Bottom line: We are trying to find the right balance between being risk aware and risk averse as we look to protect client capital, but also try to outpace inflation and meet long term objectives. On one hand, we are seeing lots of warning flags that historically have preceded recessions and/or market downturns. However, we also see plenty of bright spots that could keep the economy and markets in the black for several more quarters.
- Areas of concern: The biggest red flags for us are an inverted yield curve and tariff pressures hitting manufacturers, both of which suggest a recession is more likely, judging by past trends. Additionally, we are watching for any incremental oil supply disruptions in the Middle East, as any commodity price spikes could depress consumer demand. We also see modest downside in corporate earnings forecasts as bullish views begin to come down to Earth. Finally, we see modest complacency with broader markets near all time highs and volatility drifting down.
- Reasons to stay fully invested: Despite our laundry list of what could go wrong, we also see bright spots in the economy and in markets, especially for buyers and sellers insulated from the US – China trade war. Surveys point to steady or improving growth in the domestically oriented services sector as jobs remain plentiful and as rising wages give consumers the confidence to keep buying. Falling interest rates may continue to favor spending over saving and lower mortgages may boost housing. The icing on the cake for optimists is valuations, as stocks continue to trade around longer-term averages, despite the steady growth in the economy and consumption.
Theme: As we look the thread the needle between downside risks and slow and steady growth, we favor a mix of defensive (CLX, LLY) as well as higher growth companies (CRM). Since many other investors are chasing safe haven stocks and bidding up their prices, we also favor non-cyclical stocks trading at or below long-term averages. On the growth side, we like companies in the early stages of creating new markets or disrupting poorly run industries.
- Clorox (CLX): We think CLX is an attractive way to own a high quality and defensive sector at a major discount. Our sense is smaller home and personal care companies, such as CLX can outgrow their larger rivals, such as PG and KMB, which face market saturation risks. With a relatively small sales base, CLX can make tuck-in acquisitions every year or two that can actually make a difference in driving overall growth. We also like CLX’s valuation, which is just above its long-term average, compared to PG for example, which is trading at an 18% premium.
- Eli Lilly (LLY): We view LLY as a way to own a defensive sector that offers growth, improving fundamentals and an attractive valuation. Other defensive sectors, such as consumer staples, REITs, and utilities, have become expensive this year, leaving telecoms and healthcare as the only inexpensive non-cyclical sectors. With lots of leverage and a big 5G investment in telecoms, we like healthcare from an organic growth perspective. Within healthcare, LLY offers low to mid-teens earnings growth starting next year as many of LLY’s diabetes and cancer drugs have already won FDA approval, reducing risk. We also see LLY embracing a more patient-friendly approach to drug pricing as taking the steam out of political pressure for lower prices. Our sense is sentiment will start to improve for LLY as investors warm up to the company’s growth and a valuation well below long-term averages.
- Salesforce.com (CRM): Investors looking to add diversification to a portfolio of more defensive stocks may want to consider CRM for durable growth and an increasingly attractive valuation. We anticipate long-term growth in the 20-25% range as CRM’s software connects buyers and sellers, while taking share from older incumbents. We could also see management guide to a longer growth runway at the company’s investor meeting in November. In the near term, we see upside from CRM’s recent purchase of Tableau (DATA) as the company’s revenue trends move up, but the stock remains around $150. Bears may fear downside for high growth companies if we hit a recession, but we see a fairly sticky customer base, especially for government and non-profit users. We also think customers may continue to use CRM software during a downturn, since the technology helps drive revenues for users.
Disclosures: Bailey & FBB Capital Partners own CLX, LLY, & CRM