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Prospect of impeachment & more trade uncertainty sink stocks

Great investors are not unemotional but are inversely emotional – they get worried when the market is up and feel good when everyone is worried. – Bill Miller

The stock market declined for the second straight week as investors became unnerved by continued trade uncertainty with China as well as new political uncertainty over an impeachment inquiry announced by House Speaker Nancy Pelosi. The S&P 500 Index dropped 1% while the Nasdaq Composite Index slid 2.2% as technology stocks were particularly weak after Micron Technology issued a cautious earnings outlook. Optimism on trade had resurfaced early in the week after President Trump had agreed to delay escalation of tariffs on October 1st and China had recently purchased a large amount of American soybeans and pork. Both U.S. and Chinese trade officials had also made positive comments about their negotiations the previous week, using terms such as “constructive” and “productive”. That all seemed to change, though, when a formal impeachment inquiry was made after President Trump allegedly pressured Ukraine’s leader to investigate Democratic presidential candidate Joe Biden’s family. A whistleblower complaint said that Trump used his office to solicit interference from a foreign country ahead of the 2020 presidential election. A transcript of the phone call between Trump and the Ukrainian leader was released and created even more divisiveness between Republicans and Democrats. The Democrat-controlled House could vote to impeach the president followed by a trial in the Senate, but the Senate is controlled by Republicans who are not likely to find him guilty. The impeachment process could drag on for months and the uncertainty could affect not only Trump’s political future but also trade negotiations with China, which seem to be the most significant issue facing the stock market right now. Friday’s news that the White House is considering delisting Chinese stocks from U.S. exchanges in its ongoing trade war with China was a surprise and caused weakness in the market. With trade talks set to resume on October 10th and 11th in Washington, D.C. the timing of such a move along with increased political uncertainty could create headwinds for stocks.

Last Week

Consumer confidence slipped in September from August and was worse than expected while consumer spending slowed more than expected in August and was the softest it has been since February. U.S. manufacturing, though, rebounded in September and was at the highest level since April. New U.S. home sales were also much stronger than expected in August due partly to a sharp drop in mortgage rates.

For the week, the Dow Jones Industrial Average dropped 0.4% to close at 26,820 and the S&P 500 Index declined 1.0% to close at 2,961. The Nasdaq Composite Index sank 2.2% to close at 7,939.

This Week

The September employment report is scheduled to be released on Friday and is expected to show that about 150,000 new jobs were created and that the unemployment rate remained at 3.7%. August construction spending is forecast to show a modest gain while August factory orders are forecast to show a modest loss after posting a sizable gain in July. The ISM non-manufacturing or services sector index for September is expected to be comfortably in expansion territory while the ISM manufacturing index is expected to be at 50, even with August and at the threshold that differentiates between expansion and contraction.

Third quarter earnings season will begin in earnest around the middle of October. This week’s agenda will be relatively light, with the most notable companies being McCormick, Pepsico, Costco Wholesale, Constellation Brands, Paychex and Lennar.

Portfolio Strategy

As if investors don’t have enough to worry about, third quarter earnings season is set to begin and S&P 500 profits are forecast to decline modestly on a year on year basis. The softness in expected earnings has been due weakening economic growth, both here and abroad, recession fears, muted inflation pressures and trade uncertainty between the U.S. and China. Despite these headwinds, the stock market has performed well this year as the S&P 500 Index has produced a total return of nearly 20% through Friday’s close and is within about 2% of its all-time high. While the market is not cheap, it is not overly expensive either as it trades at a forward price earnings ratio of about 17.5, slightly higher than its historical average but not unreasonable based on the current low level of interest rates. Within the S&P 500 index, sector valuations vary widely. Defensive sectors such as utilities, real estate and consumer staples have seen their valuations and forward price earnings multiples increase sharply with their strong performance. Two growth sectors, communication services and information technology, have also seen their valuations surge. On the other hand, sectors that have lower price earnings ratios and valuations than a year ago include health care, financials, energy and industrials. For the most part, their performance has lagged the overall market this year. Fortunately, earnings growth is expected to be positive in the fourth quarter and more than offset the weakness in the third quarter. Over the near term, stocks are likely to mark time and trade sideways until trade negotiations resume and earnings season gets into full swing later in October.