Tariffs, Tweets and Valuation
Clients of the Firm,
As we start the second quarter of 2018, volatility continues in the market, precipitated by fears of a trade war with China through tariffs and the response to the Fed tightening cycle. Last night, the Trump administration proposed tariffs on over $50 billion of China’s imports. This proposal would assess levies on 1,300 categories of products. Tariffs of 25% would apply to goods from medical equipment to chemicals.
As a response, Beijing announced, this morning, proposed tariffs covering 106 categories of products that affect $50 billion in Chinese imports, ranging from airplanes and cars to soy.
It is important to note that none of these tariffs have yet gone into effect, with an open comment period until mid-May for the US proposal and an undetermined timeframe for the Chinese counter measure. With markets poised to open sharply lower on this news, we will again likely test the market lows set in February and will again be in a market correction for the major US indices of 10% or more below the highs set in January.
The correction is now creating some value in the market as we get closer to a normal P/E ratio for the broad US market (S&P 500 and the Dow). Earnings are expected to be significantly higher than last year for the S&P 500 and companies remain poised to benefit from the corporate tax cuts enacted by Congress in late 2017.
Fear and negative sentiment are ruling the day as investors fret over a tweet to tweet policy environment, trade war prospects and corresponding inflation against the backdrop of Fed tightening. These are valid individual concerns and taken collectively, have created the conditions for a correction in the stock market, despite earnings that are increasing at a significant pace. With the broad market P/E normalizing (currently at 16.5 and going lower) and earnings increasing, the risk of making a bad choice on deploying new capital also decreases as prices become more rational.
Ultimately, stock prices will be determined by the profits the companies we invest in make. We can’t control sentiment. We can’t control the timing under which the market will recognize company earnings and assign the appropriate multiple. Over time, we have seen that prices tend to normalize at around 15 times forward earnings. If we buy investments that are priced below that level and have good earnings growth prospects investment outcomes tend to be good. In short, we can control our own decision making as investors and can look to either invest or hold investments in times like these.
Again, generally good long-term investment results come from an environment where multiples contract and earnings are growing as we are seeing today. Phasing in purchases of securities is the wise way to proceed as market sentiment can often outweigh rational thought in the short-term. As we have said many times before, in the short-term, the market is a voting machine heavily influenced by sentiment. In the long-term, the market is a weighing machine which values companies based on the profits they make and are likely to make in the future. Our focus will remain on the latter.
Thank you for your continued confidence in this challenging time for investors.
Peter C. Wernau
Wernau Asset Management
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