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The Brave Report: Market Commentary for July 2018

Click here for PDF version of this report: The Brave Report-July 2018

Earnings to the rescue, kind of. By almost all metrics, this has been another stellar earnings season, with around 80% of companies that have reported beating their earnings estimates.  This has led to another great month for market performance, especially for the DOW Industrials. However, all these positive reports have not been able to remove the shadow of a potential trade war that still hangs over the markets.  Even with the great market performance, it is tough to not think about how much better the last few months could have been without the uncertainty of a trade war.  Earnings have succeeded in changing the focus, even if it just for a few weeks, but I fear the continued trade overhang will continue to mute potential investment gains in the coming months.  With earnings season coming to a close in the next few weeks will the focus again move back to the daily tweets of our president?

Market Overview

All three major indices marched higher during the month of July.  The markets pretty much traded in lockstep until the last week of the month when we saw a sharp selloff in the tech-heavy NASDAQ.  Over the course of the month, the DOW was the winner, gaining around 4.2%. The S&P and the NASDAQ were up 3.3% and 1.8% respectively. This was a rare month where the NASDAQ wasn’t the big winner but even with the sharp late month selloff still had a very respectable month.

On the fixed income side rates were pretty stable for the majority of the month with the 10-year trading between a yield of 2.81% and 2.9% for the first three weeks of the month.  However, we saw a quick spike to end the month with the rate almost reaching the 3% level.  The overall rate story still remains the same as the 10-year still remains reluctant to break through the 3% level convincingly.  We are still watching the spreads between the short and long-term as the fear of continued flattening and even inversion remains in the cards.

Earnings: I sound like a broken record when I have been doing these earnings recaps over the past few quarters but again we have seen a very strong quarter across the board.  Earnings growth of S&P 500 companies for the quarter is again above 20% even if you remove the energy sector (which was an outlier at 123% growth due to changes in energy prices). This strong earnings performance is expected to continue for the next two quarters as many companies affirmed or raised their future guidance.

We continue to hear grumblings from pundits that we are reaching peak earnings but even if we are reaching that level it doesn’t mean that, historically speaking, strong results can’t continue.  The major risks to this kind of continued growth are the potential trade war with China, inflation and the inversion of the yield curve. However, as we saw with the recent GDP number, the economy is showing few signs of slowing down and until any trade war uncertainty starts spilling over to actual corporate results we should continue to see strong earnings reports.

Tech Rollover?: For the past year (and for even longer for that matter), technology has been the top performing sector.  This outperformance has been primarily driven by some of the larger tech names. Some refer to FANG but this outperformance has stretched across a to other large tech names that don’t fit into the FANG moniker.  However, what we have seen is a large correlation develop between many of these names. There have been a sharp run-up across the sector and handful of quick selloffs driven primarily by these larger names running or selling off.  If bad news comes out about any of these companies or any of them disappoint an earnings report, the losses tend to not be restricted to that one name but stretch across the entire sector.  Part of this is driven by algorithmic trading and some is driven by index selling. One of these selloffs occurred at the end of July as two of the biggest names, Facebook and Netflix (Netflix is actually not technically included in the tech sector) delivered earnings reports that didn’t meet street expectations. The result was the technology sector selling off more than 5% in 3 sessions. This selling was even in the face of a number of other companies delivering stellar results.

With the run tech stocks have been on, whenever a selloff like this happens, even if it is short-lived we start to question if these stocks have topped out and are reverting to the mean or if this is just a blip on the continued ride higher. I would argue the latter. Until we start to see weak results from a wider range of companies these short-term pullbacks just create great buying opportunities in the other companies that get unfairly sold.

With that said, these types of pullbacks also present a risk I have alluded to before in these reports and is one that scares me if the markets start to turn south. Does this type of forced selling, either driven by algorithms or index investing, lead to more exaggerated selloffs? When index ETFs start to see outflows they must sell some of the underlying stocks within that index, this causes forced selling across the board. A lot of good names get sold off with the bad. This completely changes the dynamics of how markets are supposed to operate. If the results of just a few companies can drag down entire sectors or markets so much, this additional risk must be factored in moving forward. The opportunities it could present in the names that are unfairly dragged down should also be taken advantage of.

Strategy Commentary

I continue to maintain my overall equity exposure which is a little below my normal allocation.  This caused me to lag the markets slightly over the past month. The trade overhang still ads an increased risk to equity markets. Overall fundamentals are still there for the markets to make another move higher and if we can remove some of this uncertainty around trade negotiations I will quickly add back any equity positions I have cut.

I am still maintaining my overweights to technology and consumer discretionary.  We saw a sharp selloff in technology stocks in the last week of the month but even with that it still has been a great outperformer for a while now. A few percentage points pullback is not going to make me change my stance. Healthcare has been a strong outperformer in recent months. This sector could be on my buying list if I do add more equity in the coming months.  I increased my overall domestic exposure as I made some cuts internationally.  These additions were broader and not sector specific.

Internationally, I cut my exposure to Japan and am currently underweight in almost all international markets. As I just mentioned, I replaced these cuts with some broad domestic exposure.  The prospects for growth and current corporate results are just stronger in the US.  I do think emerging markets have been pretty oversold so far this year.  If we start seeing some progress on the trade front there could be some great selective buying opportunities in a few emerging markets countries.

I am still underweight on most of the fixed income space. With the small exposure I do maintain I am staying on the short end of the yield curve.  As a replacement for my fixed income exposure, I am maintaining higher cash levels.

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