For the month of June, stock prices, measured by the S&P 500 rose 6.89%, a robust bounce that more than made up for the -6.58% plunge in May. For the first six months of the year, stocks are now up 18.54%. These are big returns in relation to the recent past. For example, last year the S&P 500 was up 2.65%, and in 2017 it had returned 9.34% at the mid-way point. Prices for the first half of the year are now up more than any prior period dating back to 1997. In my opinion, stock prices are inflated.
There was a moment back in late 1996, during a speech by then Federal Reserve Board chairman Alan Greenspan, when he expressed some concern over lofty stock price valuations and mentioned the term “irrational exuberance”. To the irritation of many Wall Street investors, the market immediately sold off. Quite the opposite of those in power today, he was trying to talk some common sense into investors. The term is also the title of a 2000 book by Yale professor Robert Shiller, a well-regarded writer on financial markets and behavioral investing. In it, Shiller asks, “is the market high only because of some irrational exuberance – wishful thinking on the part of investors that blinds us to the truth of our situation?”
Today, expectations are clearly inflated, and they have been since November 2016. Generally easier financial conditions are helping lift stock prices. Cheap money and low inflation have allowed multiples to rise. The Tax Cuts and Jobs Act of 2017 provided a jolt of adrenaline to supply-siders. There is some concern that Washington is manipulating the narrative to simultaneously stroke the markets’ perpetual need for good news, and its own re-election agenda. There are also concerns, again contrary to Alan Greenspan’s time, that the Federal Reserve is no longer an independent body, rather it’s now a tool of the administration. New appointees will be considered based on their willingness to pawn themselves, versus their economic policy credentials.
The situation is not dire, but it is uncomfortable and merits close attention. The market’s fundamentals are stretched. According to FactSet Research, earnings for 2Q 2019 are expected to decline 2.6%, which will mark the first quarter over quarter decline since Q2 2016. The market is currently priced at 16.9x forward estimates, versus its 10-year average of 14.8x. According to JP Morgan, corporate profit margins fell in Q1 2019. The recent drop in interest rates and price inflation have allowed the market’s P/E ratio to rise. This has been the singular driver of higher stock prices this year, in the face of declining earnings estimates.
We are growth stock investors and my concern is the multiple of threats to future growth. The trade war (since March of 2018) is clearly costing the American consumer. The economic slowdown looks to be taking hold separate from the damage related to the tariffs. An echo effect is the softening economic data globally. With no inflation (price inflation), the consumer may actually be more price sensitive than might otherwise be the case. With the inevitable price increases from the tariffs, or potential costs related to product replacement, the table is set for a decrease in consumer spending.
While there has been a flight to stable (consumer staples) and dividend paying (utilities and REITs) stocks, this has distracted many investors from the ongoing success of stocks with strong growth factors. The large cap growth segment of the market has continued to be the driver of the market’s returns. People have been pre-emptively buying what’s cheap and out of favor, such as value and small cap stocks. We will consider opportunities on the value side if in fact the market starts to direct returns to those types of names. In the meantime we are staying the course.
As I said last month, I expect the tension in the markets to continue. It is a fraught time – investor fears are inflated. Still, I remain convinced the best opportunities for long-term investment gains remain in select growth stocks, versus the default approach of owning the market. Please feel free to check in if we have not spoken recently.
Bruce Hotaling, CFA