Annual Investors Roundtable: Volatile markets cause optimism to wane

The stock market continued its volatile ride in the last week of the year, with some of the widest swings ever seen.

When the Star Tribune met Dec. 10 with eight professionals for our annual Investors Roundtable, the volatility had already picked up, based largely, they said, on President Donald Trump's trade policies. Fundamentals, including company earnings, are still strong, however, leading the panel to be generally optimistic for 2019 even if enthusiasm is waning.

Here are highlights from the 90-minute discussion, edited for length and clarity.

Martha Pomerantz: I thought this was going to be a really good year. I thought global growth was picking up. I thought corporate earnings were better. We had tax reform. I thought deregulation was improving, so companies were feeling more ebullient, like they could spend money. Unemployment rate was down. Things were going great until we hit sort of an inflection point middle of the year, and I think the trade issues just sort of got the whole thing going here, and since then, it's been a much rockier time.

Lisa Erickson: For us, the year has gone similar to how we expected. We started the year cautiously optimistic in some ways, but I think we moved very quickly to a more balanced reward/risk perspective, and what we saw is that while the macrofundamentals were very good and the corporate earnings outlook was very good, there were a number of uncertainties, whether it was geopolitical risks, whether it was the looming trade talks, whether it was a number of different issues. And I think what we basically saw near the tail end of the year is that those uncertainties really began to sprout up and capture investor sentiment.

Beth Lilly: I think the inflection point occurred with midterm elections, and I think that there's the concern about trade and the problems it's going to cause for the U.S., particularly with China, and the problems with China and the U.S. are deeper than trade. I also think a really crucial issue in all this is Donald Trump, and I think that the likelihood that he finishes out his term is very slim, and I think that's going to be really good for the stock market.

Justin Kelly: What we saw this year is confirmation that stocks are again being priced off of the fundamentals of the businesses as opposed to dividend yield, which was predominant during the negative interest rate environment that we had 2012 to 2016. And that's happening at a time when, yes, there are various macroeconomic forces, but every company in America is facing this transition from the analog world to the digital world, and that's creating bigger winners and losers, i.e. more dispersion in the market than it has historically.

Doug Ramsey: We got cautious in January and then sort of steadily reduced equity exposure throughout the year, so we're pretty close to our minimum, so we've been pretty well prepared for this. I think the surprise has been maybe we've been right for not necessarily the right reasons. Our concern coming into the year, certainly, was we're sort of close to an overheating in some measures of economic growth and inflation.

Craig Johnson: When we got into September, it was pretty clear to us that this wasn't a breakout, this was going to be a fake-out, and this market was going to roll over, and we got a lot of clients out of the way at that point in time, based upon what we were seeing in the charts. So at this point in time, I think we're coming to some interesting support levels we're going to want to pay attention to in the coming several weeks and months.

Mansco Perry: When we started out in January, it was pretty exuberant and everyone was off to the races until February, and since then it's been pretty rocky. Much of the reason for the rockiness is primarily the tariffs. People forget about Brexit, which is still in the news, no one knows how that's going to play out. Interest rates, while they've gone up to a rip-roaring 3 percent, are still at historical lows, which kind of mutes most portfolios. You know the old adage, investors abhor uncertainty, and I'd say we've got a lot of it, unfortunately being geopolitical and unfortunately starting the year.

David Royal: I think [federal interest] rates have had a big part in the volatility we've seen. So it seems like the half-life of a trade scare is getting shorter and shorter, but we pay a lot of attention to the effective rates in the equity markets.

Pomerantz: I think one issue has been the fact that we're at a 10-year anniversary since the big downturn, and that provoked a lot of news articles and coverage over the course of the summer that we're 10 years into this bull market, therefore we must be closer to the end. And I think that just has people on edge. But time does not indicate when you get to the end of the bull market. You're looking for some excesses that have built up, and people haven't spent enough time looking into that.

