The S&P 500 fell 0.2% to 3234.85 last week. The loss was the result of a sell-off on Friday. The S&P closed at 3257.54 on Thursday, a new record high. It fell to 3222.34 at the open on Friday before recovering to 3245 by noon. Investors couldn’t push it any higher from there and the index traded between 3246 and 3234 throughout the rest of the afternoon. The assassination of Iranian Major General Qassem Soleimani by the U.S. is unlikely to have any long-lasting impact on the market, unless it does. 

The nature of catalysts that spark sustained selling are unpredictable and defy forecasting. There are plenty of talking heads who claim they predicted this event or that event that is identified (after the fact) as a catalyst for the selling that leads to a meaningful correction or even a bear market. However, most of them did no such thing. What they did was throw out a dozen or more possible catalysts for a selling spree by investors and when one of them happens to lead to selling they claim victory. The problem is that an investor can’t take advantage of that shotgun approach to make money or prevent losses. Furthermore, even the pundits that can show they mentioned an event in passing as a possible catalyst for a correction never get the timing right. Every professional money manager knows that timing is as important as the event itself. 

The assassination won’t have any impact on the U.S. market. An Iranian retaliation just might though, especially if investors conclude any retaliation is an opening salvo in an escalating hot war. Or not. Investors will drive themselves crazy trying to figure it out. Let’s not play that game. Instead, let’s look at the price level of the market, the underlying economy and, most importantly, the value of the businesses we own.

The S&P 500 is expensive. It’s trading at 18.2x 2020 earnings estimates. The average since 1986 excluding the dot.com years is 14.4x. It’s even more expensive based on likely revisions to 2020 earning’s forecasts, which will probably see estimates fall to around $170 from the current $177.99. Markets can remain expensive for years but will eventually trade back to long-term average levels. Call the S&P 500 high risk for now.

The economy is struggling. The Conference Board's economic forecast is 2.3% in all of 2019 with real GDP growth of 2.0% in Q4 2019. Economic growth in 2018 was 2.9%. The consensus of professional forecasters, according to the St Louis Federal Reserve, is that real GDP growth will fall below 2.0% in 2020, although there are few signs that a recession is coming according to those same forecasters. Of course, economic forecasters aren’t very good at forecasting. For instance, they missed on their forecast for the Institute for Supply Management’s manufacturing index report out last Friday. It unexpectedly fell to 47.2 in December from 48.1 in November. Economists polled by Bloomberg anticipated an increase to 49. The reading reflects the weakest level of manufacturing activity since June 2009 and it’s the fifth straight month of contraction in the sector. “This is a seriously weak report, and we see little chance of a sustained near-term recovery,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics on Friday. Meanwhile, Eric Parnell of Global Macro Research pointed out recently that there is a serious risk of a corporate earnings recession for the first time since late 2016. Importantly, a decline in business profit growth typically leads to weaker economic growth as well. “Frequently a decline in profit growth will lead to the onset of an economic recession and bear market by as much as nine months to a year,” according to Parnell. Although reported profit growth is still positive, it turned negative by -2.9% on a tax return basis (NIPA) all the way back in Q1 of 2019. Reported earnings are often massaged while tax return earnings are real since corporations don’t pay taxes unnecessarily. Call the economy and corporate earnings weak and at risk of getting weaker.

We spend a lot of time doing basic business valuation before we buy a stock for our clients. We spend just as much time doing basic business valuation before we sell a stock. We’ve learned over the last three decades that how much time we spend on each is a pretty good indicator of whether the market is overvalued and likely to correct soon or not. We were frantically evaluating stocks to buy during Q4 of 2018 and subsequently ended up buying more than a few. Recently, we’ve noticed that we’re spending almost all our time on reviewing the stocks we already own, trying to decide if we should sell several of them or not. We don’t like owning businesses that are trading above fair value because they won’t outperform the market over the long run – by definition. Of course, the point is that we’re getting a bit nervous given that we’re struggling to find good companies on sale to buy and instead find ourselves spending an increasing amount of our time thinking about selling. We can’t help but wonder how many other investors are thinking about the same thing. 

Regards,

Christopher R Norwood, CFA

Chief Market Strategist