The Market is Not Always Rational

When the market goes up, it is said, it takes the stairs; when the market goes down, it takes the elevator.

Today’s market performance was a result of the President’s tweet indicating that he will add an additional 10% to $300 billion in imports from China. We quickly do the calculation and figure that adds up to $30 billion. (How about that? Didn’t even need to break out a calculator.) Does that in anyone’s right mind justify a 3% or so market sell-off? I am pretty sure the rational person would say no, after all, wouldn’t you just lower the market valuations by the amount of the tax and move on, just the way a stock goes ex-dividend? The market is not always rational.

There have been several factors that have led up to this sell-off. First, Q2 earnings, while they beat the estimates, have been lowered quite significantly. Earnings management at firms reporting to Wall Street has become commonplace. These lowered earnings do mirror much of the economic data that suggests the global economy continues to grow, but not at the same pace over the past three years.

Second, equity valuations have a perception of being high. This is due to the very fast response to Q4 performance numbers that saw the indices fall over 20% in some instances. If we looked only at year to date numbers, we would see exceptional growth in equities. If we average them over the past two years, not so much. This market is not yet overvalued with a growing economy.

Third, the Federal Reserve has made several policy mis-steps in their first term. It is clear that when you have a growing economy and you need to look at inflation as a concern, slowing increasing rates makes sense. To spike up short-term rates with little to no inflation in the data would be silly. However, when trying to spur the economy in a slowing environment, taking the rate down quickly and calling it a day, is a much better policy response. We now have business leaders that think, as a result of the Fed, he will lower the rates in the future due to a future slowing economy. That puts capital expenditures on the back burner, waiting for things to get better. The Fed should not be in the business of causing things to slow down.

Where does this lead us in the trade war? As First Trust has reported a couple of days ago, our trade with China is changing and they are not going to like it. This year, US imports from China are down 12.4%. We are not buying as much from them. Does that mean our economy is slowing? No, we are importing them from other countries: up 33.4% from Vietnam, up 20.2% from Taiwan, 10.7% from South Korea, 10.0% from India and 6.3% from Mexico. US companies are very skilled at finding manufacturing to fulfill the needs of the growing economy. We are not fully reliant on China to be our cheap manufacturer. The numbers tell us this story.

What will this increase in tariffs do to US pricing? The current estimate is that a retail product in the US will increase 1%. Not exactly what I would call a massive price hike. What is interesting about this is that literally for almost a decade, we have been trying to bring inflation up to 2% with little success. This tariff may actually spur some price hikes; is that any different from what the Fed has been trying to do?

What has changed? China will be under considerable pressure to resolve this issue. It is likely that they will try to hang on until the election next year to put pressure on the US President to get the trade negotiations resolved. I am not so sure that he really cares about getting the deal done, but we will see how much he wants to be elected next year. This will continue to put pressure on China based equities. As such, our allocations in the emerging market sector will change to reflect this.

As always please let us know if you have any questions. Thank you for your continued support.

August 5, 2019