Erickson: Another contextual thing to consider if you look at the last couple of years, volatility has actually been artificially low by historical standards, and so certainly volatility, particularly in the last few months, has been high and it's been noticeable. But that being said, it's in the context of people being used to the markets just generally going up, so there has to be kind of a historical perspective put on it. As far as whether volatility will continue, I think if we continue to get more historical norms, yes, you will see more volatility.

Lilly: The Fed's pulling $50 billion out of the system every month. That's a staggering number. So on an annualized basis, that's like $700 billion. As they shrink the liquidity in the system, the volatility's only going to increase.

Kelly: The best attributes you're looking for are defensive growth, so companies that are either participating in less cyclical end markets, like health care, or are innovating at a level that will allow them to grow right through a slower economic backdrop. And where we're finding most of those opportunities is in technology — say, the payments companies like PayPal — software and IT services, but also health care devices, where there's a ton of innovation going on, and health care services as well. So those would be areas we think can power through slower economic growth and do quite well.

Johnson: I go through and look at what are the strongest and best performing industry groups happening at this point in time. It's dominated by electric utilities, it's dominated by real estate investment trusts, thrifts and also some of the wireless telecom players, companies like Verizon. Millennials nowadays would rather lose power to their house than lose their cellphone service.

Royal: The market typically peaks three to six months before a recession, so if the October highs are the highs, that would mean that we are going into a recession very soon, and there's really nothing in the macroeconomic data that would support that. So we would actually tend to be a little more bullish. When the recession comes, you'd want companies that could generate organic growth, and probably I would skew it toward larger companies.

Ramsey: I'm leery, because I've called three of the last zero bear markets, but I think there's a really good chance that a cyclical bear market is underway, and I'm not to the point of making a recession call. I mean, if you strip away utilities, health care and consumer staples, cyclical groups have just taken an absolute beating. And if you look at what foreign stocks have done, you don't even have to forecast a bear market, it's happening. At the same time, I'm very impressed with the values that have already been created.

Lilly: I mean, the economy's fine, right? The consumer is 70 percent of the economy, and jobs are plentiful, there's wage growth, household incomes are up, there are tax cuts. Yes, car sales are down and debt is up, and home sales are trickling down. But the problem is that if the consumer starts to get concerned and loses confidence, then you're going to have 70 percent of the GDP start to go down and then [businesses] will start to spend less because of tariffs. So we're not even getting the business growth.

Perry: I'm not a chartist. But if you look historically about how bad things have been on and off for the last three decades, the S&P has been negative six times. Two-thirds of the times, we've had double-digit returns. So as long as the U.S. economy continues to plug away, as I think it will — but what I do agree with you is the geopolitical concerns. Not only can we not predict what's going on elsewhere, we haven't got a clue as to what's truly going on in Washington, and until that clears up, there's going to be uncertainty. And I go back to the cliché. As long as we're uncertain, be skeptical about where you're going to put your money.

Kelly: Every day my team is dialoguing with CFOs and CEOs, and we ask them, "Are you preparing for the second round of tariffs?" And almost unanimously, they don't think it's going to go through. So the amount of disruption that's going to occur from this is significant. We've already seen many companies pull their supply chains out of China, but it will accelerate, and the market is not pricing that in, so that is a near-term risk. Who knows how long that could last. Trump is causing a level of uncertainty that's not constructive for business confidence.

Erickson: The other thing I'd add on tariffs is they have contributed to the volatility. I think, though, from a sizing perspective, you have to keep in mind that the numbers that are out there are large in a stand-alone sense but not large relative to the size of the economy. So, for example, if you take the amount of trade that we have in the U.S. with China, it's about $500 billion. But to a backdrop of our GDP which is $5 trillion. I think the relative magnitude is misunderstood. So really, where the tariffs are going to have a greater impact is more expectational as opposed to the absolute impact on the economy.

Johnson: Let's watch Walmart and Target. Let's see what happens to their profit margins. They import a lot of their goods from China, and a lot of the products are manufactured over there. So as we go through the next earnings season, that'll be interesting. Right now, there's a lot of discussion and there's a lot of headline noise that's getting made, whipping up fear in the markets, but when you come back and you look at a lot of the numbers, there hasn't been that much of an impact yet.

