• Investors are happy with year-to-date returns (the S&P 500 is up 12%), but the market is actually trading at the same level it was 16 months ago.  We’ve had big up and down moves, but in the end, we have been trendless.  We think valuations have a lot to do with that (and the trade war, too).  Valuations remain rich but are much lower than January 2018.  More on the trade war below.
  • Yesterday Fed Chairman Powell indicated the Fed might respond to any economic weakness by cutting interest rates.  This sparked the 500 point rally in the Dow.
  • According to last week’s AAII survey, only 25% of respondents are bulls, while over 40% expect stocks to be lower in six months.  This is the most pessimistic response since last December’s low.  Since this is a contrarian indicator, this reading is a short-term positive.

The Realities of the Trade War With China –
and What to do With Trade Sensitive Stocks

American negotiators are trying to convince the Chinese to make changes to their system, particularly in the ability of their government to extract technology and intellectual property from our business sector.  But does China really want to make changes to their system?  Will they adapt to a Western-led financial and trade system, one that in their eyes took the world to the brink of depression with the 2008 financial crisis?  Their alternative is ‘authoritarian capitalism’ (a term coined by Wall Street Journal columnist Gerald Seib) which they believe is the better model for them and others to follow.  It will not be easy for U.S. negotiators to extract systemic concessions from China.
The new cold war has put technology companies on the front line.  Tech is the most affected, mainly because of the risk of spying or military use.  Investors fear a rebuilding of the global tech industry with separate U.S. and Chinese spheres of influence.  In particular, the U.S. semiconductor industry would be hard hit.  The semiconductor index is down about 15% from its April high.
The dominant narrative is that there is going to be a trade deal but the timing, of course, is unknown.  The bigger question is whether a prolonged stand-off is adequately discounted in share prices.  May’s big decline in the stock market certainly shows increasing investor skepticism for a favorable deal.  A few key questions:  Will the ‘reformers’ in China exert enough influence on Chinese leadership to bend to U.S. terms.  Will China wait out the rest of President Trump’s first term?  Will President Trump continue to play hardball once U.S. consumers are impacted by tariffs and farmers continue to suffer.  We think there is just too much uncertainty for a sustainable rally in the market.  Of course, this could all go away with a handshake.  It is also possible it won’t.
Long term investors should not overreact to the trade war.  The stocks of companies with strong fundamentals that do business in China should be held.  Many stocks with China exposure have already corrected, trade near single-digit P/Es, and have significant upside once a deal is reached–whenever that is.  In fact, we are putting together a wish list of inexpensive trade sensitive stocks for possible purchase.  We will try to take advantage of bargain basement prices for high-quality stocks caught in the crossfire.

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