Q2 2018 Investment Management Update

By Eli Sallman on July 19, 2018



The second quarter of the year can be called a lot of things, but boring isn’t one of them. The potential for a trade war between the United States and China heated up in April as China responded to the threat of U.S. tariffs on Chinese imports by warning of the same magnitude of tariffs on American exports. Favorable corporate earnings reports helped calm some of the global economic angst investors may have felt. The indexes listed here ended the month of April ahead of their March closing values — but only barely. The Russell 2000 (0.81%) posted the largest monthly gains, followed by marginal upticks in the S&P 500 (0.27%), the Russell 1000 (0.23%), and the Nasdaq (0.04%).

Despite expanding trade tensions between the United States, China, Canada, Mexico, and the European Union, equities enjoyed a better month in May, riding surging energy stocks. For most of the month, oil prices hit multi-year highs before falling at the end of May. Robust first-quarter earnings reports also helped push stock markets higher. In fact, each of the indexes listed here posted strong end-of-month gains. The small caps of the Russell 2000 (5.95%) and the tech-heavy Nasdaq (5.32%) enjoyed the largest gains, followed by the Russell 1000 (2.32%), and the S&P 500 (2.16%).

A strong jobs report kicked off the month of June on a mostly positive note. Stocks closed the first full week of June higher, led by the large caps of the S&P 500. However, by the middle of the month, investors were hit with China’s threat of increased tariffs on U.S. exports, while Canada pledged to impose retaliatory penalties as well. By the end of the month, the indexes posted marginal gains.

Overall, the second quarter saw the tech-heavy Nasdaq gain over 6.0%, only to be bested by small caps of the Russell 2000, which grew by almost 7.5%. The S&P 500 and Russell 1000 also closed the quarter ahead of its first-quarter closing values. Prices for 10-year Treasuries rose by the end of the quarter, pulling yields down by 13 basis points. Crude oil prices closed the quarter at about $74.25 per barrel by the end of June, almost $10 per barrel higher than prices at the close of the first quarter.

Markets as of June 29, 2018

Eye on the Month Ahead

Moving to the second half of the year, the economy, in general, and the stock market, in particular, will likely react based on the ongoing global economic trade wars. Fewer imports could lead to more domestic sales, which could add to job growth. However, prices could also increase at a rate ahead of wage growth.  While the underlying economy is very strong, the stock market will face the headwind of concerns of an economic trade war.  We would expect the stock market to be positive the second half of the year, though the upcoming election and trade war talk will impact to what degree it is positive.  

As of this writing, the Forward P/E on the S&P 500 is 15.9X next year’s earnings.  Even more importantly, the Free Cash Flow Yield 1   is 4.3% (higher is better).  Since 1990, when this data started being kept, the median Free Cash Flow Yield of the S&P 500 is 4.5%.  While stocks continue to be neither expensive nor cheap, we continue to see more value in stocks relative to other asset classes.  We have maintained our overweight position in growth over value.

We have maintained our underweight position in Fixed Income as we continue to see the yield curve flatten.  At the end of March, the difference between the 2-year and 30-year Treasury was 0.71%.  As of the end of June, that difference is down to only 0.46%.  With the Federal Reserve expected to raise interest rates two more times in 2018, we should continue to see pressure on the yield curve.  

We remain optimistic for the second half of the year.  We would look at any pullbacks as buying opportunities as the economy is very strong.  It should be able to continue to remain strong even though any economic trade war could provide a short-term drag on some economic numbers.

 1 Free Cash Flow Yield is the inverse of the Price-to-Free-Cash-Flow multiple.  For example, if a stock is trading at $100 and has Free Cash Flow of $5 then its Price-to-Free-Cash-Flow is 20X and its Free Cash Flow Yield is 5% (5 divided by 100).

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