The Independent Market Observer

A Look Back at Q1 2018 and Ahead to Q2

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 5, 2018 1:25:06 PM

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Q1 2018The first quarter of 2018 saw the end of the bull market. Not in stocks necessarily, as the upward trend remains intact, but certainly of the bull market in confidence. January was a strong month, but then the world changed. Markets dropped in early February, only to bounce and then drop again in March. Let’s review why things changed in Q1, plus what we might expect in Q2.

A look back

Why the change? The most direct cause was the tariffs announcement by the U.S.: first on steel and aluminum, and then on a wide range of Chinese goods. The market has bounced back, and the expectation is that the trade measures are more about negotiation than anything else. But after two down months, the blind confidence that took markets up in an uninterrupted path has clearly disappeared, at least for the moment. In fact, the loss of confidence was so extreme that markets dropped down to one of the first long-term trend lines that often signals further trouble—the 200-day moving average. On April 2, the S&P 500 closed below that line for the first time since June 2016.

What hasn’t changed? One thing that hasn’t changed is the fundamentals. The economy continues to grow. In fact, hiring actually strengthened during the first quarter. Both consumer confidence and business confidence are at extremely high levels, matching levels last seen in the dot-com boom, and spending continues to grow. U.S. manufacturing is doing extremely well due to strong growth abroad, as well as a relatively cheap dollar. In fact, growth at the end of last year ended up higher than expected. Plus, the Fed recently raised interest rates with the clear expectation that the economy was healthy, and likely to keep getting better.

Other forces. Beyond the current health of the economy, forces are in place that are likely to accelerate growth. The tax cut package passed in the first quarter, along with the enhanced federal spending that also passed, should turn government from a headwind to growth into a tailwind. Companies are seeing large bumps in expected earnings, due to lower taxes, which makes the market less expensive. The market's rise in January clearly took all of this into consideration.

Political and economic concerns. Since then, however, while all of the good factors remain, the prospect of continued improvement has become considerably less certain. Politics is a big part of it, with the tariff announcements front and center. But there are economic concerns as well.

Confidence, for example, is close to as high as it has ever been and is more likely to go lower than higher. Job growth is strong, but the economy is running out of people to hire. Spending, while growing, is slowing down. And the tax cut? While boosting corporate earnings, it is a one-time effect. In other words, things are about as good as they can get—and an awful lot of good news is priced into markets.

This is a major reason the tariff announcements had such a big effect. They took the possibility that something could go wrong, against where the market is priced, and made it real and immediate. The story of the past quarter was investors being forced to face the possibility that their confidence in the future might be excessive. The story of the second quarter will be how that plays out.

High expectations, investor uncertainty. While the economic news is likely to continue about where it is now, the potential for corporate earnings announcements to shake confidence further is very real. Expectations are very high; the expected earnings growth, at more than 17 percent, is the highest since 2011. So, the potential for disappointment is real. If companies do less well than expected, even if the results are good, confidence will be rattled. Even more, if companies start to talk about the effects of tariffs in their earnings calls, investors will be reminded once again about the very real policy risks out there. This could shake confidence further.

By taking the focus away from the economy and toward policy, investors become more uncertain and less confident. By taking control away from the U.S. and bringing China’s response into the picture, the future becomes even less certain. By then trying to anticipate the effects on what companies are doing, the uncertainty ratchets up even further, and this is what is likely to have the biggest effects on the markets.

A look ahead

This is what I will be watching as the second quarter gets underway: how companies are processing the increased uncertainty and risks. The fundamentals should remain solid. But what will matter most is how companies react, as this is the news most likely to change investor confidence in a sustainable way.

At the moment, the trend remains up. In fact, the real thing to bear in mind about the past two months is how little damage has been done. The S&P 500, for example, has not even formally moved into a correction (i.e., a 10-percent decline). While it did hit its trend line, it then bounced. Investors are clearly still confident, although nervous. Given the news, the fact that the damage was not worse is actually a positive sign, so the trend remains positive.

It also remains vulnerable, though, to a more sustained loss of confidence, which is quite possible if the trade confrontation worsens, or if companies start reacting in the expectation that it will. That will be the thing to watch.

What really matters?

To sum it all up, while the trend remains positive, policy and perception risks have increased substantially and bear watching. The volatility of the past two months is likely to continue, as we are once again in a policy-driven market environment rather than one driven by fundamentals. The fundamentals will continue to cushion the markets. But what really matters is now happening in Washington and Beijing. That alone makes investors much less confident.

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