Smooth Operator

The S&P 500 returned 3.7% while the broader MSCI All-World index gained 3.0% in July, recording the strongest gains for stock markets since January and putting the S&P within 50 points of its all-time highs.

Corporate America announced a boom in profits for Q2, which grew at more than 24% year-over-year. Solid profit growth was in line with the U.S. economy growing at 4.1%, exceeding expectations.

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All this is occurring at the time that central banks are selling down huge quantities of assets bought post-crisis to revive the economy by flooding the financial system with money. The transition from extremely low interest rates and quantitative easing is the most perilous aspect of the Fed’s plan to deal with the post-crisis economy. So far, this transition has gone smoothly. Longer term interest rates have risen steadily as a result. As we write, the U.S. 10-year government bond yield is again touching 3.0%. Overall, the broad US bond benchmark was flat in July but is down 1.6% for the year.

The monetary changes are underway and, for now at least, the economy and the markets are relatively undisturbed. The biggest issues now facing the stock market are a worsening trade war and a huge loss of confidence in some of the biggest stocks driving the market. The Fed’s current steady approach could be upended if the trade policy gets out of hand.

Trade Roulette

Investors are duly concerned about escalating tariffs, the ultimate consequences of which are difficult to gauge but could come back to haunt us in the form of higher prices and slower economic growth. Ask Whirlpool, who had actively lobbied for tariffs on imported washing machines only to see shares of their stock slump over 20% this year as tariffs on steel prices raised input costs.  Now, consumers are feeling the pressure of a 20% increase in the price of washing machines in the last three months.

The markets are clinging to the hope that the administration’s tough talk is essentially a negotiating tactic, a kind of Russian roulette for trade. What the President does is more important than what he says, creating a difficult position for investors. How these trade disputes get resolved is anyone’s guess. For now, China is not backing down, hoping politically sensitive retaliatory tariffs will erode the President’s support. Regardless, trade is likely to be the driving narrative for markets in the near term.

The Road to $1 Trillion

A group of fast growing technology stocks, known by the acronym FAANG (Facebook, Amazon, Apple, Netflix, and Google), has dominated the US stock market since early 2017. Together, these stocks represent a combined market value of slightly over $3.3 trillion, or 12.4% of the total value of the S&P 500 index. Apple just crossed the $1 trillion mark to become the most valuable company ever. Even more impressive, and unsettling, is that the performance of the shares in these five companies represented 21.1% of the total S&P 500’s performance over the last twelve months.

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The FAANGs are not cheap stocks. The weighted average price/earnings (P/E) multiple for the group is 65.1 versus a 20.4 average for the entire S&P 500 index. If you strip out the FAANG stocks, the P/E for the remaining 494 stocks is 14.1, or 31% lower.

The appeal of the FAANGs is they are consistently growing, less sensitive to business cycles than other stocks, and largely immune to the impact of trade disputes. They represent the primary ways consumers use the internet. Facebook for social media; Amazon for shopping; Apple for mobile access, Netflix for entertainment; and Google (Alphabet) for search, video, and maps. Unlike the wildly inflated internet stocks of the late 1990’s era – many based on hype and hope – today’s tech leaders have viable models and real earnings.

While grouped together in a catchy title, they are also different companies with different business models and risks. That was clear last week when Facebook lost $120 billion in one day based on slowing user growth and ad sales related to earlier concerns about its ability to protect user data. Netflix’s stock price had dropped precipitously the week before on slowing growth.

All this points to fundamental questions for investors. Are these “must own” stocks or should they be avoided due to high valuations and increasing risk? The rise of exchange-traded funds and index-based investing have increased correlations among the FAANG group and stocks in general. Capitalization or market-weighted indexes can result in increasingly concentrated positions when a select group of companies grow so large that they represent a disproportionate share of the index.

For most long-term investors, the diversification and cost advantages of index investing outweigh other risks. Nonetheless, owning some individual securities in combination with index funds can help manage concentration risk.

We do not predict an imminent meltdown of the FAANG stocks. Stocks trading at high multiples can continue to rise for a long time. Expensive stocks, however, are risky and at some point they will correct and likely account for a similarly outsized portion of the S&P 500’s downside.

We invest in several FAANG stocks but not all, and not in the weights found in the broad market index. Our approach is to evaluate these companies based on their individual business models and competitive advantages, or economic moats, and to discriminate among them accordingly.

What It All Means

Whether you agree with him or not, we have an unconventional president who discounts economic norms, criticizes the Federal Reserve, threatens trade wars, and is nonchalant about government debt. Plus, corporate profits are high, valuations are no longer low, and interest rates are rising as stocks enter the 10th year of a bull market run. None of this means the run will end this year, next year, or even the year after that, but it’s easy to understand why investors are increasingly nervous. The paradox is that a sense of nervousness is healthier than all out exuberance. Look out when the consensus view is that “this time is different” and the fear of missing out takes hold. Economic performance drives markets in the long-run, but short-term market cycles are driven by human emotion.

An overly cautious approach to investing can be costly as higher inflation eats into future living standards. Chasing hot stocks or riskier higher yields can be devastating when the market eventually goes into a correction. It’s important to keep investing, but cautiously and with a keen eye on understanding the risks in your portfolio. Broad diversification with stocks is always key, as is making sure your overall stock/bond allocation is aligned with your needs.

We continue to trim overweight stock positions and look for opportunities when stocks that were fully valued suddenly trade at attractive prices. Our focus with bonds is to protect capital as interest rates rise, so clients will have ample liquidity to get through the next downturn in stocks.

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DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.