The “Good Cop-Bad Cop” Trade War
Trade rhetoric has softened in recent days, but I’m not buying it. I’m reminded of the “good cop-bad cop” routine that’s a cliché of crime movies:
Cop #1 leaves the interrogation room after roughing up the suspect. Cop #2 walks in, offers a cigarette to the battered interrogee, and says in a soothing voice: “Sorry about that. My partner is crazy.”
I see the same pattern with U.S. trade policy. President Trump angrily attacks China, sending stocks downward. Afterward, a White House official appears on cable news to tone down the president’s stance and indicates that a deal is in the works. Relieved investors push stocks higher.
Stocks shot higher yesterday after U.S. Commerce Secretary Wilbur Ross said the U.S. and China are “making good progress” in their negotiations to forge a trade deal. The main indices closed at record highs. In pre-market futures trading this morning, stocks are poised to open higher for the third straight day.
But if past is any prologue, these trade pronouncements are empty words. JPMorgan Chase (NYSE: JMP) CEO Jamie Dimon recently predicted that a trade deal between the U.S. and China is unlikely before the 2020 election. (I think he’s right.)
The predictable rise and fall of stocks based on official pronouncements about trade policy brings up another matter: insider trading.
News reports recently surfaced that a secretive group of futures traders may have generated $3.5 billion in profits off stock plays timed to tweets and statements about the trade war and economy. Members of the House of Representatives have urged federal regulators to investigate.
In my view, we’re witnessing a market “melt-up.” A melt up is a dramatic rise in stocks driven by a stampede of investors who don’t want to miss out. Fundamentals are taking a beat seat to euphoria, which means that a correction could loom around the corner.
Below, I’ll steer you toward an investment theme that’s best positioned to profit from these risky conditions. It’s an asset class that offers a combination of income and growth, but also the safety you need to survive the imbalances and shenanigans I’ve just described.
The best (and worst) earnings performers…
Let’s put aside the on-again, off-again trade war and focus on the hard data, specifically corporate earnings.
To date, about 71% of the companies in the S&P 500 have reported actual operating results for the third-quarter of 2019. According to the research firm FactSet, companies are reporting earnings that are 3.8% above estimates and revenues that are 0.9% above estimates.
The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report) earnings decline for Q3 is -2.7%, smaller than last week’s projected earnings decline of -3.8%.
Five sectors are reporting year-over-year growth in earnings, led by the health care, utilities and real estate sectors. Six sectors are reporting a year-over-year decline in earnings, led by the energy, materials, and information technology sectors (see chart).
The blended revenue growth rate for the third quarter is 3.1%, which is above the revenue growth rate of 2.8% last week. Companies with greater exposure to the trade war are experiencing the worst pressures on both the top and bottom lines.
Negative earnings growth has occurred in the first three quarters of 2019. The consensus looks for an earnings decline in the fourth quarter as well.
Expectations for earnings growth for Q4 2019 have been slipping in recent weeks. As of November 1, the projected earnings decline was -0.4%.
Five of the 11 sectors are now projected to report a year-over-year decrease in earnings for the fourth quarter, led by the energy (-29.7%) and consumer discretionary (-10.3%) sectors.
If the S&P 500 reports a year-over-year decline in earnings in both the third and fourth quarters, it will mark the first time the index will have reported four consecutive quarters of year-over-year earnings declines since Q3 2015 through Q2 2016.
For the rest of this week, 90 S&P 500 companies are scheduled to report results for the third quarter.
The forward price-to-earnings ratio (FPE) of the S&P 500 is 17.2, which is above the five-year average (15.1) and the 10-year average (14.0). The disconnect between negative earnings growth and relatively high valuations puts investors at peril. I refer you to the nasty market plunge of December 2018 as a history lesson.
The appeal of essential services…
With interest rates and inflation both still at historically low levels, quality dividend-paying stocks have a lot to offer. As trade war-induced volatility whipsaws investors, are you paring back your stock allocations? That would make sense. You shouldn’t pare back your dividend holdings, though. Dividend payers offer potential income growth and share-price appreciation, as well as ballast for your portfolio.
The key is to pick the right dividend stocks. I’m bullish on the utility sector.
Utility stocks have been soaring this year, with plenty of upside still in the cards. With interest rates at low levels, high-dividend utilities are an attractive hedge.
The utility sector has enjoyed a big run-up so far this year but it’s poised to continue outperforming. The Wall Street consensus expects the sector’s year-over-year earnings growth to reach 6% in 2020, as compared to shrinking expectations for most other sectors.
Utilities are a buffer against trade war uncertainty and they’re recession resistant. That’s because these companies derive their revenue domestically and they provide essential services that people need, regardless of economic ups and downs.
Stocks of companies that provide essential services tend to be long-term survivors. The world can do without another coffee shop or social media app. But even in the worst of times, people can’t do without electricity.
Sure, bonds provide safety and income. But unlike bonds, stock dividends are not fixed. If you invest in solid companies with steady earnings and cash flow, your dividend income will rise.
To find the highest-quality utility stocks at reasonable prices, consult our “dividend map” for recommendations. If your investing goal includes a portfolio full of double-digit yielders with growing dividends, you need to check out the stocks on our dividend map. Unlike a suspect in a cop movie, you won’t take a beating.
John Persinos is the managing editor of Investing Daily. He also serves as managing editor of the premium trading service, Utility Forecaster. You can reach John at: firstname.lastname@example.org