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Stock market volatility has increased over the past several months as uncertainty over trade talks, tariffs and Fed policy have dominated the news. The market has remained in an upward trend for the year, however, helped by stronger than expected second quarter earnings reports. Earnings for the S&P 1500 companies averaged 5% higher than expectations with positive surprises in all 11 sectors. Healthcare and communications services registered the strongest growth in the quarter with both sales and earnings rising at double digit rates. On the flip side, energy and materials saw double digit declines in year-over-year earnings but those earnings were above expectations. All 11 sectors have generated positive stock price increases in 2019.
The current economic expansion is the longest in history but risks to its continuation are rising. Falling yields signal slower growth as do softening commodity prices and a weakening global manufacturing sector. But consumer spending, which accounts for 70% of the U.S. economy, remains strong. Despite the very real problems of trade wars, tariffs, Brexit and possible recession in Europe, U.S. consumers continue to spend freely. Unemployment is near a 50-year low. Wages are rising at the fastest pace in over a decade. Home values and 401(k) balances are quite high – all of which are keeping consumer confidence at a high level.
Strength among consumers and in the services sector have helped investors brush off talk of an imminent recession for now. Recent Labor Department data showed the U.S. extended a record 107-month streak of job creation, while the service sector grew for the 115th consecutive month. One negative leading indicator that has gotten a lot of press is the inverted yield curve (longer term interest rates are below short-term interest rates). However, an inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn't as accurate a predictor of economic downturns as widely believed. It can be misleading.
Economist Ed Yardeni recently published a study "The Yield Curve: What Is It Really Predicting?”. He concluded that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So, investors on the lookout for a recession should instead pay attention to credit availability and bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch. Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.
On a valuation basis, stocks remain attractive relative to bonds. The 10-year US Treasury bond yield at 1.7% is below the S&P 500 dividend yield, at 1.9%. The drop in the US bond yield since the beginning of the year certainly has benefited dividend-yielding stocks. The S&P 500 sectors that tend to have lots of dividend-paying companies have outperformed those that tend to have fewer of them. During August, the bond yield fell below the inflation rate. In other words, in real terms, bond yields are entering negative territory. Low interest rates should continue to benefit dividend-yielding stocks.
Craig A. Vander Molen, CFA, CPWA ®
Managing Director and Chief Market Strategist