This is -Normal?
April 2018
Stocks rallied throughout January, with the S&P 500 climbing a whopping 7.5% at one point prior to month-end, only to experience a precipitous decline as interest rates moved markedly higher on inflation fears, leading to a revaluation for stocks. Interest rates/inflation have an inverse relationship with the valuation multiples investors are willing to pay for future earnings – higher interest rates/inflation = lower forward earnings multiples for stocks. Equities regained their footing in early February after a two-week period in which the S&P 500 entered correction territory (10%-20% decline peak-to-trough), rallying 7.8% from its year-to-date low on February 8 through March 12. From March 12 through month-end, stocks gave back much of their gains from the prior month due to a triumvirate of noteworthy events: an ongoing trade spat with China and tit for tat tariff announcements; escalating tensions between the European Union and Russia due to the poisoning of a former Russian spy on U.K. soil; and allegations that tech bellwether Facebook sold user data to Cambridge Analytica, leading to calls for boycotts of social media platforms and increased governmental oversight of technology firms. After all that, on a total return basis during Q1, the S&P 500 declined 0.7%, the Russell 2000 was flat, international developed market stocks (MSCI EAFE) fell 1.6%, while emerging markets (MSCI EM) rose 1.2%.
A picturesque backdrop for global equities last year lulled investors into believing that the good times would roll on into 2018, making the late January spike in volatility even more painful than it would have been coming off of a more “normal” year. The CBOE Volatility Index, or VIX, hovered around 20 at March-end after spending much of 2017 closer to 10 - its historical average has been 19.4 since 1990. The S&P 500 has experienced a year-to-date peak-to-trough drawdown of over 10%, versus last year’s max drawdown of less than a 3% decline. With the return of volatility and multi-directional trading, markets are again functioning normally. Investors now need to come to terms with the realization that last year was an outlier in many ways, and was an environment that is likely not to be replicated in the near-term. Elevated volatility brings with it fear, but also opportunity, and is cause to review our thesis in an effort to strengthen process and ensure that we’re not missing something. In this case, little has changed to alter our overweight stocks relative to bonds call and our call to overweight international markets.
At the end of March, the analyst consensus estimate for full-year 2018 S&P 500 earnings was $157.80, up from $147.24 at the end of December, implying 18.5% earnings growth over full-year 2017. At the end of March, after falling 1.2% in price over the first quarter and with earnings expectations moving higher, the S&P 500 traded at 16.7 times projected 2018 earnings, versus 18.1 times at the end of 2017. With earnings estimates climbing higher and stock prices moving lower over the course of the quarter, domestic large-cap stocks now sit not far from their long-term historical average forward price-to-earnings ratio of around 16. Fundamental underpinnings at present remain supportive of current valuations for U.S. large-caps, while investor sentiment on stocks has soured of late from excessively optimistic levels in late January, a positive contrarian indicator. As 1Q18 earnings season begins later this month, we will be monitoring forward guidance. In the face of talk on tariffs, companies may be more conservative than anticipated, setting up a potential under-promise/over-deliver situation as the year progresses and trade war fears are ultimately alleviated.
On the surface, international developed markets (MSCI EAFE) didn’t fare that badly during 1Q, falling 2.4% in price, but EAFE’s return in U.S. dollars (USD) masked market weakness in local currencies. The Nikkei 225 in Japan declined 7% during the quarter in yen, while falling only 1.6% in USD as the yen strengthened substantially versus the dollar. The blue-chip Eurostoxx 50 Index fell 3.8% in euros during the quarter, declining only 1.6% in USD. A 4.2% decline for Germany’s DAX Index in USD – down 6.3% in euros - during the quarter was most unsettling. Germany is an important bellwether for the health of the Eurozone economy as a whole as its tentacles extend far and wide. Further weakness in the DAX could portend tough sledding ahead for EAFE. We remain overweight international equities relative to our strategic target, but international-developed markets must climb a substantial wall of worry.
Source: Bloomberg, Factset
