Stocks: Silver Linings
November 2018
Unless you’re a short seller or just enjoy pain, you’re likely happy to have October in the rearview mirror. Domestic markets experienced bouts of volatility coinciding with sharp daily declines – the S&P 500 didn’t experience back-to-back positive performance days until the last two trading days of the month. Without a 2.6% rebound on the 30th and 31st, things would have looked and felt much worse. Once October had mercifully come to an end and the dust had settled, the S&P 500 had declined 6.9%, while the small-cap Russell 2000, which outpaced the S&P 500 for most of the year through September, had fallen 10.9%. International markets, even after posting year-to-date losses through September, again failed to garner much interest from those taking profits in domestic markets, as the MSCI EAFE fell another 8% while the MSCI Emerging Markets Index dropped 8.8%.
We’ve read a litany of commentaries, articles, musings, and diatribes in which an author attempts to pinpoint, ascertain, or explain away the root cause of the sell-off in domestic stocks – we’re going to add our two cents here. Most pundits appear to have settled on the premise that U.S./China trade “reality” hitting home, a perceived slowdown in domestic economic growth, and out of touch or ill-advised comments from FOMC Chair Jerome Powell related to how much higher the Fed funds rate might need to go as drivers of the most recent market pullback. Additionally, corporate buybacks were halted in advance of earnings season as companies entered black-out periods, while at the same time hedge funds and other large institutional investors attempted to beat peers to the profit-taking punch as the third quarter wrapped up. These were contributing factors, as was algorithmic or program trading, which likely exacerbated intra-day moves to the downside. There have been fewer large buyers willing to step in while there have been plenty of computers willing to sell/short mid-afternoon as stocks fall. The sell-off has been painful for those overweight risk assets, but we see silver linings amid the chaos.
Third quarter earnings, broadly speaking, have surprised to the upside. With 75% of S&P 500 companies having reported, year over year EPS growth has been 26.4% – this after 25.2% year over year growth in 2Q. While earnings have remained strong, valuations based on projected forward earnings have become more attractive. The S&P 500 traded at 16.4X expected full year 2019 earnings at the end of September, but earnings estimates remained stable as stock prices gapped lower during October, and the S&P traded at 15.2X projected ‘19 EPS at the end of the month. After making a beeline higher in early October, rates were range bound over the back half of the month. The 10-year U.S. Treasury yield closed October at 3.15% - 6 basis points higher than where it began the month. Interest rates stabilizing should benefit stock prices as analysts aren’t being forced to revise assumptions related to discount rates on projected future cash flows, boosting the present value of those cash flows. Earnings multiples tend to compress as rates move higher, so avoiding another rate spike may allow the S&P 500 earnings multiple to expand a bit.
It’s notable that the yield curve steepened a bit during October, relegating those calling for an imminent recession due to economic “signals” sent from a flattening yield curve to the backburner. U.S. economic growth should slow from around 3% in 2018 to the mid-2% area in 2019, but a recession remains far away. Interest rates are low, wages and productivity are gradually rising, consumer and small business confidence remain high, and the potential exists for capital expenditures to accelerate into year-end. U.S. stocks appear fairly valued, while international stocks appear cheap, but for good reason. As we close out 2018, investor attention will remain on U.S./China trade relations and FOMC monetary policy.
Source: Bloomberg
