For my final post of 2018, I planned on writing a detailed post on the consumer sector. Unfortunately my blogging time has been limited, so instead I thought I’d at least provide a brief summary.
Based on recent operating results, the consumer continues to spend; however, results do not appear as consistent and vibrant as Q1-Q3 2018. Furthermore, interest rate sensitive sectors are showing further signs of slowing. It’s possible, in my opinion, that rising wages are sustaining consumer spending in certain areas, while rising interest rates (and now declining equity prices) are causing other consumer-related businesses to slow. In effect, consumer business conditions have become more mixed versus the first three quarters of 2018, when operating results were broadly trending higher.
We’ll have a clearer picture after Q4 earnings season; however, based on recent results, there are signs that certain economic variables may be in transition. For example, the following comments from Toll Brothers (TOL) suggest a possible shift in labor availability and wages:
“…we believe we will likely see some relief on the labor front. While it is still early, we expect to see some softening on labor pricing and increased availability in some of our markets. We are actively rebidding jobs with the goal of reducing our costs.”
Toll Brothers’ comments are noteworthy as a “softening” labor market would represent an abrupt shift in recent trends. During 2018, the majority of companies on my possible buy list were experiencing a tightening labor market, not softening. Inflation and other macro variables have also been trending higher.
For most of 2018, I expected rising wages and inflation, along with elevated asset valuations, to support the Federal Reserve’s decision to continue increasing interest rates. However, there was one important caveat. Specifically, I noted if asset prices declined sharply or something in the financial markets broke, then all bets were off.
With many of the major stock indices down considerably from their highs, we’re approaching the formal definition of a correction, or even bear market, in certain sectors and benchmarks (as of December 17, 2018 the Russell 2000 is down -20% from its highs).
To what extent has the decline in equity markets influenced economic activity and corporate profits? It’s a good question that I’m currently unable to answer as my recent sample set is too small and does not reflect December’s sharp decline in equity prices. And it’s why I’m extremely interested in Q4 2018 corporate operating results and 2019 outlooks. In order to better measure the effect recent asset deflation has had on the economy, I need additional information from the front lines.
Regardless of the potential impact on the economy, it appears asset prices have moved enough to catch the attention of the Federal Reserve. Based on “The Fed Cheat Sheet”, the Federal Reserve will likely implement a wait and see approach (or pause) after raising rates tomorrow. If their cry of “monetary uncle” isn’t enough to appease investors, I expect the Fed will eventually communicate their intention to end QT and possibly cut rates. Per my cheat sheet (wild guess), I expect the next olive branch will be extended to investors near 2,300 on the S&P 500.
In summary, the financial markets, and possibly the economy, appear to be in transition. With uncertainty increasing and equity prices declining, it’s not surprising 2018 is shaping up to be a good year for investors practicing patience and prudence. Of course 2018 isn’t over. It’s possible recent declines in equity prices will cause the Fed to refrain from raising rates tomorrow, sparking a violent year-end rally. Given how much is at stake (how dependent we’ve become on asset inflation), nothing would surprise me. Nevertheless, in my opinion, the days of making money with little effort and risk to capital appear to be fading (at least for this aging cycle).
For patient absolute return investors rooting for a more favorable opportunity set, the past few months have been refreshing and encouraging. As I’ve stated in recent posts, I’m becoming increasingly optimistic regarding future opportunity. Will 2019 be the year capital can be allocated at prices that adequately compensate investors for risk assumed? I don’t know, but I’m hopeful and can’t wait to find out!
I’d like to wish readers a Merry Christmas and Happy Holidays! Here’s to a wonderful 2019 filled with considerable volatility and opportunity! 🙂