Many factors conspire to cause stock values to rise and fall, but one stands above all others — profits. Successful business investment is the beginning of profit growth and rising stock values. Such activities enlarge earnings power and drive the value of an enterprise over time.

But last year’s 30% rise in stock values1 was not accompanied by a rising tide of earnings and capital investment. Instead, the rise was mostly driven by investors’ willingness to pay higher prices for the same level of earnings. In our view, stock values will continue to rise only as a result of continued confidence, steady business investment, and profit growth.

This is why we are focused on incoming data — because it sheds light on whether or not evidence exists that this process is unfolding.

Watching Business Investment

One way to measure business investment is to look at durable goods orders. These are orders for large ticket items used in the manufacture of other things. When businesses see rising demand ahead, outlays for such equipment rise. When uncertainty clouds the outlook, businesses cut back, and capital goods orders fall. Because the investment and profit cycles are connected (chart, below), we tend to focus on changes in capital goods orders.

Last week, we saw that core capital goods orders declined by 0.9% in December, below expectations. Most core categories declined led by computers and associated equipment for the largest decline since last April. Thus capital spending continues to struggle, which could slow the profit cycle.

Coronavirus — New Factor

Another potential tailwind is the coronavirus should it continue to spread. China, the worst-hit country thus far, expects a $60 billion or 2% haircut to growth in the first quarter according to Chinese state media. As China and other countries seek to contain the virus, questions have begun to emerge about the virus’s impact on the global economy. While too early to tell, the timing of the outbreak and location of the source close to supply chains is a negative for business. Uncertainty has the potential to disrupt what seemed, until recently, to be a firming growth picture.

Slowing Profit Cycle?

A profit deceleration could weaken the bull market case. The rise in stock prices in the past year, to some extent, relies on a rebooting of earnings growth. Global monetary easing, improved trade tone, and better-defined path for Brexit set the stage for a first-half rebound. To the extent that the lift-off of this rebound is stalled, recent stock market gains could be called into question.

Conclusion

To extend the bull rally, it is important that the 2019 downshift in global growth, and flattening of profit picture becomes reversed. Improved confidence, business investment, and earnings growth would provide support for stocks. The most recent data on capital goods orders (as a proxy for business investment) and new uncertainties raised by the coronavirus pose challenges for the bull case.

1 As measured by the total return of the S&P 500, a market capitalization-weighted index of the 500 largest U.S. companies stock price performance.

Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst

(973) 549-4168

www.washingtoncrossingadvisors.com
www.stifel.com  


Disclosures

WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

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