Like a Hawk
2018 has been a profitable year to invest in US stocks. Apart from a sudden drawdown early in the year (stocks fell 3.89% in February and 2.69% in March), stock prices have moved upward at a fairly reliable rate. August saw prices rise 3.03%, and the S&P 500 has generated a 9.94% total return year to date. In the 21-month span since the November 2016 election, stock prices have risen in 19 of those months for a cumulative return of 36.59%. In spite of a record long bull market for stocks, there is a level of discomfort, like we are playing a high-stakes game of musical chairs.
The discomfort stems from the charged backdrop. Daily news paints a picture more reminiscent of a reality TV show than what we became accustomed to growing up with Walter Cronkite and David Brinkley. The tension may only continue to increase. September is historically the worst performing month of the year and often the most crisis-riddled as well. Ten years ago, on September 15th, Lehman Brothers declared bankruptcy, setting off a months-long decline in the markets. Seventeen years ago, on September 11th, four coordinated terrorist attacks on the United States caused the stock market to close until September 17th and when it reopened, the S&P 500 lost 11.6% over the ensuing five trading days.
The strength in US stock prices since the November 2016 election can be attributed to many things, including somewhat remarkable corporate tax cuts, a hands-off regulatory approach, low interest rates, low wage growth and a period of global economic stability. These factors have all led to a remarkable inflection in corporate earnings. During the period 2013 through 2016, earnings grew, but at a modest 2.4% rate. According to FactSet Research, earnings are expected to grow 20% in 2018 and 10% in 2019. Wall Street analysts who forecast earnings are maintaining their optimistic outlook for the future.
From a fundamental perspective, as impressive as this growth cycle has been, the forward P/E multiple on the market is 16.8x, only slightly higher than the 5-year average of 16.3x. We have a situation where stock prices are hitting record highs, but stocks are not overly expensive from a fundamental viewpoint. This, like so many aspects of investing in the stock market, is nuanced. The relative attractiveness of a stock, or the stock market as a whole, is tied to investors’ subjective interpretation of the marketplace.
In the shadow of the market’s recent strength, there are some indications change we are watching closely. The Federal Reserve continues to normalize (raise) interest rates and de-lever its balance sheet. Often times, a rising rate environment can be challenging for stock prices. 2019 GDP forecasts have fallen. Much of what caused the recent surge in economic activity has now run its course. Markets around the world are beginning to show signs of slowing. The emerging markets have been in a bear market territory for months and a high US dollar will challenge their ability to repay dollar denominated debt.
Some investors have pre-emptively begun to transition to more risk-averse positions in defensive stocks with low valuations and high dividends. While not unreasonable, the growth stocks that anchor our investment style have led the market in 2018 and I expect this to continue, for the near term. We will watch closely on September 26th when the industry classifications for many influential stocks will be changed, thus effecting the industry makeup of the S&P 500. Stocks such as Alphabet and Facebook are leaving the technology sector, and Netflix will leave the consumer sector to become part of the new communications services sector. Prices may experience some turbulence while the ETFs and mutual funds are rebalanced.
At this juncture, I think the best course of action is to watch closely and review our target asset allocation. The atmosphere on Wall Street is a juxtaposition of fear and unconstrained optimism. This is often referred to as climbing the wall of worry. I suggest we stay close to our target allocations to stocks. For many this may involve some profit taking, as many of our growth stocks have seen outsized returns over the last few years. In the meantime, please feel free to call if we have not been in touch recently.
Bruce Hotaling, CFA