3 Reasons to Be Skeptical About President Trump's Stock Market Bullishness

The stock market rally has been primarily driven by defensive sectors

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May 22, 2019
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President Trump loves talking about the economy. He also loves talking about the stock market, particularly as a gauge for overall national success. Using the S&P 500 to judge the health of the broader economy is somewhat inappropriate (financially speaking), but that is beside the point. The real question is whether corporate America is actually providing the fundamental strength to justify the exceptionally high valuations that we see today. A recent research note from Morgan Stanley (MS) argues that earnings growth in the second half of 2019 will disappoint.

Play defence

If the economy is doing so well, then why aren’t we seeing better performance from cyclical stocks that typically rally during economic expansion? Sure, the large caps have been rallying so far in 2019, but that was to be expected given the Federal Reserve’s dovish pivot back in January. The note argues that defensive stocks have actually been responsible for much of the rally:

“We have been noting for months that the equity markets continue to trade very defensively under the surface. Specifically, low-quality cyclical stocks have rallied very little from their December lows, while defensive sectors and high-quality stocks are well above their all-time highs reached last year.

Since last summer when we made our call that growth was peaking, and upgraded utilities, staples and telecoms services stocks, utilities have been the best-performing sector, followed by real estate and staples. Furthermore, that defensive sector relative performance has widened during the recent trade-induced correction.”

By contrast, small caps have underperformed over the last 12 months. The Russell 2000, the most commonly used gauge of small-cap performance, is down almost 5% year-on-year. If the majority of the 2019 rally so far is coming from defensive stocks and blue-chip companies (perhaps boosted by corporate buybacks?), what does that say about the rest of the market? We think it implies that there is underlying weakness in expected corporate earnings.

Paying for yesterday’s excess, today

The note sees three overhangs from last year that may contribute to this. There first of these was last year’s inventory build:

“There has been a significant inventory build over the past year, some of which was due to an overheating economy which led to double-ordering, and some of which was directly the result of tariffs enacted last fall. There is now evidence from several leading semiconductor companies these inventories are beginning to be purged, which will weigh on GDP growth as much as the inventory build flattered it, to the tune of almost 3% over the last three quarters.”

The second was last year’s corporate capex splurge The tax cuts and repatriation of overseas cash allowed C-suites to invest more money than they otherwise would have into their businesses:

“During the first quarter we saw the payback begin with the big cloud computing leaders missing their capital spending plans by over 30%. Yet investors are still hopeful this capital spending will snap right back. We think such a snap-back is unlikely given the negative earnings story we see still from the customers of the cloud computing providers.”

The third factor is labor shortage. Today’s historically low unemployment rate means upwards pressure on wages, which could significantly compress margins, and potentially lead to layoffs:

“So far, companies have avoided big layoffs as they lean on other operating and capital expenditures to cut first. If they can avoid cutting labour then we are likely to avoid an economic recession. If not, then the risk of a recession increases substantially. Unfortunately, the re-escalation of the US-China trade conflict increases the likelihood of this outcome.”

Taken together, these factors suggest that the future may not be as rosy as present valuations suggest. While a full-blown recession may not come to pass, it does feel as if there could be a slowdown for investors on the horizon.

Disclosure: The author owns no stocks mentioned.

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