October Investment Comments
Against a backdrop of tariffs, Federal Reserve interest rate increases, and emerging market struggles, the S&P 500 steadily advanced to a new all-time record in late August. This has now become the longest bull market in history, measuring 9½ years from the low of March 9, 2009.
Common sense would dictate that what goes up must come down. However, in the long-term the market’s value is a function of corporate earnings growth, and that has been stellar. According to FactSet Research, second quarter S&P 500 earnings growth was 25%, supported by a 10.1% sales advance. Analysts expect third quarter earnings to grow 20% and full calendar year 2018 growth of 20.6%. A one-time event, corporate tax reform has accounted for about half of the earnings increase, but accelerating sales supported by a strong U.S. economy is an ongoing market driver.
Market valuations look stretched on a historical basis, but the market’s value is not solely a function of history. On a trailing twelve-month P/E basis, the S&P 500’s multiple is around 21, about 11% and 24% higher than the past 5-year and 10-year averages, respectively. This P/E only captures half the benefit of tax reform. Moreover, analysts expect continued growth for calendar year 2019, with earnings and sales expected to increase approximately 10% and 5%, respectively. On a forward twelve-month basis, the S&P 500 P/E ratio of 16.7 is only 2% higher than the five-year average (16.3) and 16% higher than the ten-year average (14.4). Earlier in 2018, stocks looked much pricier as the forward twelve-month P/E was about 18.5.
The U.S. economy is doing its part to contribute to corporate earnings growth. Second quarter Gross Domestic Product (GDP) was revised to an increase of 4.2%, up slightly from the initial 4.1% estimate. Recent economic indicators point to more of the same for the third quarter. Retail sales notched another healthy gain in July, increasing 0.4% from the previous month. Factory activity in August expanded at the strongest pace in more than 14 years as the Institute for Supply Management reported its manufacturing index rose to 61.3, supported by growth in new orders, output, and employment.
Job gains, rising wages and tax cuts have put more dollars in consumers’ pockets. This is important as consumption accounts for about 70% of GDP. The Labor Department reported that August added 201,000 jobs, about the same monthly average of 207,000 for 2018. The unemployment rate was unchanged at 3.9%, as labor force participation declined slightly to 62.7%. This is probably due to a statistical quirk as the drop in participation was concentrated among teenagers who are likely heading back to school.
The robust job market is beginning to impact wages, which grew 2.9% in August from a year earlier, the largest increase since mid-2009. Employers are struggling to find skilled workers and are turning to higher wages to attract them. However, higher inflation is eating into this increase as the year-over-year Consumer Price Index rose 2.9% in July, matching wage gains. Even so, take home pay is being augmented by employees working longer hours, faster growth from bonuses and employee benefits, and lower tax rates.
Against this backdrop of rising inflation and low unemployment, the Federal Reserve continues its program to normalize interest rates. Most economists consider a 0.75%-1.0% premium of the Federal Funds rate versus inflation as a level of interest rates that would be considered “neutral” to the economy; i.e. neither stimulative nor contractionary. Markets are forecasting two more 0.25% increases in the Federal Funds rate by the end of 2018. This would leave the rate between 2.25%-2.5%, a slight premium to the Fed’s preferred inflation measure of 2%. In 2019, the Fed’s interest rate decisions will become more challenging as it gets closer to “neutral” monetary policy.
As interest rates have increased, the bond market is getting closer to signaling possible recession. This is due to the flattening of the “yield curve,” which illustrates the rates of shorter-term and longer-term Treasury bonds graphed as one curved line. In expansionary times the yield curve typically has an upward slope reflecting the higher cost of borrowing for longer maturities. Over the past few months, the curve has flattened as the gap between short-term and long-term Treasuries has narrowed. Since 1969, the economy has experienced seven “inverted” yield curves, i.e. short-term Treasury rates eclipsing long-term rates. In each of these occasions the economy has experienced, on average, a recession about twelve months later.
However, an inverted yield curve might not have the same predictive power today. Unlike the U.S., worldwide central banks have continued to provide monetary stimulus to their economies in the form of ultra-low rates and bond buying (quantitative easing). These low rates attract foreign investors to relatively higher long-term U.S. treasuries, depressing their yield. Further, U.S. monetary policy remains somewhat stimulative even after the Fed’s rate increases to date.
U.S. tariffs on foreign goods are another risk. Tariffs act as a tax on consumers as they raise the price of goods and lead to lower demand. As of this writing, the Trump administration has yet to levy tariffs on about $200 billion of Chinese imported goods. However, the recent trade agreement with Mexico and talks with Canada provide some hope that these trade disputes can be successfully resolved.
At the end of 2016, the market looked overvalued. The forward twelve-month P/E was over 16, about the same level as today. Since then, the S&P 500 has advanced about 34%, a performance no one expected. This reinforces the philosophy of buying well-run growth companies at acceptable prices, regardless of market environment.
Dan J. Boyle, CFA