Progress Not Perfection
By John Stoltzfus,
Chief Investment Strategist
Be Careful What You Wish For
The age-old adage applies as investors sort out the last 10 trading sessions and look ahead
Amidst last week’s ruckus in the markets, a good friend reminded us of the old saw, “The stock market is the only market where shoppers don’t shop when things go on sale.”
For quite some time now and right through the market’s run-up in the fourth quarter and up until just a week or so ago, it seemed to us that there was no shortage of long term market skeptics who were on the sidelines saying that they were “waiting for a correction to step in and buy stocks.” Now that a correction has occurred with stocks having fallen a little over 10% from a January 26 peak through the market close last Thursday, we are waiting to see if those skeptics indeed will step up to the plate.
After stocks had risen in fourteen of the first eighteen trading sessions this year, the ten trading sessions that followed saw stocks decline on seven of those days. You almost could hear a collective sigh of relief on Friday when the market closed higher on the day—and ahead of a weekend at that.
The Dow Jones Industrials, the S&P 500, the S&P 400 (mid-caps), the Russell 2000 (small caps) and the NASDAQ Composite (some 40% weighted in technology-related stocks) as of now stand respectively lower from the start of the year as follows: 2.14%, 2.02%, 4.2%, 3.8% and 0.42%. Their respective declines from the market’s peak on January 26th are: 9.1%, 8.82%, 8.74%, 8.10% and 8.41%.
We’ve been asked over the weekend if it appears to us that the sell-off is over.
While we believe that the majority of the sell-off may be over for now, there is likely to be a continuation of recurring volatility as speculative positions are unwound by some investors and as still others ponder some of the worry-items that helped cause the market stumble.
High on the list of concerns remaining near term is the substantial increase in the deficit likely to come from the recently enacted tax reform package, the cost of the pending infrastructure program (as yet undefined—though the President is scheduled to speak on it later today), and the effect on the budget and deficit of significantly increased spending on defense necessitated by geopolitical risks.
We see these deficit concerns as legitimate and not likely to go away or be addressed suitably in the near term as a result of the need for action in areas that require investment, costly changes, and major upgrades for the military, infrastructure as well as lower taxes for corporations.
“Valuations aren’t cheap though we’d suggest that they aren’t terribly rich considering six quarters of consecutive earnings growth as well as the relative valuations of stocks and bonds…”
Another risk overhanging the markets is a perception by some investors that worrisome levels of inflation could appear near term as a result of increases in employment and rising wages. We believe that wage growth so far remains modest even as the headline unemployment rate stands at or near a seventeen-year low. Wage increases thus far appear to us offset near and intermediate term by secular forces driving technology (algorithms in the offices, robotics on the factory floor) and globalization (lower barriers of entry for competition in a myriad of businesses worldwide from mom and pop shops to multinational corporations).
Don’t Blame the Fed
While the market has shown some concern over the transition in leadership at the Federal Reserve and the risk that monetary policy makers could make a mistake that would cost the markets dearly, so far there is no evidence that it will happen. For now, the Federal Reserve has shown it remains committed to a policy of interest rate normalization at a pace sensitive and suitable to economic growth.
The markets worldwide have their eyes trained on policy makers of the major central banks. The attention of the markets is so focused on these institutions that it appears to us that the markets are more likely prone to making a mistake in judging monetary policy makers’ decisions than are the policy makers apt to stumble. So far, the collective experience of the world’s major central banks has been remarkably positive for economic recovery and growth over the last nearly ten years since the world was enveloped in the Great Financial Crisis.
Corporate Earnings Are Strong
From a perspective of the fundamentals that traditionally drive stock prices higher, things are decidedly encouraging. Economic data persists to signal steady but moderate growth. Corporate fundamentals continue to improve stateside and around the world. Q4 results for companies in the S&P 500 with some 341 of 500 companies thus far reported show earnings growth of 15.74% in the quarter on back of an 8.34% increase in revenues. Seven of the benchmark’s 11 sectors have thus far reported double digit earnings growth for Q4. (See p. 6 of this report for details.)
On a valuation basis, concerns remain. Valuations aren’t cheap though we’d suggest that they aren’t terribly rich considering six quarters of consecutive earnings growth as well as the relative valuations of stocks and bonds against prospects we see for reflation versus worrisome inflation.
The trailing-12-month price/earnings multiple of the S&P 500 which had stood as high as 23.2 times at the market peak on January 26th eased to a level of 21.1 times on Friday.
While the current level of the TTM P/E multiple remains high from a historical perspective compared to the average 12 month P/E multiple of 16.7x all the way back to the end of 1965, the current multiple of 21.1x against the U.S. 10-year Treasury’s yield of 2.8% on Friday last appears relatively modest if we consider that the average yield of the ten year Treasury all the way back to the end of 1965 is 6.4%.
For now, we suggest that investors check their shopping lists of stocks, equity benchmarks, sectors and thematic ideas that a few weeks ago appeared to “have gotten away.” At this juncture we won’t suggest “backing up the truck” but rather selective shopping for quality securities including “babies that may have been thrown out with the bathwater,” which appears appropriate in our view.
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