.
Looking forward, resolving the China trade war, finding a path for the UK Brexit, and a conclusion to the Mueller investigation, are all likely to occur during 2019. We do note that this is an unusual period for the market because it is set up for a binary outcome. With a resolution to the trade war the economy is likely to experience a modest slowdown. However, should the trade war worsen then there is a risk that the economy could slide into a recession. Since November we have been assembling a shopping list of companies to purchase should market volatility present opportunities. Overall, we’re comfortable with the quality of the companies held in client portfolios and we continue to believe that owning well run businesses that generate solid free cash flow and deploy that money in shareholder friendly activities is the recipe for long term investment success.
Our firm is stronger with the addition of Joe Ryan following the merger of our firms on November 30. We welcome Joe and his clients to Ayrshire and look forward to working together for many years ahead. Thank you for entrusting Ayrshire Capital with the management of your money and we look forward to speaking with you in the months ahead. Happy New Year.
JM Sam Nevin, Jr.
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