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Fed Gives Thumbs Up to Banks, Markets Rise

The second quarter has been volatile but it ended on a positive note Friday, with the major stock indices closing in the green. However, the Dow Jones Industrial Average finished well off its session high of more than 250 points, as gains evaporated in the final minutes of trading. Trade war fears continue to weigh on investors.

Financial stocks were the biggest gainers today, after the Federal Reserve on Thursday gave big banks a clean bill of health on their “stress tests.”

The Fed’s approval allows banks to proceed with their capital plans, such as dividend hikes and stock buybacks. The sector also boasts strong projections for quarterly earnings growth.

With the first half of the year officially over, what lies ahead for investors?

Beware of TV soothsayers…

Whenever a financial analyst makes predictions, I’m reminded of Johnny Carson’s character, “Carnac the Magnificent.”

For those unfamiliar with the recurring comedy sketch, Carnac was a psychic whose hilariously ridiculous insights came from envelopes that had been, as sidekick Ed McMahon explained, “kept in a mayonnaise jar on Funk and Wagnalls’ porch since noon.”

In the investment world, the consequences of bad predictions aren’t funny at all. The worst offenders are the suited soothsayers on financial television, who often seem as crazy as Carnac.

And yet, as we face the beginning of the third quarter, it’s prudent to determine investment strategies for the road ahead.

Trying to time the market remains a fool’s game, but it’s still possible to pinpoint regular patterns of performance. We can make informed extrapolations based not on wishful thinking, but on historical trends and time-proven economic laws. That’s my mission for today, with a focus on “growth versus value.”

For U.S. stocks as a whole, it’s been a mixed year so far. The tech-heavy Nasdaq has gained 8.79%, the S&P 500 has added 1.68%, and the Dow has dropped 1.80%.

The good news is that national economies and corporate earnings around the world are still growing. The bad news is that this growth is slowing amid a potentially ruinous trade war.

European Union leaders vowed Friday to respond swiftly to protectionism and urged the EU to aggressively screen foreign investments, with the U.S and China in mind. EU leaders said the Trump administration’s import tariffs on EU steel and aluminum were unfair and called for legal challenges.

Investors this year have mostly shrugged off trade disputes, seeing them as negotiating bluster. As measured by the MSCI AC World Index, the global stock market is close to where it began the year. But it’s increasingly apparent that the trade war isn’t just rhetorical. It’s very real and that’s a danger to the world economy.

Global economic growth was strong in 2017, with Europe putting in a surprisingly solid performance. The year-over-year rate of gross domestic product (GDP) growth in the euro zone was 2.8%, exceeding the 2.6% pace in the U.S.

However, as the Trump administration takes a wrecking ball to the western alliance and attacks America’s traditional allies in Europe, the Continent’s growth is under threat. The same risks apply to Canada, Mexico, Japan, and of course China.

Tit-for-tat tariffs between Europe and the U.S. already are disrupting global supply chains and prompting major export-dependent corporations to downgrade profit outlooks. Global growth slowed in the first half of 2018 and predictions call for further cooling.

The silver lining is that these headwinds are prompting European central bankers to take a slower stance on ending stimulus this year.

In light of trade conflict and other headwinds, there’s a growing risk of a recession and subsequent bear market. That’s why it’s crucial for investors to re-balance their portfolios away from riskier momentum stocks and toward value.

Long-term trends typically reverse during the latter stages of the economic cycle. As we approach the tail end of the recovery that began in 2009, the bull market will start to lose steam.

With the second half of 2018 at the starting blocks, it makes sense right now to de-emphasize growth stocks in favor of value-oriented plays.

After more than a decade of growth stock out-performance, the trend could be on the verge of reversing because of the stage of the economic cycle, the difference in valuations, and the wide gap in relative performance (see chart, compiled with data from Bloomberg):

Economic recoveries typically last about eight years; the current recovery started nine years ago. This economic law has not been repealed. History also teaches us that rising interest rates tend to kill bull markets.

Corporate earnings projections remain strong but several factors could soon conspire to undermine growth and underscore the appeal of value.

Ballooning public and private debt, trade conflict, rising interest rates, mounting inflation, political dysfunction, and geopolitical tensions are likely to tip the scales in favor of value over growth stocks.

The overvalued “story stocks” still sing their Siren’s Song, but as the new fiscal quarter gets underway, be a contrarian and consider a different tune.

Friday Market Wrap

  • DJIA: +0.23% or +55.36 points to close at 24,271.41
  • S&P 500: +0.08% or +2.06 points to close at 2,718.37
  • Nasdaq: +0.09% or +6.62 points to close at 7,510.30

 Friday’s Big Gainers

  • Vertex Pharmaceuticals (NSDQ: VRTX) +15.16%

Biotech benefits from rival’s stumbling product. 

  • Nike (NYSE: NKE) +11.16%

Athletic apparel maker reports improved sales.

  • Wells Fargo (NYSE: WFC) +3.45%

Banks pass Fed stress tests, sector jumps. 

Friday’s Big Decliners 

  • Verona Pharma (NSDQ: VRNA) -11.47%

Analysts turn bearish on prospects of biotech’s drug candidates.

  • China Rapid Finance (NYSE: XRF) -11.11%

Lender’s earnings under pressure.

  • Community Health Systems (NYSE: CYH) -10.38%

Health care provider offers notes to pay off debt. 

Letters to the Editor

“My small-cap holding was added to the Russell 2000, 3000 and Russell Global Indexes on June 22. Is it good or bad for the stock?” — Lyubov L.

Getting added to an index confers legitimacy on a stock. It means the company has been deemed representative of its niche. Typically as a result, the stock will see a spike in price. But after the enthusiasm wanes, the stock should return to trading based on its fundamentals.

Any investment topics you’d like me to cover? Let me know: mailbag@investingdaily.com

John Persinos is managing editor at Investing Daily.

 


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