July 2018

Who Wins the Race – Earnings or Tariffs?

There are times when the market movement seems not to reflect what is really going on. This is one of those times.

In the first quarter of this year, companies in the Standard & Poor's 500 reported earnings growth of almost 25 percent. In this quarter, earnings are expected to be almost as good. Yet at the start of the year, the S&P 500 was at 2683.7. At the close on July 30, the S&P was 2802.6, which is up only about 4.4 percent. If earnings are so strong, why isn't the market reflecting that?

There are a couple of possible reasons. The first might be that the market is simply returning to more traditional P/E ratios and growth after years of exceptional returns. The current bull market turned nine years old in March, making it one of the longest in history. Although many experts are expressing optimism that the bulls will continue to run, they also note that this market is already in unusual territory. And perhaps investors, worried about overheating after this long bull market, are simply being more cautious and pulling back a little.

But there could be other forces at work. Markets also react to decisions out of Washington, and to the psychology around those decisions. For example, the markets surged after the tax reform bill passed, giving big tax breaks to corporations. But some recent events appear to have made the market nervous.

Chief among those are the so-called trade wars. President Trump has imposed stiff tariffs on a number of products coming into the U.S. from many countries, including China, Mexico, Canada and the European Union. These tariffs can make it more expensive for companies to produce certain goods, potentially cutting into profits.

Those countries are retaliating by imposing tariffs of their own on our goods, which can make it more difficult for American companies to sell their goods overseas. Trump recently announced a $12 billion program to provide short-term relief to farmers unable to find markets for soybeans, pork and more.

There is evidence that the tariffs are beginning to affect the earnings of corporations. Whirlpool, for example, saw its shares fall 14 percent last week after the company reported weaker-than-expected earnings that executives blamed largely on fallout from the tariffs on aluminum and steel. Some companies expect a minimal impact from tariffs, and some believe they could improve earnings over the long run. But about 44 percent of companies issuing earnings reports through midweek last week mentioned the impact or potential impact of tariffs during their earnings call, according to FactSet.

At Peachtree Investment Partners, we think that when it comes to investing, it is best to focus on what you know, while being aware that you don’t know everything. What we know right now is that there are many signs that are positive for the economy: As noted above, earnings continue to be excellent; more than half the S&P companies had reported earnings through the end of last week, and 83 percent of those reported that their actual earnings were stronger than the estimates, according to FactSet. Employment is strong, and inflation is increasing slightly but is not concerning. The Federal Reserve continues to take a reasoned, careful approach. All these are cause for cautious optimism. Meanwhile, we will keep an eye on trade wars, deficits and other potential barriers to economic growth.

Regardless, though, we believe that the best approach, in virtually any kind of environment, is to buy the stocks of large American companies with strong cash flow, good management and a sustainable competitive advantage. We also believe that owning stocks that pay dividends can help reduce the impact of volatility, since not all your profits come from changes in stock prices. In addition, reinvested dividends can add to your overall returns over time.

In other words, focus on what you know, but keep an eye on everything else.

Garry K. Schaefer
Atlanta, Georgia
July 24, 2018

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