Signs of Maturity
May 2018
A flurry of overwhelmingly positive earnings reports over the past few weeks has so far failed to snap equities out of their 3-month long malaise. Two significant tailwinds supporting the near decade-long rally in equities are fading away - ultra-easy monetary policy globally and persistently low inflation - causing some heartburn for equity investors questioning how successfully stocks will ultimately weather these changes. We continue to see signs that the aging bull market for stocks can charge on for a bit longer, but we would be remiss if we weren’t also cognizant of present or emerging risks. Sir John Templeton famously stated that “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” The ledger of market “debits” and “credits” continues to lead us to a constructive view on stocks and will frame our argument as to why this may be a mature bull market but isn’t one yet ready to be put out to pasture.
Weighing on the equity market outlook at the present time are the “big 3” in our view: rising inflation expectations, rising short-term interest rates, and trade uncertainty. Break-even rates - effectively, investor expectations of future inflation - on Treasury Inflation Protected Securities (TIPS) have moved higher across the yield curve by 25 to 40 basis points over the past 6 months. Inflationary pressures bubbling up lead to fears over declining profit margins -some corporations may be able to pass along rising input costs via higher prices to end consumers, while others may not. Hence the “this is as good as it gets” mindset pervading the market at the present time. Profit margins, broadly speaking, remain high at present, which firms may consider when pondering price hikes. Secondly, burgeoning inflation expectations lead to a higher discount rate being used to value future cash flows – in short, higher inflation = a lower price investors are willing to pay now for expected future earnings and cash flows. Inflationary pressures gradually building, driven by a robust economic growth outlook often produces a positive backdrop for stocks, but an inflation scare akin to what we experienced in late January spurs equity investors to sell first and ask questions later.
Rising inflation is often associated with tightening monetary policy from central banks in an effort to maintain price stability, and this time around is likely to be no different. The FOMC is expected to hike the Fed funds rate two more times throughout the balance of 2018, and we will monitor inflation data for clues as to what might steer the committee toward a more aggressive stance once the June dot plot is released. Higher short-term interest rates provide increased competition for stocks that pay relatively high dividend yields and are appealing substitutes for investors favoring the “bird in hand.” A higher risk-free rate of return on Treasury bonds pulls capital from risky assets such as stocks into stable, low-growth investments as the expected forward return differential between stocks and bonds narrows. Lastly, uncertainty is the name of the game around trade as talk of tariffs, which countries may ultimately be impacted, and to what magnitude, is forcing companies to take a wait-and-see approach. The global economy may be on firm footing at the present time, but the possibility of a drawn-out trade war between the U.S., China, and/or Eurozone is undoubtedly weighing on investor sentiment and desire to put cash to work in stocks.
While the “big 3” loom large, we remain optimistic on stocks. Earnings season has been, in a word, outstanding. Entering reporting season, the consensus estimate for S&P 500 year-over-year earnings growth was 18.5%. On May 1, with 60% of the S&P 500 having reported, year-over-year earnings growth was actually 25.5%. The current analyst consensus estimate for S&P 500 earnings per share (EPS) of $159.63 in 2018 will likely prove to be conservative in our view as second-derivative impacts of tax reform are realized. Corporations remain flush with cash and continued capital return to shareholders via buybacks and dividends, along with robust merger and acquisition (M&A) volume, remain supportive of stock prices. Outflows from equity mutual funds and exchange traded funds (ETFs) in April, coincident with the largest inflow into bond ETF’s since October of 2014, based upon TrimTabs data, point toward investors crowding into safety trades. Investor sentiment sits between neutral and downright bearish as the American Association of Independent Investors (AAII) Sentiment Survey taken on April 25 highlights only 36.9% of respondents believing stock prices would be higher in 6 months. This marks the 9th consecutive week and 10th week out of the last 12 in which optimism remained below the historical average of 38.5%. We see a market teetering back and forth between skepticism and guarded optimism, and given investor sentiment and positioning, one that remains a far cry from euphoria in our view.
Source: Bloomberg, FactSet, AAII
