The S&P 500 advanced by 300% from March 2009 low, and after peaking on the 26th of January, the market experienced a correction, dropping 10% for the first time since January 2016. This is a big change following a year in which there were only eight days with a move of 1% or more and the biggest decline was less than 5%. By comparison there have been greater than 1% moves about half the time since the peak in January, and we just experienced our 7th day with a 2% decline this year. In 2017 there were none. For perspective, the S&P 500 Index is now about unchanged from the end of 2017.
The swings in stock prices from day to day have raised concerns about the near-term prospects for the economy and the market. It feels like there is a heightened degree of uncertainty, with the potential disruption to global trade from tariffs, the rise in interest rates and fears that the Fed will accelerate its move to tighten monetary policy, as well as geopolitical risks with North Korea, Russia and Syria. The potential of tariffs being instituted has led to some of the big sell-offs in recent weeks and markets have subsequently rebounded with China indicating that they are willing to enter into negotiations on trade issues.
In contrast to the weakness in the stock market, the fundamentals remain strong. Profit estimates are rising for this year and next, partially helped by the Tax Cuts and Jobs Act (TCJA) passed by Congress in December 2017. As we have noted before, the risks inherent in a protectionist trade policy could disrupt the economic environment globally, but for now it’s just talk.
Rising interest rates have also been cited as a reason for the return of volatility in the equity market and investors are skittish about whether the Federal Reserve will increase interest rates too fast, as it could upset the prospects for a strong global economy. At this point we believe the rise in rates is a reflection of the underlying strength in the economy. With rates still relatively low and likely to rise moderately from here, we have very low return expectations for fixed income investments.
Earnings season is now under way and we are optimistic that profit growth will support our positive outlook for higher stock prices. Industry analysts are expecting S&P 500 revenues to grow by 6.8% this year and 4.8% next year. 2018 earnings for the S&P 500 are forecast to be up around 20% and 10% in 2019.
The long rise in stock prices that we have seen can be partly explained by confidence in an exceptionally durable economy, good profits, productivity gains and subdued inflation. With just a few interruptions, we are in what will probably be the longest and best balanced cyclical expansion in history. However, in the late stages of a bull market it is often the case that a few companies with good long-term prospects have their stock prices pushed up too far. This will limit future returns or there may be a risk of a substantial loss if the expectations end up being overly optimistic.
Risk management is a critical component to any investment strategy and one of the important disciplines is to not pay too much for a stock. Therefore we stick to our investing disciplines of quality, sustainable earnings and valuation as we seek a margin of safety in our research on individual stocks. In itself, volatility in the market is normal, but whenever volatility increases at a time when the economy falters, we want the peace of mind that comes from owning investments that are undervalued on the basis of their fundamentals and long term prospects.
Economies and markets do not die of old age. The extended rise in stock prices since 2009 has been based on expectations of continued strength in the economy. Stock prices are weak when earnings are threatened by the prospect of a recession. That is not the case today. The market as a whole is not over-priced, but some segments are selling at prices that cannot be justified by earnings likely to be reported this year or next.
The old adage is true of course that past performance is no guide to future results, but it is undeniable that in many ways past events cast their shadow before them. As we ponder the various risks facing investors today, we endeavor to detect the difference between the return of higher/normal volatility and the possible prospect of a significant change in events that may impact financial markets in the future. For now we remain optimistic.
Note: We have gathered the information contained in this report from sources we believe reliable; however, we do not guarantee the accuracy or completeness of such information. You should not assume that any discussion or information contained in this market commentary serves as the receipt of or as a substitute for personalized investment advice from Whitnell & Co. No part of this publication may be reproduced in any form or referred to in any other publication, without express written permission. Whitnell & Co. is an SEC Registered Investment Adviser.