The S&P 500 sold off again on November 20th, bringing it into negative territory for the year. The markets feel rudderless. Deckhands who have been used to continuously increasing markets are wondering which way we are now sailing. Let’s look at the seascape that is generating increased volatility and negative market returns.
- Tariff & Trade Wars – Markets are concerned for tariffs and a trade war with China. Tariffs are considered bad and the uncertainty elevated by rhetoric is concerning.
- Global Growth is Slowing – Global austerity and the apparent end of monetary policy easing is concerning for those withdrawing from the sugar highs of easy money. Throw in a concern for a slowing Chinese economy into the mix.
- Fed Increasing Interest Rates – There is a concern that the Federal Reserve is intent on increasing Fed Funds rates until something breaks.
- Corporate Earnings – Is this as good as it gets? Earnings are robust, but investors seem to be fixated on what’s next.
Rhyming Story Line?
As we mentioned in our last quarterly market commentary, looking at history can be instructive. In 2015 we encountered a period that feels like a rhyming story line. Consider the following.
|The Issue||December 2015||Today|
|The Fed||The Fed made its first interest rate hike in December of 2015 since the Great Recession and telegraphed four more hikes for 2016.||Fed has raised rates three times already in 2018, telegraphing another rate hike in December and four more in 2019.|
|China||China reported some softer economic growth numbers adding to the never-ending “hard landing” concern.||China is reporting some softer economic numbers.|
|Oil Prices||Had been dropping and slid very hard on the Fed’s hike and concerns for an economic slowdown.||Have dropped over 20% from recent highs at the beginning of October.|
|Equity Market Reaction (Initial)||S&P 500 dropped over 10% from late December 2015 through mid-February 2016.||Has dropped nearly 10% from recent high in October.|
|Equity Market Reaction (Following)||Equity markets rallied for 2016 ending on higher ground (domestic stocks up 11.9%, emerging markets stocks up 11.2% and international developed markets were up 1.0%). Economies continued to grow albeit at tepid rates and equity markets continued an upward trajectory in 2017 (emerging markets up 37.3%, international developed up 25.0% and domestic stocks up 21.8%,).||To be determined.|
The following exhibit visually illustrates the similarities between these two periods.
Exhibit: The Fed, Oil and S&P Prices (2015 and Today)
While we cannot forecast how markets will behave in the short-term, we can gauge other indicators to see where we are and where we might be headed.
- Global Growth Forecast – The IMF – an organization of nearly 190 countries working to foster global cooperation and growth – recently downgraded global growth for 2018 and 2019 from 3.9% to 3.7% based largely on tariffs and trade war concerns. Although this was a downgrade there is still an expectation for positive growth in 2019 and 2020.
- U.S. Economic Forecast – According to the most recent Bloomberg survey of 45 economists, the chance of a recession in the next 12 months is only 15%. The poll also showed expectations for economic growth this year to be 2.9%, before slowing to 2.7% next year and 2% in 2020.
- S&P 500 Corporate Revenue & Earnings – The quarterly earnings growth rate for the S&P 500 is expected to come in at 25.7% for the third quarter of this year – the highest since the third quarter of 2010. Revenue growth is expected to come in at 9.4% – the highest rate since the third quarter of 2011. However, markets are looking to see how growth will be in future years. The current expectations are for S&P 500 earnings to grow by 9% to 10% in both 2019 and 2020.
- S&P 500 Valuation Levels – Based on today’s S&P price (2,642) the “forward” (based on forward earnings) PE ratio is 15.4X, which is below its 20-year average of 16.3X. Moreover, a PE ratio should be considered in light of current interest rates and inflation. With inflation in check at 2.1% (ex food and energy) a historical “trailing” (based on trailing earnings) PE ratio has averaged 17.3X, which is higher than our current rate of 16.8X. So, while we may be entering the later stages of the economic cycle, valuation levels are not stretched.
- International Equity Perspective – As we have discussed before, diversification can be difficult unless you are immune to the behavioral finance pitfalls of anchoring and home bias as a U.S. investor. After outperforming the S&P 500 in 2017, international equity markets have underperformed this year. As it stands, international corporate earnings are still growing at attractive rates (emerging markets higher than domestic) and valuations levels are cheaper than the U.S.
- Global Stocks vs. Leading Economic Indicator – In the exhibit below the red line is the ISM Purchasing Managers Index – a leading economic indicator. A number above 50 means an economy is growing. The blue line is the MSCI ACWI Index – the world stock market. As the chart shows there is generally a correlation between global equity prices and this leading economic indicator. The correlation has recently broken down and this could signal an end to the poor performance of the global equity market.
Exhibit: Global Stocks vs. Global Leading Economic Indicator
The markets appear to be trying to find a bottom. In the coming weeks there may be some positive catalysts. President Trump is scheduled to meet with China at the G20 summit in Argentina to potentially iron out a trade agreement. Similarly, the Fed may provide some relaxed language regarding rate hikes for next year at their mid-December meeting. OPEC appears poised to cut demand to support oil prices, albeit President Trump is pounding the table for lower prices. Will these actions create an outcome similar to 2015/2016?
While there are many other positive factors and risks to consider, an actual recession is not on the horizon. That does not mean that markets can’t sell off without a recession. It can and does happen. Moreover, time will tell if equity markets can climb back into positive territory by year-end, but facts suggest markets aren’t expensive and irrational exuberance just isn’t part of the scene.
Beware of deck hands stating that the ship is sinking. It isn’t. The U.S. economy is strong and we have encountered many stock market pullbacks over the years. Nonetheless, we have been reducing various risks in portfolios and will continue to adjust as makes sense within a goals-based investment approach.
We will continue to monitor the markets and provide updates as warranted.