Animal Spirits

by Catherine Trinder Miller, October 26, 2018

“In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated, that error tends to come to light when the market is at its nadir.”
- Howard Marks, Legendary Investor, Author, and Founder of Oaktree Capital Management

The stock market this week reeked of animal spirits. For those less familiar with ‘animal spirits,’ it is a term coined by British economist John Maynard Keynes in 1936 to explain financial and buying decisions in conditions of uncertainty. Animal spirits describes the human emotion that influences these decisions.

Uncertainty ignites emotion. Emotion and investing are rarely a successful combination.

While global capital markets are complex and there are many factors influencing market movements, this week’s U.S. stock market volatility was largely driven by mixed corporate earnings reports. From Caterpillar to Google and growth darlings like Amazon, earnings were good. Yet investors, conditioned to expect higher future earnings guidance, were at times disappointed.

On the other hand, equity stalwarts such as Visa, Microsoft, and Boeing reported earnings results celebrated by investors.

The spark that fueled the 2018 U.S. stock market rally through September is strong corporate earnings growth ignited by powerful tax reform, deregulation and repatriation of large offshore pools of cash.

Our capital markets rewarded this growth.

So is this growth gone? I think not. Forty-eight percent of S&P 500 companies have reported third quarter earnings to date with year over year aggregate growth rates of over 25% and every sector growing. Revenue growth rates for these companies are 7.7% in aggregate. Equally impressive, these strong earnings growth rates follow two quarters of over 25% growth each quarter, respectively. 1

Our economy is strong. Inflation is moderate. And interest rates, while rising, are still low in absolute terms and relative to history.

So why the volatility? Exuberance after two great quarters of earnings and revenue growth may have pushed asset prices too high too fast. Resetting valuations and expectations is healthy.

The more challenging drivers of recent volatility reside in uncertainty surrounding the upcoming mid-term elections and the U.S/China trade negotiations. We are 11 days from mid-term election outcome ‘certainty’. Simply having a known outcome should provide some relief to capital markets investors.

The U.S. / China trade negotiations may take longer to resolve. President Trump and Xi Jinping are scheduled to meet at the end of November at the G-20 Summit. The goal on both sides is to strike a deal at the meeting, but differing negotiating tactics divide the two sides exacerbating uncertainty in the near term.

Trump has warned of tariff increases on Chinese goods of 25% in January 2019 if deal isn’t struck beforehand. Incentives are high for both countries to come to an agreement; it is unclear how quickly terms that are mutually acceptable can be reached. At this point, the impact of higher U.S./China tariffs has been limited and manageable. Markets are increasingly discounting a worst case outcome in U.S. / China trade negotiations.

One of the most important things you can do during periods of volatility is to reflect upon your financial plan. If you don’t have one, then take action now -- seek advice and create one! Your plan should embody your cash flow needs, investment time horizon, tolerance for volatility, and specific financial goals. It should guide your investment diversification across low, medium, and higher risk assets in a manner customized to meet your immediate and longer-term objectives. Volatility must be anticipated. Understand that volatility is not loss. It is to be expected, particularly in equity investing, and for an appropriately diversified portfolio it creates opportunities for future gains.

We see more and more great companies trading at valuations that present compelling long term investment opportunities. Credit markets are not showing signs of distress. While late economic cycle investing informs us to move forward with caution, we seek opportunities that periods of market volatility inevitably uncover.

We are vigilant in managing risks and laser focused on helping you achieve your financial goals.

1 Thompson Reuters S&P Earnings Scorecard. 10/26/18

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Catherine Miller and Teri Benson and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. No investment strategy can guarantee success. Past performance may not be indicative of future results. Investing in the energy sector involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary.

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