The first quarter is complete—and what a ride it has been! Market participants have gotten more than they expected, including the first 10%+ pullback for the S&P 500 in nearly two years. The ride isn’t over yet either—not by a long shot. There is a long way to go still in 2018, and every indication so far is suggesting it should be a thrill ride.
There is a lot happening right now, yet the increased volatility in the early part of the year reflects an awareness that this bull market is starting to question its own mortality as it is being confronted with changes in its physiology:
Valuation has been “full” for some time. The difference today is that interest rates have moved up and there is less certainty about interest rates remaining low.
The S&P 500 entered the year trading at 18.2x forward twelve-month earnings, which was a 27% premium to its 10-year average, while the 10-yr note yield entered the year at 2.43%. At the apex of the January rally, the S&P 500 traded at 18.6x forward twelve month earnings. The 10-year note yield, meanwhile, hit 2.94% on February 24.
Things got a little dicey in early February when a fear of rising interest rates and a collapse of short volatility ETFs prompted a collective reassessment of risk exposure.
The S&P 500 declined as much as 11.8% in just ten trading sessions. At its low on February 9, the S&P 500 was trading at approximately 16.0x forward twelve month earnings. The S&P 500 has recouped a good portion of its lost ground and currently trades at 16.4x forward twelve month earnings, which is a 15% premium to its 10-year average.
In brief, the P/E multiple has compressed as interest rates have moved up.
How high interest rates go is anyone’s guess, but where they go should be everyone’s concern. They will dictate a lot about the path of the stock market, not to mention the path of the housing market, lending activity, the dollar, emerging markets, and the global economy.
Interest rates have moved up this year, but they haven’t gotten unruly.
Some argue the rules of engagement for equity investors will change when the 10-yr yield hits 3.00%. We can see why that would be, but a lot depends on how—and why—the 10-yr yield goes to 3.00% (or higher).
Is it because the economy is picking up and there is a rotation out of Treasuries as inflation concerns increase? That’s more tolerable for the equity market.
Is it because the deficit is increasing and there is a seeming lack of regard out of Washington for its trajectory and that of the national debt? That’s less tolerable for the equity market.
Is it because foreign governments, hit with protectionist trade policies, are retaliating by selling their Treasury holdings and driving up rates to make the U.S. government’s fiscal challenges more difficult to manage? That would be an extreme (and foolish) tactic, yet it would be intolerable for the equity market.
The speed with which rates go up is important, yet the message availing itself in the early portion of 2018 is that the path of least resistance for interest rates is to the upside.That’s because the Federal Reserve is expressing a greater inclination than it has in recent years to raise the fed funds rate. It’s because there is an underlying assumption that other central banks will begin tightening the screws on their very loose policy accommodation. And it’s because a low unemployment rate of 4.1% in the U.S. is provoking wage-based inflation concerns.
Inflation, however, has yet to hit worrisome levels, which is why it can be said the fear of inflation is running stronger now than inflation itself.
That view might ring hollow for some readers since inflationary pressures hit home for people in specific ways. The fact of the matter, though, is that the Federal Reserve looks at inflation in total by way of the PCE Price Index—and that index, which captures the substitution effect, is up 1.7% year-over-year and up 1.5% year-over-year excluding food and energy. The PCE Price Index is running below the Federal Reserve’s 2.0% target and it has been for some time.
That’s why the Federal Reserve wants to follow a gradual pace of rate hikes. There is reason to think inflation will be picking up, but the Federal Reserve is trying to thread a needle with gradual rate increases so as not to choke off the progress in meeting that target.
The source of angst for the equity market is that the Federal Reserve also risks keeping rates too low, for too long, and fueling asset price inflation that could eventually be undone in a nasty correction. Some would argue that risk is at hand given the premium multiple at which the S&P 500 is trading, yet others, such as Warren Buffett, sound more sanguine about the “full” valuation given the relatively low level of interest rates.
The commonality is that interest rate moves are going to matter for the stock market for better or worse. The perception, though, that the best of the low interest rate days are behind the stock market is why the stock market has been volatile this year.
Rates are low, but they are moving up and that is prompting investors to think more carefully about how willing they are to pay for every dollar of earnings.
SUPPORT FROM EARNINGS
Fortunately, the earnings outlook is as bright as it has been in some time.
According to FactSet, the S&P 500 is expected to produce double-digit earnings growth every quarter this year and 18.4% growth for all of 2018. That is terrific, yet it’s not a revelation for a market that is already trading at a 20% premium to its 10-year historical average.
What it is is an underlying source of support that keeps the equity market thinking optimistically when it isn’t being distracted by outside influences like trade wars, ballooning deficits, late business cycle dynamics, and—you guessed it—rising interest rates.
The strong earnings growth reflects a pickup in end demand, lower corporate tax rates, and ample corporate share buyback activity.re we at peak earnings growth? Will 2018 be as good as it gets, especially as companies might have to contend with paying higher wages in a tightening labor market, thereby cutting into profit margins?
These are nagging questions, which is why the trend in earnings growth estimates will likely be more of a focal point than the earnings growth itself.
WHAT IT ALL MEANS
The S&P 500 is up just 0.64% (before dividends) as of this writing, which is stagnant for a three-month period.
The path to that gain has been more volatile than a lot of investors have grown accustomed to seeing in recent years, and it seems likely that investors will have to get acclimated to an environment of increased trading volatility.
That’s because a transition is unfolding whereby the central bank protectorate is pursuing a protectionist route of its own.
The Federal Reserve has an aim to take back some of its policy accommodation and to tuck those basis points in its back pocket to ensure it has some protective cover to offer the U.S. economy, and the market, in the event there is an economic development that necessitates lowering interest rates.
That necessity isn’t imminent, which is why the stock market could keep climbing a wall of worry related to interest rate moves so long as any interest rate move isn’t a shock to its system and a blow to projected earnings growth. Investors will need a good understanding of their risk tolerances and an inclination not to be greedy. The physiology of this bull market is changing and returns seem likely to moderate just as the activity level of an aging person does because of the changes in their physiology.
The transition to higher interest rates is happening and it won’t be smooth. No thrill ride is.
John P. Swift, CFA, CPA
CEO & Chief Investment Officer