Last quarter, we wrote that the stock market had continued to defy calls for a correction and had held its ground time and again in the face of scary-sounding headlines. The market was performing well due to the stabilizing force of strong earnings growth and the persistence of low interest rates.
We said at the time that, if there were to be a destabilizing force for the stock market, it would be disappointing earnings growth and/or rising interest rates that lessen the relative appeal of owning equities. That was an observation, by the way, and not a forecast.
Since that time, market participants have learned that second quarter earnings increased 10.4%, per FactSet, well above the estimated growth rate of 6.6%, and we have seen the yield on the benchmark 10-year note tick up slightly to 2.20%, which is still 28 basis points lower than where it started the year.
The S&P 500 Price Index for its part has increased another 3.96% percentage points, bringing its year-to-date return as of September 29th to 12.53% and squashing the popular belief last quarter espoused by every corner of the financial press that participants with a shorter-term outlook might want to quit while they were ahead for the year.
We didn’t share that popular belief then and we don’t share it now. Although we do not expect strong gains in the U.S. due primarily to relatively high valuations, we see the continuation of rather synchronous global growth, low inflation, low unemployment, and decent corporate earnings growth as factors supporting global equity markets.
Interest rates are low, volatility is low, inflation is low, earnings are still growing, the promise of tax reform continues to hang on the near horizon, and, well, the stock market just never seems to go down that much before it bounces back to a new high.
As it so happens, the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are all trading at record highs. They are doing so despite a very uneasy geopolitical climate, a crushing blow to Texas and Florida from Hurricanes Harvey and Irma, an unstable political environment in Washington DC, and a heightened sense of uncertainty about what the market can expect in terms of tightening action from the Federal Reserve and the European Central Bank.
Those things, though, continually get reduced to conversation pieces — or topics of debate — that stir a lot of passion, but ultimately don’t do anything to derail this bull market.
It is due to the persistence of low interest rates, which are as important for the stock market as having Tom Brady at quarterback for the New England Patriots. Without low interest rates and Tom Brady the market and the Patriots, respectively, would not have enjoyed the historical success they both have seen.
Low rates help market participants rationalize lofty valuations, they help underpin corporate earnings expectations, and they help fortify the appeal of stocks as the best investment alternative.
This is not to suggest any bump in rates is going to be the end of the bull market. The stock market can handle higher rates if they are going up for the right reasons, which would be rooted in stronger economic growth that produces stronger earnings growth.
With interest rates having been so low for so long, market participants will be attentive to the pace at which rates rise if, and when, they do.
If it is a quick pace, then it will create some turbulence for a stock market that has handled lofty valuations with a sense of aplomb due to the persistence of low rates.
A quick spike in rates could happen if it is thought the Federal Reserve is behind the curve in fighting inflation, if interest rates abroad go up and lead to a mass unwinding of interest-rate differential trades, if China, in a bout of economic warfare, starts unloading its Treasury holdings, or if the Federal Reserve misfires with its effort to normalize its balance sheet.
Pinpointing the trigger is a guessing game.
The point is that rising interest rates will create a headwind for multiple expansion, which seemingly doesn’t have a lot of headroom considering the S&P 500 already trades at a 25% premium to its 10-year historical average forward twelve-month P/E multiple and a 30% premium to its 10-year historical average trailing twelve-month P/E multiple with the benchmark yield at a lowly 2.20%.
A 3-handle on the 10-yr note yield, we think, is where the plot for this bull market will thicken since it will create a better investment alternative for fixed-income investors who have been chasing (dividend) yield in the stock market.
A TAXING SITUATION
Absent a marked jump in rates or a decline in earnings, the biggest risk for the stock market seems to be exogenous in nature, namely a military engagement with North Korea or a terrorist incident that leads to a material downward revision to earnings growth estimates.
Some might say the inability to get a tax reform deal done is the biggest near-term risk for the stock market.
It would be disappointing to the stock market if a tax deal didn’t get done, yet it strikes us that the major indices are at a record high despite a lot of misgivings about Congress’ ability to strike a tax deal.
The stock market has exhibited a tolerance for the prospect of a tax deal not getting done, because it has had strong earnings growth and low interest rates on which to hang its bullish hat.
Accordingly, the disappointment of a tax deal not getting done wouldn’t be the end of this bull market, even if it clipped the bull at the knees for a bit, since the economy and earnings are growing, and the labor market is tightening without any fiscal stimulus.
Ironically, a tax reform deal getting done could usher in the end of this bull market eventually if it accelerates growth in a way that stokes much higher inflation and prompts the Federal Reserve to be far more aggressive with its tightening action.
That’s just food for thought, though, because it isn’t a situation that will be in play by the time we provide our next market view update in January.
WHAT IT ALL MEANS
The stock market has that vibe of being an unstoppable force. We’re hearing increasingly these days that it has ample room to run still, because investor exuberance isn’t high, because investors in general are underweight the stock market, and because fund managers are holding relatively high cash positions.
In turn, the fundamental backdrop of low interest rates, low inflation, and solid earnings growth is still intact.
Also, it is possible that a tax reform deal gets done and pushes up earnings prospects for the S&P 500 in 2018, which would help dial back some of the concerns about the market’s lofty valuation that exist today.
Frankly, it is that high valuation that leads us to be cautious-minded with our market view. The stock market is priced for perfection and things, arguably, have continued to be close to perfect in stock market terms.
That takeaway is captured in the Goldilocks narrative where things are not too hot and not too cold, but are just right.
You’ll be entering at your own risk, though, in much the same way Goldilocks entered the bears’ house, somewhat oblivious to the risk she was running and caught up in the simple pleasures she found there until she got caught by surprise when the bears came home.
The stock market might seem unstoppable, but given its lofty valuation, this isn’t a time to throw caution to the wind because the easy money has already been made.
As always, I look forward to catching up with you soon.
John P. Swift, CFA, CPA
Chief Investment Officer & Managing Partner