Time to check in on stock valuations. After providing our assessment of stock market fundamentals, sentiment, and technical conditions over the past few weeks, this week we turn to the last piece of our investment process: valuations. Here we will make the case that stock valuations are reasonable, despite above-average price-to-earnings (PE) ratios.
The U.S. economy grew at 2.3% in the first quarter, better than the consensus estimate of 2.0%, but a slowdown from the near 3% growth of the prior three quarters. Persistent problems with seasonal adjustment of first quarter data and a lull in consumer activity after some spending was pulled forward in the fourth quarter, likely due to post-hurricane recovery and anticipated tax gains, all weighed on first quarter growth. We continue to expect U.S. growth to accelerate over the rest of the year as these temporary factors roll off, with a strong job market, fiscal stimulus, and global demand providing potential support for consumer and business spending.
The latest edition of the Federal Reserve’s (Fed) Beige Book, released Wednesday, April 18, 2018, sustained a positive view of the U.S. economy. The Beige Book is a qualitative assessment of the domestic economy and each of the 12 Fed districts individually. The report is prepared eight times per year, ahead of each Federal Open Market Committee (FOMC) meeting — the next of which is set to take place May 1 – 2, 2018. We believe the Beige Book is best interpreted by measuring how key words change over time. The qualitative inputs for the April 2018 Beige Book were collected in the weeks prior to April 9, 2018.
There are several market myths related to certain market indicators which have the tendency to distract investors from what really matters in assessing market opportunities. We believe the overall fundamental backdrop is currently quite positive thanks to solid economic growth and strong corporate earnings trends, while market sentiment and technicals continue to suggest future equity strength. This week we will bust some common market myths.
Producer and consumer prices moved higher in March, but both remain manageable. Inflation has been a major topic for financial markets in 2018, with concerns initially sparked by a January wage growth number that exceeded expectations. Wage growth cooled somewhat in February and March, though it currently stands at 2.7% year over year, which remains toward the top of its post-financial crisis range. While faster wage growth is a good thing for workers, wages are one of the largest expenses for employers; and a strong move higher could lead companies to pass higher wage expenses on to consumers, potentially fueling inflation and causing the Federal Reserve (Fed) to become more aggressive with rate hikes. However, this domino effect hasn’t happened so far. The latest readings for the Producer Price Index (PPI) and the Consumer Price Index (CPI) were released last week, and both moved higher, but remain at manageable levels. Perhaps more importantly for the Fed, core personal consumption expenditures (PCE) — the Fed’s preferred inflation measure — remained well below the Fed’s 2% target in February. March data (which will be released on April 30), would need to move significantly higher to even approach the Fed’s 2% target [Figure 1].
The February 2018 market correction caught many investors off guard, but the longer-term trend remains higher. This year has provided more volatility than we’ve seen in recent years, with many wondering if the movement is a sign that the bull market is ending. Remember that when the market is finding its lowest point (the bottom), the process to get there can be quite frustrating and even confusing for investors. As a result, we acknowledge we are amidst the bottoming process, and we don’t think the bull market is ending, as longer-term technicals continue to look strong, along with sentiment flashing levels of worry seen at other previous major market lows.
Data pointed to a U.S. economy that has slowed slightly but continued to grow at a steady pace during the first quarter. Real gross domestic product (GDP) growth increased at an annual rate of 2.9% in the fourth quarter of 2017, above the average for the economic expansion at just over 2%. As of quarter end, Bloomberg economists’ consensus forecast for first quarter GDP stood at 2.5%, while leading economic indicators pointed to continued solid growth, due in part to the new tax law.
Increasing trade tensions weighed on markets during the first week of April, and a weak March jobs report added to concerns, but in this market a little perspective can go a long way. The S&P 500 Index fell on April 6, but the drop may have seemed worse for investors because January 2017 – January 2018 was one of the least volatile periods for the index in history. The S&P 500’s 2.2% drop ranked as the fifth largest single-day decline year to date. However, compared to 2017, which saw a maximum daily decline of 1.8% in May, and only experienced four days the entire year where stocks dropped more than 1.0%, the move seemed much larger. While a 2.0% or larger move in the S&P 500 may not be the new normal, we believe that we may continue to see increased volatility in 2018 as markets weigh policy decisions and economic data in the short run. However, when we take a step back from the day-today fluctuations of individual economic data points and markets, the economy remains on a positive footing. This solid underpinning, combined with continued potential for strong earnings growth (see our Weekly Market Commentary for a first quarter earnings preview), and the potential impact of fiscal stimulus, leads us to believe markets may have room to move higher in 2018.
First quarter earnings season, which kicks off April 12–13, sets up to show solid growth, buoyed by tax reform. The S&P 500 Index has grown earnings at a double-digit clip in three out of the past four quarters, a trend that is poised to continue for the first quarter. The index could also extend its streak of 35-straight quarters of exceeding earnings expectations. In this week’s commentary, we preview what we expect may be a very strong earnings season and highlight some key dynamics we will be watching.
After such a calm 2017, it was reasonable to expect higher volatility in 2018, and February and March certainly delivered. As the quarter came to a close, the S&P 500 Index finally snapped a nine-quarter win streak, but we think the bull market still has legs. As we turn the calendar to April, plenty of rain will be in the forecast, however the future might not be so cloudy with earnings season underway and fresh economic data for investors to assess.
We’ve created this quick guide outlining key events on the April 2018 market calendar to help investors get ready for the new month.