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THE WEEK AHEAD

Flush earnings still help, but higher interest rates and trade concerns hurt the bull case for stocks.

MACROECONOMIC INSIGHT

Not much happens when businesses, investors, and consumers decide to pull in their horns. Fortunately, the past couple of years have had most people feeling relatively optimistic about the outlook. Consumers are benefitting from full employment, rising wages, and increased wealth. Business owners and investors are reaping the benefits from a growing economy and large profits. For the past several years, no attractive “risk free” investment alternative existed to compete against riskier assets.

One way to think about compensation for risk taking is the “excess return” that can be earned over holding what is often referred to as a “risk-free” asset like Treasury bills instead. Of course, knowing in advance the stock market’s return is impossible and no investment is without risk. However, we can look for some proxy of profitability and value to provide a reference point. One such reference point is the forward-looking earnings yield for the S&P 500. The chart below shows that yield which is calculated by dividing the 12-month forward analyst earnings estimates for the S&P 500 by the S&P 500 index itself. Strong earnings and/or better valuations will raise the earnings yield (making stocks more attractive), while weak earnings and high valuations reduce the earnings yield (making stocks less attractive), all else being equal. As one last step, we should look at the earnings yield versus the risk-free alternative to assess the relative attractiveness of stocks versus holding cash or another safe asset .

A casual look at the chart above shows that today’s earnings yield remains relatively attractive compared to the short-term Treasury rate. However, it is clear that the Federal Reserve’s (FED) rate increases of the last year are starting to reduce that advantage somewhat. If, at some point, the differential between the risk free rate and the earnings yield becomes too small, then markets could decide to reallocate capital away from risk-oriented investments. For now, there still seems to be a significant gap between the short-term “risk-free” rate and the earnings yield on stocks. This was the case back in the early 1990s, early 2000s, and 2007-2008.

The Risk of Rising Trade Tensions

The good economic environment and the situation just described creates an excellent environment for the stock market. The last two years saw improved growth, rising earnings forecasts, and a benign inflation and policy backdrop. We are closely watching fundamental conditions evolve since last year, however. Our own WCA Fundamental Conditions index, which tracks a host of inputs relating to markets and the economy, peaked early in the year and has drifted lower ever since. We have steadily cut risk exposure on a tactical basis as the result of the slippage in tactically invested asset allocation portfolios.

At the same time our barometer has been fading, a U.S. led effort to renegotiate trade deals is leading to a heating up of global rhetoric on a wide variety of trade issues. While we will stop short of laying the slippage in our barometer at the feet of a trade dispute, we cannot dismiss the possibility of a connection either. Although there has been relatively little actual impact on trade yet, the atmosphere has clearly been tainted by a constant stream of headlines that points toward growing uncertainty surrounding the future of global trade.

We are especially interested in seeing how businesses respond to the changing landscape, because this has a direct link into investment and hiring plans in the real economy. In the next several weeks, we will look to highlight business and manufacturing surveys as key to tracking how capital investment and hiring plans are evolving in light of the newly developing narrative on trade.

CONQUEST PORTFOLIO POSTURE

On June 15, we reduced equity exposure and raised core bond exposure in satellite portion of portfolios. Tactical tilts in the core include an overweight to value vs. growth, underweight emerging markets vs. developed, underweight gold vs. REITs.

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

(973) 549-4168

www.washingtoncrossingadvisors.com

www.stifel.com

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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.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

The Standard & Poor’s 500 Index is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

Washington Crossing Advisors LLC is a wholly owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF).