- The S&P 500® Index's 14% gain in the first quarter of 2019—following the 14% loss in Q4 2018—is another example that sometimes the best action for an investor to take is no action.
- Context is everything, and the 4 lenses of earnings, liquidity, valuation, and sentiment remain moderately constructive for risk assets, in my view.
- The main risk at this point is that the expected "V-shaped" earnings recovery turns into a "U" or an "L."
- If that happens, I think the Federal Reserve will need to cut rates several times, and that doesn't seem likely anytime soon.
- But with China reflating, an L-shaped earnings curve also seems unlikely; indeed, if earnings rebound as expected, new highs may not be far behind.
Well, that was quick: Following a 14% decline in Q4 2018, the S&P 500® (total return) index gained nearly all of it back in the first quarter of 2019. Stocks put the "V" into "V-shaped," although a 60/40 portfolio combining the S&P 500 with investment-grade bonds did even better, gaining 9% after losing 8%. It's a good reminder that sometimes when the market is going through a correction, the best action to take: nothing. Selling just because the market is headed down is not always a winning strategy for investors, as many recently found out the hard way. Investors redeemed $89 billion worth of US equity funds and ETFs in Q4, and they kept right on selling in Q1—to the tune of at least another $66 billion—despite the market's strong rebound.
Will the stock market recovery continue? As investors, we have to make assumptions as to where we are in the business cycle and beyond; otherwise, most indicators become a coin toss.
The chart, The market is about as likely to rise as it is to fall following a sharp decline, illustrates how the market historically has performed following a 20% decline. The odds of a strong gain are roughly equal to the odds of a further sharp decline. Context is key. For me, that context comes through the 4 lenses of sentiment, rates, earnings, and valuation. So, let's take a look.
As noted above, I think sentiment remains oversold. Despite the rally, investors continue to sell at a record pace. According to EPFR Global, since Q3 2018 through Q1 2019 investors have sold a staggering $147 billion of equity funds and ETFs. That's pretty amazing considering that this bull market is now 10 years old and the S&P 500 has so far charted a nearly 5-fold increase. Usually everybody loves the market after a long advance, in my experience, but that is not the case today.
Perhaps this is how things will continue, or perhaps at some point the public jumps back in. Maybe the world's aging demographics play a role here in terms of investor preference for income-producing assets instead of straight equities. Or maybe investors have been getting their equity exposure through multi-asset-class funds instead of pure equity products (the data I look at considers only pure equity vehicles). But it may also be that even after 10 years investors remain traumatized by the 2007–2008 financial crisis and don't trust the stock market with their money. And if they do invest, they have an itchy trigger finger, as the recent outflows illustrate. When I am out talking with other investors and financial pundits, the questions generally still center on what can go wrong rather than what can go right.
This skeptical sentiment likely is compounded by the fact that the stock-market gains since 2008 were at least in part catalyzed and compounded by the Fed's quantitative easing and policy of zero interest rates, as well as by companies' financial engineering. It's a fair enough argument. I also think that there's a behavioral aspect going on here: People fear financial losses more than they desire gains, and now that the cycle is so advanced, many just assume (perhaps correctly) that the next big move is more likely to be down than up.
All in all, though, the sentiment lens still paints a fairly constructive picture, in my view.
What about interest rates and financial conditions? According to the March Federal Open Market Committee (FOMC) meeting, the current Fed tightening cycle is a wrap. After 9 hikes totaling 225 basis points—plus around $800 billion in balance-sheet reductions—the Federal Reserve apparently is ending its policy-normalization campaign. (See chart The Fed signals an end to its policy-normalization campaign.) Hard to believe how fast the narrative has changed from 6 months ago, when the Fed was raising expectations for 5 more hikes through 2020.
If estimates for the so-called neutral rate, or "R-Star," are to be believed, the Fed has ended its policy-normalization campaign just below neutral. If we add in the effects of balance-sheet reduction, I would argue that the "shadow" policy rate (i.e., adjusted for the Fed's balance sheet) will end just shy of +1.0% later this year. That's still right around neutral—and also well shy of previous Fed tightening highs, which saw inflation-adjusted policy rates peak at 3.3% in 2007, 4.8% in 1999, and 5.4% in 1989. Makes me wonder where the next cycle peak will be—or the next trough for that matter. The last 3 troughs in real rates were +0.1% in 1993, –1.1% in 2004, and –2.0% in 2012. Are we looking at –3% in 2022? To me, that's a scary thought.
While the Fed looks like it panicked in December—giving the appearance that it is beholden to the market or to political pressures—when you consider the pivot in the context of the tightening in financial conditions it appears prudent, in my view. The persistent undershooting of inflation targets (despite rising labor costs), the proximity to the neutral rate, and the unknown consequences of balance-sheet reduction, all support the Fed's decision.
But as we can see from the action in the yield curve in recent weeks, the conversation seems to be quickly switching gears again, this time toward an even bigger pivot. First it was about tightening less than advertised via the dot plot (the graph showing FOMC members' expectations of future policy rates), then it was about not tightening at all. Now it's about easing. Indeed, the money-market curve is now pricing in several rate cuts by 2021. That's not my base-case scenario at all, and I suspect the prospect of rate cuts may be a bridge too far for this Fed, or at least too soon.
How quickly the Fed may or may not follow the market's lead toward rate cuts could end up making a big difference for stocks. For instance, during the 1994 and 1998 market cycles, the Fed started cutting rates in just a matter of weeks following their respective stock-market corrections, and in both cases the market responded with a "melt up" in stock prices. But in 2007, the market's signal for the Fed to cut rates went unheeded for many months. We all know what happened next. I don't think today's conditions are anything like 2008, but the example does highlight that the Fed's response to the bond market matters.
Earnings and valuation
As for valuation, the price-earnings (P/E) ratio for the S&P 500 is in the neutral zone at 16.7x expected earnings. The January 2018 valuation peak found the P/E was at a "nosebleed" level of 19.5x, only for the P/E to fall 6 points to the low of 13.7x in December 2018. In 2019, it's lately back to middle ground. As I see it, with the Fed on hold, valuation all comes down to earnings. If earnings growth stages the V-shaped recovery that the market expects, the current valuation makes sense; if not, it's probably too high.
The year-over-year annual earnings growth rate peaked in Q3 2018 at +26%. It decelerated to +14.5% in Q4 and, with quarterly earnings season around the corner, is expected to decline to –3.9% in Q1. For calendar year 2019, Wall Street's estimate is for +4.6% growth (following +22% growth in 2018). I still see some downside risk to the 2019 estimate given recent downward drifts in estimates, but mostly I think we'll see at least a little growth in 2019 before earnings presumably return to trend in 2020.
The Street is betting on a V-shaped earnings recovery to begin in the second half of 2019, to match the V-shaped stock-price recovery. If that happens, I think the Fed can probably afford to do nothing—neither easing nor tightening—for the next few quarters. The downside risk, as I see it, is that the V turns into a U or even an L, in which case the Fed will need to heed the bond market's warnings evidenced via the recent brief inversion in the yield curve.
But the upside is that the global earnings picture could get a shot in the arm, especially now that China is reflating again. So far the results have been muted, but China's latest PMI (purchasing managers' index) reading above 50, indicating an economy in expansion mode, suggests that maybe China's various stimulus measures are gaining some traction. If so, that could boost global GDP and earnings outlooks.
The bottom line
All in all, the 4 lenses suggest to me a continued risk-on stance. I think markets will be hard pressed to repeat Q1's performance, but at this point we are pretty close to the S&P 500's old highs of 2940. If earnings stabilize in the second half of 2019 and revert to trend in 2020, new highs for the major averages may not be far behind.
My sense is that without an inflation shock forcing the Fed into a policy error (i.e., tightening too much), and without the kind of financial imbalances (excess leverage) that we saw in 2008, little stands in the way of further gains. Yes, we could get a recession, but absent these 2 components any recession could well be short-lived, in my view. If we indeed end up in a bear market, that too could prove to be short and shallow, similar to the previous 2 brief 20% drawdowns, in 2011 and 2018.
All of this serves to return me to the secular roadmap and my impression that the past 10 years have been very similar to the 2 preceding secular bulls: 1949–1968 and 1982–2000. We'll see whether this one, too, proves one of the greats; so far it's still on track, despite all the naysayers.