In my 30-plus year career, I have been through four or five other markets like the current one. It’s unloved, and many folks, including savvy institutional investors, have been underinvested. We continue to struggle over each rung on a ladder of worry, including several concurrent trade wars, an inverted yield curve, negative rates spreading around the globe, declining earnings, decelerating economic data, and more.
In the face of all this, the market has been hitting new historic highs. Why this apparent disconnect between fundamentals and reality? That brings me to an adage that has held true throughout my career, and that is, DON’T FIGHT THE FED.
Rather than struggle up each rung, we should be taking the central bank’s express elevator to the top. Time and again, it has proven a fool’s errand to go against central banks once they have opened up the liquidity spigot. With rates dropping towards zero, a melt-up scenario seems more probable now than a recession. In addition, the Fed is now pausing after three rate cuts, which historically points to a higher market twelve months out.
Much of this newly robust scenario is still contingent upon a Phase 1 China trade deal, a resulting bounce in business sentiment and bottoming manufacturing PMI, continuing accommodation by central banks, potential fiscal stimulus, and rising earnings comparisons. Should this materialize, we could be in store for further highs in equity markets and other risk assets. Valuation will play a role in dampening the move upward only to the extent that earnings fail to keep up. The market should be willing to tolerate PE multiple expansion in the neighborhood of 18-20x earnings until that catch-up is realized.
While most boats may rise during this classic melt-up phase, we still continue to favor growth stocks and dividend payers, although deep cyclicals are also showing signs of strength. Staying diversified is critical, as many other asset classes that have been out of favor may start to display outperformance during this period, which may include developed international, emerging market, and small cap equities. Finding entry points on individual common stocks will be tricky as we see the new-high list swell, but our research team will maintain our disciplined approach to initiating positions.
It is difficult to be sanguine this late in the market cycle, but the ingredients for a recession that looked more probable just three months ago have begun to dissipate. This outlook could still change quickly given the fragile state of most global economies, so stay tuned to further updates.
Please call or email me with any questions at 804-774-2087 or Jesse.Ellington@MiddleburgFinancial.com.
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