Ramsey: I think the funny thing about this year is the impact of the corporate tax cut was so large — we've never had anything like that, a 40 percent one-time reduction of the corporate tax rate — that it's been hard to see the impact of the tariffs and rising wage inflation and other things that would normally crimp margins at this stage in the cycle.

Johnson: There are about 50 public companies that are included in the Piper Jaffray Minnesota Company Index, and I see a lot of health care companies that look attractive — UNH, Medtronic — and also on the staples side, Hormel looks like a very constructive setup on the charts. Financials, unfortunately, look a little bit weak. And then I'd also say the electric utilities have a good-looking chart. I'd also add Ecolab in there, too.

Royal: We don't generally make big sector industry bets. We do bottom-up fundamentals. When you look at the long-term secular trends, probably technology and health care. But you've got to have a little bit of fun. UnitedHealthcare we like, but that's too easy, so I'll throw out one name — Tactile Systems Technology, TCMD, proprietary technology for treating lymphedema, swelling. It's a Minnesota company we like a lot. And then going from health care to retail, we own Duluth Holdings, a retailer with both strong e-commerce and brick-and-mortar store growth.

Kelly: We like the health care sector, so we would think companies like Medtronic and Abbott [which bought St. Jude's], would do quite well. While everybody seems to be liking UnitedHealthcare, I would also say that stock could see as much as 20 percent appreciation next year from these levels if things break right.

Ramsey: Pretty much in line. We do like health care. That's been our No. 1 sector here in the last several months. And I like the idea of utilities as well.

Lilly: I continue to believe that there are wonderful little microcap companies that aren't on Wall Street's radar screen within 90 minutes of the Twin Cities that I think are going to do extremely well.

Lilly: So I know I can't give two answers, but I think if we have a change in leadership in the White House, the market could go up 15 percent next year. If we continue with the path we're on, I think we're going to be in a down market, and I think it'll probably be flat to down 5 percent. If Trump's in office, my number is 2,400. If he's out of office, my number is 2,860.

Pomerantz: We don't think we're in one of the last innings. We think we have a few innings to go. We think revenue growth will be reasonable next year. We think inflation's going to stay low, we think interest rates will stay low, and I think investors have been skeptical. That's typically a good time to look for some opportunities, so I think the S&P 500 will be up next year to 2,800.

Johnson: I think we'll be stuck in a bit of a trading range in 2019, so I'll give you a range of 2,500 on the low end, 2,900 on the upper end. I don't think that the secular bull market will end until — well, certainly not in 2019 from our perspective — so 2,725 as an ending number.

Erickson: We're constructive on the market for next year, although it may not be at the same pace as we've had in the last several years. So our target is actually on the optimistic end so far, at 3,100. Again, the economic fundamentals, even though there's a little bit of softening, still are solid.

Royal: Earnings are up 22, 23 percent this past year. We're estimating about 9 percent earnings growth next year. I don't see any reason, absent some dramatic rise in rates, for multiples to compress more. My number is 2,943.

Kelly: So we think earnings growth is going to slow to maybe 5 percent the next couple of years, and that's largely priced into the market today. The market multiple actually goes up from 15 to 16 times; investors get a 10 percent return, which is 2,900 on the S&P; plus the 2 percent dividend, so 12 percent total return; and your active stock pickers like Winslow do a lot better than that. 2,900.

Ramsey: The Halloween costume place didn't have a bear suit for a guy my size. I'm going to go with 2,250, and I'll tell you why that is not as Draconian as it sounds. It'd be 18.4 times current trailing reported earnings, not operating earnings. It'd be the same multiple that existed on Oct. 9, 2007, the peak before a 57 percent decline. So we're just going back to the valuations I think that existed at a pretty good time to sell. It's another exercise that shows you don't have to work that hard to find considerable downside, even after the losses we've had.

Perry: 2,875. It's pretty simple — the real rate plus inflation over where we are now.