Interim Market Commentary – December 27, 2018
Spasms of volatility and uncertainty have gripped the stock and bond markets in recent weeks. Investors haven’t experienced such whip-saw action since at least 2011 when the stock market sold off by 19% in a matter of weeks. As of Christmas Eve, The S&P 500 stood 19.78% off of its record close last summer, just a tick short of an official bear market. We believe the selling is overdone.
Let us take this opportunity to summarize our position on this fast-moving market. The paroxysms that are currently afflicting stock prices stem from a toxic brew of Federal Reserve interest rate hikes, trade policy uncertainty and political bumbling from Washington. Stocks have been pummeled as investors fled uncertainty and long-term government bonds have rallied as money found its way to safe haven assets.
The price to earnings ratio of the S&P 500, based on an estimate of forward (next year’s) earnings, now stands at around 14.2 compared to over 18 as we entered 2018 and a 10-year average of 14.6. This does not make stocks generationally cheap, as they were in early 2009, but certainly the “froth” of excess optimism has mostly been purged.
The biggest contributor to the decline is, in our view, investors’ reaction to the Fed’s dogged determination to raise short term interest rate to a level that neither hampers nor helps the economy (the so-called neutral rate). This theoretical rate is elusive and is often discovered by the Fed looking in the rear view as the economy slows and overshoots its mark. We believe that the Fed will be particularly sensitive to this possibility in light of the negative market reaction to its last rate hike on December 19th. New chairman Powell does not want to lead the U.S. economy into its first recession since the financial crisis.
Concerns around trade are well founded. The U.S. is making demands that China will be either unable or unwilling to concede. A quick and easy resolution is not in the cards. The biggest risk in this stalemate is the resulting slowdown in Chinese growth and its knock-on effects. To counter this risk, Chinese authorities will pursue considerable measures to stimulate its economy, muting the overall malign effect on markets.
Politics are the least fathomable of the above cited risks. Certainly, the current government “shutdown” gives investors and citizens pause. It also serves to underline how difficult it is to make policy changes in a largely dysfunctional Washington. With the Democrats in control of the House, policy deadlock seems set to continue. This is not all bad for investors. The policy stalemate between the Obama administration and Congress was a good time for stock investors.
Amid the tumult, there is a lot of good news that has been disregarded. 2018 has seen the highest increase in profits (20%) for the members of the S&P 500 since 2010. Revenue growth has also been strong. Currently, market analysts are forecasting a 7% improvement in S&P profits for 2019. While there are reasons to be skeptical of forecasts, it is difficult to reconcile the markets’ recent decline with such a benign profit outlook. The U.S. economy is expected to grow next year, albeit more slowly than this year.
In summary, there are and always will be causes for investor concern. The key to successful long-term investing is balancing these concerns with a clear-eyed view of the facts. To us the facts support the idea of an economy and profits coming off the boil but still growing. Under these conditions a steady but watchful approach is the order of the day.