February 15, 2019 
The biggest risk to stocks right now might not be as much of a risk as you think       
Riddle me this: If I could somehow guarantee that over the next year corporate profits of publicly traded companies will be up over 20%, over a Trillion Dollars in stock buybacks, and the 10 year Treasury bond yield would end the year barely above the level it was at in the beginning of the year, twelve months later the stock market will go:

A. Up

B. Up like a rocket

C. End unchanged

D. Down

The correct answer is choice D - Down. This describes the stock market in 2018. If I asked investors this a year and a month ago, I think it's fair to say most would've chosen choice B - Up like a rocket, because you couldn't ask for a better set of bullish conditions.
But here's the thing, there are lots of variables that affect stocks. Let's take a quick look at the biggest risk facing investors today; an earnings recession.
In an article by  Thomas Franck at CNBC, Mike Weston, Morgan Stanley's U.S. equity chief says the long awaited earnings recession is finally here and investors are not prepared for it. His reasoning is that this quarter (Q1-2019), earnings are tracking at a below-consensus 1% and he doesn't expect an earnings reacceleration during the second half. His year-end target for the  S&P 500 is 2,750, right about where it is now. So, we may infer from this that he sees this year as good as it's going to get. He says "Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been."
My own forecast for this quarter is negative earnings year over year. If Q2-2019 is also negative, then we have two quarters in a row of negative growth, the textbook definition of an earnings recession. Standard & Poor's, FactSet, and Refinitiv are all forecasting a decline in earnings for Q1. By the way, this shouldn't be confused with a recession in the U.S. economy, which is defined by two quarters in a row of negative GDP.
The odd thing is how much earnings have fallen off a cliff in so short a time. The tax cuts boosted earnings growth last year but have actually become a headwind this year. In an article by  Patti Domm of CNBC, Patrick Palfrey, U.S. equity chief at Credit Suisse, makes it clear why. The tax changes became a drag because in 2018, the tax impact included benefits that are now unavailable, like a deduction for capital expenditures. "We're cycling against tax benefits and taxes actually become a headwind in 2019, where as in 2018 we benefited 7 to 8 percent. I think the expectation was taxes aren't going to be a factor. What we found is the tax rate is going to bump up incrementally in 2019 and subtract 1 percent from growth," he said.
So, if earnings are going to be negative this quarter just due to accounting changes, it could be surmised that corporations' health is better than what their earnings are reflecting.
But what we really want to know is the relationship between annual negative year over year earnings and stock market performance. Does a negative year for earnings mean a down year for stocks? The answer may surprise you. In fact, most years with negative earnings resulted in higher stocks, not lower. Ben Carlson of the widely followed blog "A Wealth of Common Sense", did the research. From 1930 through 2017, year over year earnings were down 30 times. 23 (76%) out of those times the stock market finished higher on the year. So, an earnings recession doesn't necessarily mean it's lights out for the stock market in 2019.
Stocks tell us a few things:
  1. Where they've been and what investors expect going forward.
  2. Earnings determine the direction of stocks over long periods of time. Earnings expectations, on the other hand, determine price direction over the short term.
  3. The difference between gambling and investing is that the longer term you gamble, the higher your odds go for losing money. The longer term you invest, the higher your odds go for making money.
On another note, I'm getting my video reps in on YouTube, something I've been looking forward to doing for a long time. Please head over  there now and check out a few videos. They're all about 2 minutes in length. And while you're there, please thumbs-up the videos you like and subscribe to my channel. Thanks!
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All the views expressed in this report/commentary accurately reflect our personal views about any and all of the subject securities or issuers and no part of our compensation was, is, or will be, directly or indirectly related to the specific recommendations or views we have expressed in this report. This material is not intended as an offer or solicitation for the purchase of sale of any security or other financial instrument. Securities, financial instruments, or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from securities or investments mentioned in this report may fall against your interests, and you may get back less than the amount you invested. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. You should consult with your tax adviser regarding your specific situation. Diversification is a method of managing risk and doesn't protect against loss in a down market. 

Mitchell O. Goldberg, AIF®, AAMS

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