Mid-Year Review: Time to Take Stock of Equities
Compared to the first quarter of this year, which included a meteoric 7% rise in January followed by a nerve-racking 10% plunge over the next two months, the second quarter of 2018 was a veritable cakewalk.
The S&P 500 Index ended the month of June nearly 2% higher than it started the year, despite mounting trade tensions that threaten to destabilize a fragmented global economy (see chart).
The stock market’s recovery coincided with a sharp rise in oil prices, which is unusual in that higher energy prices represent a drag on earnings for most businesses. At the end June, oil was selling for $75 per barrel, more than 50% above its price a year earlier.
Oddly, the share prices of major oil producers such Chevron (NYSE: CVX) and Exxon Mobil (NYSE: XOM) barely budged, while huge consumers of oil such as airlines predictably hit the skids.
At the same time, high-multiple momentum stocks continued their assault on the record books. Amazon (NSDQ: AMZN) is up more than five-fold over the past four years, gaining 50% this year alone, while Netflix (NSDQ: NFLX) has nearly doubled over the past six months. Coincidentally, both companies are valued at roughly 85 times forward earnings, despite rising interest rates that cheapen the value of future profits.
So what are we to make of this upside-down world where good is bad and bad is good? If revenue growth is all that matters anymore, shareholders have effectively become unsecured lenders. That’s because there isn’t much in the way of dividends or profits to share with them from many of the companies that are driving the market higher.
It appears some investors are adhering the sports truism that the best defense is a good offense. They burrow into overpriced momentum stocks without regard to valuation. So long as enough people think that way then they’ll be okay. This is known on Wall Street as the “greater fool” theory, which depends on a perpetual supply of optimistic investors to keep share prices high.
Eventually, the market gets it right. The next round of quarterly results will start hitting the street next week. The combination of rising fuel prices, higher borrowing costs, escalating trade wars and a tight labor market may start creeping into those numbers. If not now, forward guidance may reflect narrowing profit margins over the remainder of the year.
As the second half of this year gets underway, now is a good time to take a close look at your portfolio to determine if you own any “greater fool” stocks that are at risk of taking a big hit. If you do, be prepared to act quickly if quarterly results come up short of expectations. By the time Labor Day rolls around, it may be too late.