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The Brave Report: Market Commentary for August 2018

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

Summer over, party over? For most investors, this summer was a day at the beach.  Record earnings, strong economic fundamentals and traders away from their desks seemed to be a recipe for great returns this summer.  Since the beginning of July, all three major indices are up over 6%. Even with the trade war headwinds hanging over the market during the last few months most equities just continued to charge ahead.  The big question, is will this continue into the fall?

Historically, September has been the worst month for market performance, losing on average 1.1% since 1929. Add to this the end of earnings season and the expectation that the focus of the markets will again shift back to international trade tensions and we could be setting ourselves up for a bit of a pause or some profit taking in the markets.  I do not expect any major pullback because economic fundamentals are still quite strong but I would not be surprised to see some hesitation as traders return to their desks and look to bank some profits from the summer.

Market Overview

The markets again continued to advance during the past month.  All three averages gained over 2.5%, with the NASDAQ once again the big winner, gaining around 3.7%.  This performance was primarily driven by continued strong earnings and some breakouts by a number of the large technology companies. This continued outperformance from the major technology names has led to the NASDAQ outperforming the DOW and the S&P by 11% and 8% respectively so far this year. This is a pretty stark outperformance in just 8 months but as we have discussed before is reflective of the prospects of growth within the technology space.

On the fixed income side, we continue to see the 10-year treasury trade within a range that has been common for the past 6 months.  With a few exceptions, the 10-year has primarily traded above 2.81% will only briefly jumping above 3% on a handful of occasions. Outside of the first week of the month, this upper bound was just 2.9% over the month of August. While there continues to be upward rate pressure from the Fed we seem to have found a relatively tight trading range in recent months.  With the absence of any other major economic shocks, I expect the range-bound trading to continue.

Trade War: The trade war continues to be the 10,000lb gorilla in the room.  While the President was able to successfully renegotiate a new NAFTA agreement with Mexico, Canada is still holding out. Negotiations with China seem to have been put on the back burner as well. This is somewhat troubling as a new round of tariffs on $200 billion of goods is set to begin in the coming weeks. The domestic markets have performed relatively well even with this cloud hanging over everything but I think this performance is in spite of the trade negotiations and not because of them.  Market performance would have been even better had this cloud never appeared.

As I have discussed before, the actual economic impacts of these trade negotiations have not had a meaningful impact on economic results yet but the longer this uncertainty drags out, the larger the unintended consequences will be.  Without clarity, it is very difficult for companies to make long-term capital investments and forecast future growth.  Even for companies that are not directly impacted by these trade negotiations, the uncertainty around it will stifle potential growth across the board. I worry that the upcoming midterm elections will only complicate potential negotiations more.

US Dominance: One of the most interesting aspects of the markets over the past year has been the outperformance of the US markets. Over the past 12 months, the US markets have outperformed almost all other major international markets or regions by more than 20%. In many cases, this disparity is even greater. This outperformance seems to be in line with corporate results over the past year and the perceived safety of the US markets but rarely do we see such a widespread disparity.  As you can see in the chart below, the S&P500 has gained over 17% in the last 12 months while Europe and the Emerging markets were down 2% and 5.5% respectively.  This disparity even increases if you drill down to some individual countries.

The big question now is will this type of outperformance continue or will we see future performance revert back toward the mean? If we look at economic data and corporate fundamentals, it is easy to see why this outperformance has happened.  The US economy has been growing much faster than its European counterparts and corporate revenue and earnings have been growing far faster domestically. I expect this to continue over the next year

However, this also could present interesting buying opportunities as we potentially see some reversion to the mean in some of these regions. I don’t expect to see a blanket reversion to the mean in all regions.  Emerging markets investors have been expecting this for a while now and it has been a losing trade. However, there have been some international companies that have been dragged down with the rest of their markets due to trade war and currency issues and I think identifying them could be profitable as some of these international markets recover or buyers start to see the value in these companies. For the long-term investor, I think it could be a good time to identify quality companies that have been dragged down with the rest of their markets but continue to put up strong growth numbers. I will caveat this by saying these types of investments are not for everyone and will see some high volatility but for the long-term investor there are some international companies that are amazing long-term values at these prices.

Strategy Commentary

From an overall strategy standpoint, I made very few changes over the past month.  The summer tends to be a time when volumes are reduced so unless there is a major shock I tend to use it as a time to rebalance and capture some gains or losses.  Trade conflicts still present the greatest risks to the market right now.  At this point, these risks have nothing to do with actual economic impact but more about perception and fears about what may happen.  This uncertainty continues to weigh on the markets and until it is resolved I will continue to maintain my equity exposure a little below my normal allocation.

I am still maintaining my overweights to Technology and consumer discretionary and will be looking to add another sector over the next month or so.  I did take some profits in these areas as a part of normal rebalancing but still maintain my overall positive stance on both sectors. As I mentioned last month I am watching healthcare. If these trade tensions continue to push through the fall I may look to add a more defensive sector like utilities, which has outperformed in recent months and should continue to if investors run toward safety.

I continue to be underweight on almost all international markets.  While I do think there could be selective opportunities at some point in the future, the growth profile in most other developed economies and the currency issues plaguing some emerging markets countries are keeping me away. Trade concerns only add to these uncertainties. Until we get some clarity on international trade deals and some currency stabilization I will continue to maintain my underweight.

While upward rate pressure has subsided in recent month, I am still underweight on most of the fixed income space. I continue to maintain increased cash positions as a replacement for this exposure.