Wake Up and Smell The Coffee

Markets partially bounced back Tuesday from the trade war-induced carnage we witnessed Monday. But don’t get complacent.

Indeed, as of this writing on Wednesday morning, the three main U.S. stock indices were trading deeply in the red, as a slide in bond yields fueled worries about a sputtering economy. For the rest of this year, brace yourself for prolonged volatility and further sell-offs.

Sure, stocks over the long term have historically recovered from even the worst declines. But as economist John Maynard Keynes famously said: “In the long run, we are all dead.”

What did this giant of the economics field mean by his oft-quoted remark? Simply this: Immediate financial needs often can’t wait for historical inevitability.

This bull market is more than 10 years old and investors keep waiting for a correction that never seems to happen. The ostensible history lesson is to stay long and patiently ride out any downturns.

But here’s the rub: If you’re in or nearing retirement, you can’t afford the time nor income of taking a big hit. You must adopt a practical and not historical approach to the likelihood of a correction.

Most investors, especially income investors who are about to retire or can’t rely on a paycheck, aren’t able to weather a crash that clobbers their portfolios at exactly the time that they’re withdrawing income.

Think this bull market will live forever? Wake up and smell the coffee. When assets are overpriced as they are now, it takes little disappointment to send them lower. One looming disappointment right now is negative earnings growth.

According to the research firm FactSet, the blended earnings decline for the second quarter to date is -1.0%. Blended combines actual results for companies that have reported and estimated results for companies that have yet to report.

After a blockbuster corporate earnings performance in 2018, expectations for earnings growth this year plummeted. Some of that pessimism was born of basic math. Year-over-year comparisons became more problematic, after the temporary boost provided to 2018’s earnings from the U.S. tax overhaul bill signed in December 2017.

About 80% of S&P 500 companies have posted actual second-quarter results. The percentage of companies reporting earnings per share (EPS) above estimates is 76% (see chart for details).

For the second half of 2019, the analyst consensus expects a decline in EPS for the third quarter followed by mid-single-digit earnings growth in the fourth quarter. Much of the blame for weak earnings growth belongs to the trade war.

Read This Story: Is Trade Policy Driving The Market Off a Cliff?

But it’s not just corporations that are hurting. China has responded to tariffs by shifting its acquisition of key agricultural commodities, notably soybeans, from America to alternate sources such as Russia. Yep, so far, there’s only one winner from this trade war, and it’s Russia.

The big loser? It’s not China. It’s the American Farm Belt, which is part of President Trump’s political base. Farm loan delinquencies and bankruptcies in the U.S. are at six-year highs.

Whether it’s tractor-riding farmers or blue-chip manufacturers, tariffs are hurting businesses with greater overseas exposure. Tariffs increase input costs, lower customer demand, disrupt supply chains, and squeeze profit margins.

The silver lining is that corporate earnings expectations are so negative, most companies are beating them, albeit not by much.

Meanwhile, most analysts say we’re overdue for an economic downturn. Our economy periodically falls into recession. No matter which political party is in power, you can’t blame a president for the economic cycle. But the economy typically bounces back strongly within a year or two.

Maybe not this time.

The U.S. Treasury Department reports that President Trump’s first full fiscal year in office generated the nation’s largest budget shortfall since 2012. The U.S. deficit widened in fiscal 2018 to $779 billion, which is $113 billion more than the previous year, according to the Treasury’s yearly report.

So much for fiscal responsibility. This monster deficit was created by the $1.5 trillion tax cut bill, combined with increased federal spending.

Snap quiz: To help finance the federal deficit, on whom will Uncle Sam rely on the most to buy Treasury notes?

Answer: You guessed it. China.

China holds about $1.18 trillion in Treasury notes, making it our largest foreign creditor. China is the same country against which we’ve launched a bitter trade war. It was China’s threat to devalue its national currency the yuan that triggered Monday’s stock market meltdown.

China might decide it no longer wants to (nor can no longer afford) to continue subsidizing America’s exploding debt, which would in turn place upward pressure on U.S. debt interest rates.

Citing the damage from tariffs and deficits, the International Monetary Fund recently reported that growth will slow this year in not only the U.S. but every large advanced economy.

Smart moves now…

In previous quarters, robust earnings growth was a major factor keeping the bull market alive. The 2017 U.S. tax cut acted like a shot of steroids, fueling stock market gains as companies used their tax windfalls to launch share buyback programs.

Well, the steroids are wearing off. The tax cut also generated a massive federal budget deficit that will come back to haunt investors. Does that mean you should run for the hills? In a word, no. If you do, you’ll be missing out on the profitable opportunities that still abound.

One shrewd move now is to increase your exposure to small-capitalization stocks. The definition of small cap varies, but it’s generally a company with a market valuation of between $300 million and $2 billion.

Large-cap stocks are getting whipsawed by trade war headlines. One way to protect your portfolio is to buy high quality small-cap stocks, especially in sectors that benefit during the late stage of economic recovery, e.g. consumer staples, health care, energy, and utilities.

Small caps are insulated from concerns about global growth, because they tend to get most of their revenue domestically. Trade conflict and increasing instability in emerging markets have driven investors to smaller stocks, which have less exposure to these overseas risks.

Another appealing choice: dividend stocks. Dividend-payers are time-proven vehicles for long-term wealth building, but they’re also safe harbors in turbulent seas because companies with robust and rising dividends by definition boast the strongest fundamentals.

I’ll provide further investment steps appropriate for current conditions, in future columns. Stick to your long-term goals, but calibrate your holdings to mounting risks.

So yes, Mr. Keynes was correct about human mortality. No one lives forever. But you must make the right investment moves now, to live out your final years with financial security.

Questions or comments? I’m here to help: mailbag@investingdaily.com

John Persinos is the managing editor of Investing Daily.