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That is how we describe the activity in the second quarter that just ended. By definition, financial market dislocation occurs when markets operate under “stressful conditions” and therefore cease to price assets correctly. Put another way, markets trade too high or too low, relative to economic reality. The “stressful condition” overtakes the psyche of investors who will then price the markets – high or low – with very little, to no connection to economic reality. One thing for sure, history has shown that market dislocation is the precursor to a major market move ……up or down. Professional market participants love market dislocation. It helps us determine which major move – up or down – will come next. Market dislocations often drive markets to excesses. Meaning, way over valued in bullish dislocations, and undervalued in bearish dislocations. Either way, opportunities are created.
Let’s look at the second quarter activity. In an article in today’s Wall Street Journal, the byline reads: “Economic Output Steamed Ahead in Second Quarter.” Sounds pretty bullish, right? One of the key elements of a bull market is strong U.S. domestic output. The stronger the economy, the stronger the market, or so the theory goes. The economy in the second quarter was one of the strongest performances of this current economic expansion. Economic output was the strongest since 2014. Spending by consumers, businesses, and the Government was also solid. All good for the economy. Another bullish signal was the rally of the U.S. dollar. Strength in a country’s currency reflects the strength of its economy. Finally, there are corporate earnings. First quarter earnings were strong, thus providing fuel to the market. Second quarter corporate earnings are projected to be even stronger. And, the tax cuts announced at the end of the year are sure to add a boost to corporate bottom lines. With all this bullish news, one would expect a market on fire, right? Well, in the same Wall Street Journal this morning reads another byline: “Dow Slips Back Into Red for Year.” Wait, what? Isn’t all this bullish sentiment a positive for the markets? What gives? Market Dislocation!
So, what “stressful condition” created this market dislocation? Clearly and unequivocally, the dominant economic news of the day, week, and year has been the talk of tariffs leading to a trade war. When this 800-pound gorilla began to raise its head earlier this year, most finance professionals dismissed it as improbable…. present company included. As it began to roar, we all surmised that this was President Trump’s way of forcing our trading partners to revisit NAFTA, and more importantly, address China’s large trade imbalance with the United States. Although I, and others still do not believe a full-blown trade war is likely, the potential of one is starting to negatively impact everything from farmers, to steel manufactures, to car sales, and of course……. the markets. Anyone who has studied Economics 101 knows that there are no winners in a trade war. In fact, everyone loses. I do not think that this is lost on the Administration and/or our trading partners. Some type of negotiation will be worked out. We have clearly been wrong on the timing of an agreement as this talk of a trade war has gone on much too long. The only thing for sure is that it will end. However, until it does, investors will continue to run for the exit ramps, pushing prices of stocks down to levels that do not reflect the aforementioned positive economic news. An overreaction? We think so, but we also understand the psyche. So, being contrarians, we smell opportunity! As I mentioned earlier, market dislocation tends to move markets excessively high on the upside, and excessively low downside. It is our belief that we are experiencing the latter. We believe the current market dislocation is a precursor to a strong rebound in the near future. We also believe, however that there will continue to be near-term pain before we see further gain. What to do? At worst case, do nothing, as the decrease in values is a near term phenomenon that will pass. At best case, take advantage of the values being created by this market dislocation and buy, buy, buy!! The Trump Administration prides itself on the strength of the economy, and thus the markets. The United States is China’s largest trading partner and therefore, they need to continue to be able to sell their goods into our market. Mexico, Canada and the EU all depend on trading with the United States. Our hope is that cooler heads will prevail sooner than later and thus a mutually beneficial agreement will soon be reached.
Barring a protracted trade war, we believe that the economic environment will continue be beneficial. Low unemployment, strong economic output, good corporate earnings while inflation remains in check, bodes well for the markets. We continue to believe that technology (AMAZON, Facebook, and GOOGLE), retail (Wal-Mart, Home Depot, Macy’s) and the Chinese market (Alibaba. QIYI, Tencent Holding) will provide the greatest growth opportunities going forward. However, portfolios will continue to be anchored in the Standard & Poor’s 500, NASDAQ and Berkshire Hathaway.
As always, feel free to contact me for additional discussion specific to your portfolio and to let me know of any financial changes. I am honored by your loyalty and look forward to continuing to make you money for many years to come.