The Economy and Earnings Look Great

  • Eugene Yashin & Matt Etter

Eugene offers insights on factors that could influence markets.

Market Overview:  The economy and earnings look great. Stay positive and keep long-term prospective!

US Economics:  With GDP growing at 4.1% in the second quarter, things look rosy on the domestic front. Healthy sales at health care stores, restaurants, and the Internet and upturns in industrial production and factory use point to the expansion continuing, in our opinion. Supported by a bright employment outlook, we believe the economy should grow further, perhaps moderating its pace in the 2nd half of the year. Even in the case of escalating trade disagreements, the historical experience suggest that the direct economic effects would be limited. Currently we see little risk of a recession based on our Macro forecast. Inflation, unit labor costs, and inflation expectations show no sign of overheating yet, but a historically tight labor market might present some challenges in the future.

Global Economy: Per JP Morgan, the Euro area and Japan contributed to the global growth disappointment at the start of the year, but it is encouraging to see them rebounding. On balance, the Euro area and Japan look to have expanded 1.8% and 1.1% annualized in the 1st half of 2018. Growth for both looks to have been much weaker than the 3.2% projected US pace, which was roughly 1% stronger than had been anticipated at the start of the year.

Top Revenue Growers Dominate: Since late March, when trade tensions grabbed the headlines, stocks with top revenue growth (judged by the last 4 quarters) led the market by 10% in one of the best runs on record. According to Empirical Research, there have been eight similar episodes over the last 65 years. Except for one, each period ended with severe underperformance by stocks with the strongest revenue growth over the subsequent 12 months.  So, there are periods of time when “growth companies” get over-extended and start to add substantial risk to a portfolio.   

In other words, imagine you are going on vacation to ski with your family and you all step out of the gondola for a nice easy run down the mountain to get some lunch. It’s a beautiful sunny day and a bit nippy.   You go left and snake back right and back left laughing and enjoying the nice powder.  You turn back to take a video to show everyone on Facebook of how much fun you are having.  All of sudden you are off trail and onto a much more difficult slope. The grade starts to steepen, and your skis get away from you.  You start to lose control and tumble, realizing you made a terrible mistake.  That feeling is what can happen in the stock market with regard to growth companies once high expectations become too difficult to achieve.  Our goal at Signet Financial is to manage risk and look for valuations that make more sense for long term portfolios.  Sure we seek growth, but at a reasonable price.  It’s important focus on long-term goals, and not get off course and hung out over the tips of our skis.  That’s the key to long term success.

We have conducted a rough simulation of what a Growth at Reasonable Price approach would do in a similar investment regime around the late 1990’s, when internet technology stocks boomed. We used the same broad factor groups we currently use to select undervalued companies with good growth prospects. We constructed a portfolio with similar characteristics to our current strategy, rebalanced quarterly to calculate hypothetical returns.  We changed the Valuation factor group weight from Low to Normal to Only Value weighting in the factors used to select the simulated portfolio. As you remember in 1998 and 1999, growth dominated returns and investors didn’t reward value as an investment strategy. As you can see from the graph below, starting from the end of the first quarter 1998 the simulated portfolios lagged the S&P 500 between 6-10% through mid-1999, depending on the weight of Value in scoring. However, following the dip the recovery was swift and significant. The cumulative alpha (the difference between the simulated portfolio and the S&P 500 returns) became positive in 2000. The lesson learned is that price and valuation matters.  Stay the course and keep the faith in a well-designed, long-term approach.





Past performance may not be indicative of future results. Different types of investments and investment strategies involve varying degrees of risk, and there can be no assurance that their future performance will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. The statements made in this newsletter are, to the best of our ability and knowledge, accurate as of the date they were originally made. But due to various factors, including changing market conditions and/or applicable laws, the content may in the future no longer be reflective of current opinions or positions. Any forward-looking statements, information and opinions including descriptions of anticipated market changes and expectations of future activity contained in this newsletter are based upon reasonable estimates and assumptions. However, they are inherently uncertain and actual events or results may differ materially from those reflected in the newsletter. Nothing in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice. Please remember to contact Signet Financial Management, LLC, if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and/or services. No portion of the newsletter content should be construed as legal, tax, or accounting advice. A copy of Signet Financial Management, LLC’s current written disclosure statements discussing our advisory services, fees, investment advisory personnel and operations are available upon request.

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