After rising by 11.5% year-to-date through October 3rd, and after hitting our full year forecast for 10%-15% gains as outlined in our 2018 Preview letter, the S&P 500 has since declined by 8%. Let’s take a look at some of the factors behind the current pullback, review the health of our key pillars supporting the 9-year bull market and determine what action is warranted in this environment.
Factors behind the pullback
1. Concern over the pace of Federal Reserve rate hikes – The Federal Reserve has rightfully been increasing short-term interest rates to normalize monetary policy away from the extraordinary measures taken during the Financial Crisis. The key issue right now is whether Fed forecasts for one more rate hike in 2018, three in 2019 and one in 2020 will put the U.S. economic expansion at risk. The Fed is in a bit of a bind as tight labor markets and trade tariffs increase inflationary pressure. Raising interest rates helps to control those pressures but also slows economic growth. Our expectation is that the Fed will continue to raise interest rates but will moderate its forecasts should nascent signs of economic slowdown grow more concerning. Which leads us to our next factor…
2. Budding slowdown in the U.S. real estate, auto and industrial sectors is prompting fears of eventual recession in the face of the aforementioned Fed rate hikes - While we do not see this slowing as ideal, we still maintain that recession will not occur in 2019. Should this timeframe be correct, it would suggest that the current pullback is temporary and that there is room for the U.S. stock market to hit new highs by the end of this year or into 2019.
3. Peaking U.S. earnings growth – U.S. earnings growth has been incredibly strong in 2018 with S&P 500 earnings forecast to grow by 23%. Naturally, 2019 earnings growth will certainly decelerate from this abnormally strong pace. Even though 2019 earnings are still forecast to grow by a quite reasonable 8%-10%, a deceleration does act as a headwind. Our point of view is that while the sledding may be tougher, we will gladly accept 8% earnings growth every year.
4. Chinese economic and stock market troubles - The impact of trade actions is having a disproportionate impact on the Chinese economy and equity markets as their economy is much more reliant on trade than the United States. We suspect that these issues will not resolve any time soon and will add volatility to U.S. markets but will ultimately only have a limited long-term impact on U.S. markets.
5. Italian budget plans that are contrary to European Economic Union guidelines - This raises the specter of Italy leaving the EU which, in turn, raises the potential for an Italian banking crisis. In the end, Italian woes have more of an impact on Europe. The U.S. economy should be relatively insulated from Italy.
6. Fraying relations with Saudi Arabia and instability in the Mideast - Of course, geopolitical events take on a life of their own but the U.S. does not really want these issues to persist longer term. The odds are high that the news cycle will eventually shift its focus to other events.
The above is quite the list of issues currently buffeting the markets. I would be happy to discuss any of them in greater detail. That said, in stressful times it can be helpful to refocus our attention to the pillars that really drive the direction of the markets.
Fundamental Pillars of the U.S. Equity Market
1. U.S. job growth – As you have heard me discuss repeatedly, the economic indicator that is most powerful in predicting the general trend in the markets is job growth. Employment has grown in the U.S. for 95 straight months and the markets have generally tracked higher during this time span. Despite some early signs of economic slowdown, it is quite likely that the U.S. economy will continue to add jobs well into 2019. If so, the current pullback should be temporary.
2. U.S. earnings growth – As mentioned above, earnings growth has been exceptionally strong and has propelled the market higher. While earnings growth will certainly decelerate in 2019, should the forecast for 8%-10% earnings growth prove correct, then earnings growth should remain supportive to the U.S. equity markets.
3. Valuations – The S&P 500 currently trades at a Price/Earnings (P/E) multiple of 18.2x. Looking out 12 months, should earnings come through as expected the P/E multiple would fall to 16.0x which is right in the middle of the 14x-18x range that the S&P 500 has typically traded in during “normal” market environments. The point here is that the market is not wildly expensive and is arguably roughly fairly valued. Likewise, should the S&P 500 drop much further from here, we could make the case that the market is actually cheap. The bottom line is that valuations should not be scaring investors out of the markets.
The above pillars all suggest that the current pullback in the markets should be temporary and we would concur. The question now becomes what actions should we be taking in portfolios? Our answer here may surprise you since our typical response over the last 9 years has been to buy the dip (and certainly not to panic out of the market). This time around, our conclusion is more nuanced. While we do believe that the S&P 500 can regain its highs into 2019, we also fully acknowledge that the 9-year bull run is getting longer in the tooth. Every day that passes brings us closer to the next recession and thus we believe that the risk/reward is becoming less favorable for stocks and becoming more balanced with bonds. As a result, we would not be actively buying this dip but, instead, would actually be looking to sell some of our equity positions into strength (on the margin we have already been doing this throughout 2018). Of course, this does not preclude us from buying certain individual securities that are unduly punished during the correction. Our call is not for a wholesale liquidation of stock portfolios, rather it is more of a call to ensure that equity exposure doesn’t get too high for your specific goals and targets.
I have focused this note on the U.S. equity markets and have deliberately not discussed international equities since we have fortunately and intentionally biased portfolios away from international equities for many years.
Of course, I am always happy to discuss your particular portfolio strategy with you or get into greater detail about U.S. or international financial markets or anything else that may be on your mind.
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