Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: June has been a Jekyll and Hyde sort of month. After rising steadily in the first half and looking like the broader market had regained its footing, stocks have since given back all their gains and uncertainty has elevated once again, especially with regards to trade tensions with China. What are your thoughts how things are shaping out into the close of the first half of the year?

Stovall: I think investors who had been dismissing the prospect that this trade skirmish will expand into a full-blown trade war are now actually taking some evasive action. They had been rotating rather than retreating—meaning instead of retreating into cash, they rotated into more defensive sectors as well as into mid- and small-cap stocks that had less international exposure, and therefore would be less harmed by the shutting down of foreign markets.

Yet, recently we’ve found that investors have truly taken some risk off the table by selling off large-, mid- and small-cap stocks, Developed International and Emerging Markets, as well as nine of the 11 sectors, and 85% of the 145 sub-industries in the S&P 1500. So, I think investors are basically saying, “You know what? We’re really not sure what’s going to happen, so it’s better to be safe than sorry.”

EQ: In this week’s Sector Watch, you published an extensive outlook for the second half of 2018, detailing a number of positives and negatives for the market. You also noted that CFRA expects a low single-digit rise for the S&P 500 for 2018, and that you expect the market to finally break through to new all-time highs in Q3 to complete the correction that we’ve been in for most of the year thus far. It should be noted that his was published Monday morning. Is June indicative of what we may be seeing here on out in terms of very choppy trading with an overarching uptrend? Have expectations changed since?

Stovall: Through June 22, which was the Friday close just before the publication of the second half outlook, the S&P 500 was down less than 3.5% from its all-time high. I think investors were in the mindset of all these tweets and statements about tariffs really are the President’s negotiating tactics and did not expect it into morph into anything more than that.

We can see that through the fundamental numbers, such as GDP growth expected to be up 3% this year and next, as well as earnings growth expected to be up 21% this year and 10% next year. Also, the Fed is expected to not raise rates too aggressively, and as a result, not push the 10-year yield to average more than 3.5% through 2019. So, a lot of these fundamental factors were still supporting a bullish, but not outlandish, approach to equities.

But as this week has progressed, I think investors are certainly calling that into question. They’ve obviously realized that prices lead fundamentals, and if this price weakness persists, it could be an indication that some of these more optimistic GDP and earnings forecasts stick to trend in the weeks ahead.

EQ: Generally speaking, up until this point, fundamentals have been encouraging while the technicals and headline risks may continue to drive volatility. If you’re an investor, certainly you don’t want to play chicken with the trade tension, but what do you do from here? Should they be sitting on their hands, or maybe looking for buying opportunities?

Stovall: I think investors should realize that in the third quarter of midterm election years, the average daily price volatility of the S&P 500 was 34% higher than the average price volatility for non-midterm election years. So, I think first off, we have to realize that it normally gets quite volatile in that final quarter before the midterm election occurs. So, in some ways, its probably best for investors to sit on their hands.

From a technical perspective, we’re looking at the 2,675 level on the S&P 500 to be a pretty important support level. Should we break below that level then it could negate the positive move that we saw over the last couple of weeks and indicate an even deeper downside move is likely in the near term. The old saying is, “Don’t try to catch a falling knife,” and right now, that knife is precariously positioned.

EQ: In market sectors, it seems like small-cap cyclical sectors have been the sweet spot thus far. Is that likely to continue?

Stovall: I think it will continue. There are several reasons why investors are gravitating toward small caps. They underperformed last year, so it could be a case of reversion to the mean. Earnings expectations are expected to be much stronger for small caps than for large caps in the year ahead. We’re expecting to see 30% growth for small caps this year as compared to 20% growth for large caps, and next year it’s 20% growth for small caps versus 10% for large caps.

As a result, both the absolute and relative P/E ratios look very attractive from a historic basis. In fact, the relative P/E is trading at a more than 8% discount to its average over the last 20 years. Finally, because small-cap stocks have a very small exposure to overseas markets, they’re not going to be shut out, nor are the currency translations likely to affect their earnings because of the flight to safety that usually occurs during market turmoil, which causes the value of the dollar to rise.

CFRA Sector Recommendations (Excerpt from June 25, 2018 Sector Watch report):

Overweight Recommendations:
Energy: Oil prices should remain elevated as a result of increasing supply constraints in Iran, Venezuela, and likely the U.S. Permian Basin.
Industrials: CFRA analysts dismiss the possibility of a full-blown global trade war and expect this group to benefit from global economic growth and the 2017 U.S. tax cuts.
Materials: We also think this group will benefit from global economic growth expectations and recent tax cuts.
Information Technology: CFRA strategists think Wall Street earnings growth expectations for 2018 and 2019 are underestimating the potential of the sector.

Marketweight Recommendations:
Consumer Discretionary:
The effects of an improving economy are likely to be offset by interest rate, retail, and currency uncertainties.
Financials: Weak loan growth, a flattish yield curve, and revenue constraints on life insurers from annuity businesses should make this group a market performer.
Health Care: The high drug-price overhang should continue to adversely impact sales growth, profitability and share prices.
Real Estate: The group will likely be supported by a strong office and apartment market as rental rates have been on the rise but offset by rising short-term rates.
Utilities: Despite the pressure from higher interest rates on this bond proxy sector, we see share prices supported by customer growth plus rate increases from capital spending for aging infrastructure replacement and load growth.


Underweight Recommendations:

Consumer Staples:
Elevated valuations, weak relative technicals, and continued investor gravitation toward eco-sensitive sectors.
Telecommunication Services: A highly competitive environment as cord cutting reaches new heights and consumers remain price conscious.

EQ: In terms of portfolio allocation, can you elaborate on CFRA’s recommendations?

Stovall: We currently have a neutral allocation of 60% global equities versus 40% fixed income. We have an underweight recommendation to bonds, and an overweighting to cash. In January, we reduced our recommended exposure to large-cap stocks and recommended investors put that money into small-cap issues. In May, we suggested investors take 5 percentage points off the table as it relates to international stocks because we just felt the risks were on the rise, and it was time to take some of that exposure away.

So, because we’re not looking for a recession on the horizon, we’re therefore not looking for a bear market to occur anytime soon. Our belief is you still need to stick with equities because it is still the asset class of choice, but just realize that you shouldn’t go too far out on the risk curve.