· Stocks weaken due to technology sector, escalating trade war, and breached key technical levels
· Still plenty of reasons to be optimistic about equities
· Be diversified during times of market stress
U.S. stocks opened the second quarter on a weak note, as concerns about the technology sector, a trade war with China and a breached key technical level worried investors. This weakness extended the jump in market volatility that we witnessed during the final weeks of March. It was not surprising that the technology-laden NASDAQ Composite was one of the worst performers as it moved into correction territory (representing a 10% drawdown). It is also worth noting that safe havens such as gold and Treasuries are resisting today’s downturn.
Over the past couple weeks, well-publicized concerns about inappropriate data sharing as well as a self-driving car fatality have hurt the technology sector. Adding further pressure to the sector, over the weekend, President Trump tweeted and made comments about industry bellwether Amazon, suggesting that the company takes advantage of the US Postal Service and has an unfair advantage over brick-and-mortar retailers which cannot avoid charging sales taxes. While experts question the validity of these comments, they nevertheless pressured the company’s share price and the technology sector as a whole.
In addition to the weakness in the technology sector, which spread to the broader markets, investors are also concerned about an escalating trade war. Over the weekend, China announced tariffs on about 130 U.S. exports, following through on a promise to retaliate against the Trump administration’s penalties on imports of Chinese aluminum and steel. Most concerning to investors is the potential impact of a trade war on economic growth. Economists tend to cite the Smoot-Hawley Tariff Act of 1930 as an example of potential negative consequences of a trade war that many believe intensified the Great Depression.
In addition to technology and tariffs, from a technical basis, the S&P 500 fell below its 200-day moving average. This level is closely watched by technical analysts, as it is considered by many as a gauge of long-term momentum, and a close below this level could trigger additional selling ahead.
As we mentioned in previous commentaries, there is growing uncertainty in the markets right now. We have already seen volatility increase from the abnormally low levels of last year, and we expect this trend to continue.
Despite the uptick in volatility, we continue to stress that fundamentals remain positive:
· Economic data continues to be solid. For example, just today the Institute for Supply Management (ISM) reported that manufacturing continues to grow at a robust pace while the government reported strong private sector construction spending.
· First quarter earnings season begins soon. Analysts continue to raise earnings estimates as the benefits from tax reform continue to filter into companies bottom lines. According to Factset, for the quarter that just ended, the estimated earnings growth rate for the S&P 500 is 17.3%. If this estimate ends up being the actual growth rate for the quarter, it will mark the highest earnings growth since the first quarter of 2011 and this increase is from a notably higher base.
· Equity valuations look better. Also according to Factset, as of last week, the forward 12-month P/E ratio of the S&P 500 is 16.1, which is equal to its five-year average. This figure is also below the forward 12-month P/E ratio of 18.2 recorded at the start of the first quarter. Valuations have come down as we have seen recent weakness in equities despite rising earnings estimates.
· Gradual Fed rate hikes. Despite the Fed raising rates last month, they continue to follow a program of gradually scaling back accommodative policy. We do not expect a sharp rise in interest rates.
· Second quarter good for stocks. During the last 40 years, the S&P 500 has provided a positive return 75 percent of the time, with an average return of the S&P 500 of3.53%.
· Selloff in technology creates potential buying opportunity. According to Yardeni Research, through last week, while the price level of the S&P 500 Technology Index is currently trading close to its peak during the 1999 tech bubble, the forward P/E ratio of index is about half of that (see chart below).
Source: Yardeni Research, Index is price divided by 12-month forward consensus expected operating earnings per share. Data as of 3/15.
Despite these positives as a backdrop, volatility can worry investors. As such, we continue to recommend extreme diversification within portfolios. Within equities, be diversified by asset class, sector and market capitalization. We believe that bonds, despite concerns about rising interest rates, can still offer protection in times of market uncertainty such as today. In this area we continue to recommend diversification among risk factors such as duration, credit quality, sector and structure.
Overall, there are risks in both bonds and equities, so we continue to recommend including an allocation to alternative investment styles and asset classes, which have lower correlations to these traditional asset classes and may help reduce overall portfolio volatility.
This report is created by Cetera Investment Management LLC
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The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.
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