Markets Not In a Festive Mood

While 2018 was progressing well for most investors as recently as September, it is ending in disappointment.  It’s not so much that the year-to-date declines are horrendous, but more that the declines off peak prices three months ago are significant and that there were very few places to generate positive returns.  Investors with portfolios diversified across a range of asset classes can usually expect at least a couple of green arrows to help offset the red arrows.  In 2018, however, little was spared.

The current decline in stocks, at least so far, is more due to fear than the current reality.  In the last quarter, U.S. companies reported their strongest earnings growth in years.  The economy is also still on firm footing, with unemployment at the lowest levels in decades and growth still around 3%.  Thus, it is not the current environment that troubles investors.  It is what lurks in 2019.

The two items at the top of investors’ worry lists are 1) the trade war with China and 2) Fed rate hikes.

Trade with China

On the first worry, investors have adopted a “show me” demeanor.  Equity investors used to greet news about progress in trade talks with China very warmly.  Now, however, having heard on numerous instances about headway being made, they are much more inured to positive reports.  They want a credible, substantive deal locked down as soon as possible.  The absence of a deal is creating much uncertainty for corporate managers, who have no idea how their Asia-based supply chains will be affected in 2019.  This uncertainty has put many expansion plans on hold and has managers across the country sitting on their hands.

Interest Rate Moves

On the second worry, investors are looking for a slowing (or a halt) in Federal Reserve interest rate hikes. The Fed begins a two-day meeting today, and tomorrow, December 19th, it will announce whether or not it has raised rates again along with a statement of the thinking behind the policy. Even though the stock market has been suffering of late and President Trump is hectoring the Fed to halt its increases, it is highly likely that the Fed will hike rates by 0.25%.  It will simply lose too much credibility if it does not. If the rate hike occurs, pushing the Fed Funds rate range up to 2.25%-2.5%, investors will be scrutinizing language in the accompanying Fed statement about the prospect (or not) of rate hikes in 2019 and also about how much the Fed is concerned about the deteriorating global economic situation.  Right now the markets are broadcasting a very loud message.  We will see tomorrow if the Fed is listening.

The U.S. economy remains in solid shape as we approach the end of the year, but it is poised for a slowdown in 2019.  The labor market remains robust and consumer spending is healthy, but higher interest rates, trade uncertainties and the lapping of corporate tax cuts and fiscal stimulus will all likely weigh on growth in 2019.

The recent decline in stock prices leaves them trading at more attractive valuation levels than they have for years.  A simple formula for investors to remember is that. . .

Total return = Earnings growth + Dividends + or – the change in Price-to-Earnings (P/E) Multiple

Corporate earnings growth for the year has been excellent and could approach 20% when the numbers settle.  Dividends added another 2%.  However, it is the steep decline in the market’s price-to-earnings (P/E) multiple that has sacked equities for a loss.  One year ago, the S&P 500 traded at 19.8 times the then year-ahead earnings estimate for the index. (Corporations went on to post better-than-expected profits.) Today, reflecting investors’ diminished confidence about the future, the S&P 500 trades at only 16.2 times the current earnings forecast for 2019. This is a decrease of 18% in the market’s P/E multiple.

Another way of looking at this situation is that stocks are 18% cheaper relative to their earnings than they were at the start of the year.  Valuations matter to investors because future returns are usually better off lower valuations than they are off of higher valuations.

Please don’t hesitate to get in touch with me if you would like to discuss your portfolio or the markets.

 

Share this!

Peter Thoms

About the author

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has an extensive background in crafting investment solutions for high-income clients in a wide variety of circumstances.