Stocks were higher in the second quarter but rose less than 2% for the 6 months ending June 30th. Years that see a flat or range-bound market within a background of strong earnings and economic growth are rare, but not unprecedented. Historical references are never perfect, but we see similarities to both 1984 and 1994. In 1984, the S&P 500 spent most of the year in a 13% range, while earnings growth was 21% and real Gross Domestic Product (GDP) growth was up 7%. In 1994, the S&P spent the year in an even narrower range while earnings growth was 9% and real GDP was 4%. Both years were followed by strong market performances of 21% and 35%, respectively. With earnings on pace to be up in excess of 20% in 2018 and GDP forecasts to be up above 4%, we think history would argue against being too negative here. We think it is also worth pointing out again that midterm election years have been flat-to-down until a fourth quarter surge, and the S&P 500 has not declined in the twelve months following a midterm election since 1946.
With the calendar entering the third quarter, the risk of a correction rises and perhaps the two most pressing things on investors’ minds are a somewhat more hawkish Federal Reserve and the escalating trade issues. Of the two, we are more concerned about the former and a possible yield curve inversion. We are bullish on the economy and corporate earnings. The data remains strong with small business optimism at near-record highs and retail sales beating all estimates. Yet with the yield spread between the 2-year and 10-year Treasuries at less than 40 basis points, there is risk if the Federal Reserve is committed to its current tightening path. History has shown that the U.S. economy and markets can live with a narrowing spread, especially with inflation at a low level, but an inverted yield curve would not be productive.
While trade issues seem to grab most of the headlines, we think they are the least understood. Several weeks ago the Trump Administration announced plans to impose 10% tariffs on $200 billion worth of goods from China. Note that this is $20 billion of tariffs, not $200 billion. That amounts to about 0.1% of GDP. In fact, if we add up all the proposed tariffs on China and other countries, which total $120 billion (most of which haven’t gone into effect yet), they are dwarfed by the policy stimulus of $800 billion resulting from the enacted tax cuts, government spending, and estimated repatriation of foreign profits.
The wall of worry seems higher today than at the market lows in early February with interest rates and trade the major concerns. Both look manageable in our view and are backed up by improving CEO confidence, the unemployment rate, wage growth, the PMIs, and consumer confidence. Of particular note is the 20% surge in capital spending by S&P 500 companies in the second quarter. This most productive use of capital reinforces our opinion that there is more time left in the business cycle and for equity prices to eventually move higher.
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