Earnings season starts in earnest next week. Can the expected surge in earnings stabilize the market and provide a base for the next rally phase? The big question is whether the good earnings forecasts are already discounted in share prices. We won’t know that until after earnings season ends, but we do know that we are in for explosive earnings growth for Q1 and all of 2018. 2019 looks solid, too. Company outlooks cited during earnings calls are always important but especially this quarter. If Q1 forecasts are already discounted in share prices, then the outlooks could make or break the marketand individual stocks.
The disclosure of data harvesting by Cambridge Analytica angered both Facebook (FB) users and advertisers, but FB’s investors even more so. The shares plunged almost 18% at their low point on March 27 but have since partially recovered. The waterfall decline in FB was followed by declines in other FANG stocks (Facebook, Amazon, Netflix, and Google) and spread to many technology stocks as well. FB investors have real concerns about increased regulation coming (both here and in Europe) and talk of new European taxes starting at 3% of revenues.
These developments are cited by market bears as proof the bull market is over. After all, technology shares have been the best performing sector YTD, as well as over the last one, three, five and 10year periods. If not tech, what sector will be the new leader? Is FANG and the rest of technology doomed here? First, let’s take a look at actual returns through March:
| YTD % RETURN | % OFF HIGH | |
| FNG (FANG ETF) | (3.2) | (13.9) |
| XLK (Technology ETF) | +1.1 | (8.3) |
| S&P 500 Index | (1.2) | (8.1) |
Can FANG recover and pull the rest of tech with them? We think so. Investors go where the growth is. Investors will quickly forgive FB if the growth is still there. And there seems to be plenty of growth even taking into account massive legal expenses coming, more regulation, and likely more taxes. Take a look at what Wall Street analysts are projecting for three year growth rates in earnings for FANG:
| FORECAST ANNUAL GROWTH IN EARNINGS | |
| 26.9% | |
| Amazon | 24.0 |
| Netflix | 68.0 |
| 24.6 |
Source: Yahoo Finance
We remain comfortable with our diversified technology holdings in client accounts. We expect tech to stabilize and lead the market higher with industrials and financials following suit. Sometimes it takes news to trigger a correction that was likely to happen anyway.
Finally, we are not blind to the risks of FANG and tech. When people cash out of their index funds later in the cycle, FANG and other tech, because of their overweightings, will be subject to a heavy dose of selling pressure. Also, tech shares now account for a hefty 25% weighting of the S&P 500 (compared to 35% in 2000). The difference is today’s tech valuations are based on real earnings, not eyeballs or clicks.
Bond Market Normalization Takes an Odd Turn
Ten year U.S. Treasury note yields, having peaked in late February at 2.94%, had fallen to 2.74%by month end in response to rising stock market volatility and the flight to quality market uncertainty often causes. It is ironic that the threat of three additional Fed rate hikes this year, the shrinkage of QE bond balances at the Fed and a mounting (trillion dollar) budget deficit has not pushed ten year note rates soundly through 3%. Why not?
In addition to growing volatility we believe there are several factors driving 10 year note yields lower including:
- Uncharacteristically weak inflation data given the late stage of the economic cycle.
- Recent price pressure on key stock market sectors such as technology frightening investors.
- Ongoing high demand for longer maturity high quality bonds from pension investors.
- The growing threat of tariffs and the damage they could cause to the economy.
- Substantial bond market “shorts” among trading accounts (now being unwound).
- A shrinking spread between short rates and 10 year notes (10 minus two year notes are at a decade low of 47 basis points). Flat yield curves are often indicative of a slowing economy or pending recession. And lastly, a heightened sense of investor nervousness associated with owning new issue lower quality/higher risk new issue bonds. Long absent bond covenants (investor safeguards) have returned in recent bond deals.
While March alone may not be defining a new trend, we believe the difficult process of rate normalization (higher yields and wider credit spreads) across bond market sectors is now beginning. Further, these bond market trends may be helpful to all investors for the signals they provide about the economy.