Insights Q4 2018: Climbing a Wall of Worry, Part 2

Q4 2018: Climbing a Wall of Worry, Part 2

It is hard to ask much more of a stock market that is at a record high, except to ask it to keep setting new highs. That’s a tall order, especially when contemplating the notion that interest rates should be moving higher, earnings comparisons should be getting tougher, and the political climate could be getting more uncertain.


Those same considerations have been a part of the market narrative all year, and yet the stock market has traded up in spite of them, bolstered by confidence in the economic data that has tempered any forward-looking fears.

The market has focused on what matters the most; corporate earnings growth and the forward-looking health of the underlying economy.


This year has been dominated with talk of trade wars and the Trump Administration’s pursuit of correcting trade deficits with tariffs.

Those tariffs have stirred concerns about inflation picking up and growth slowing down. Consumer inflation rates have picked up some, yet they haven’t taken off.

Real GDP growth was a modest 2.2% in the first quarter, yet it accelerated to 4.2% in the second quarter. The Atlanta Fed’s GDPNow model estimate for real GDP growth in the third quarter is 4.4%.

The data in hand then has validated an economic backdrop that seems ideally suited for stocks: strong growth and modest inflation.


There are other components that have meshed nicely with that economic backdrop, namely the persistence of relatively low interest rates and the strongest earnings growth in roughly eight years that has been driven by strong sales growth.

First quarter S&P 500 earnings were up 25.0%, supported by 8.6% revenue growth, and second quarter S&P 500 earnings were up 25.05%, supported by 10.0% revenue growth, according to FactSet.

The strength in earnings has more than offset any concerns about contentious trade dealings, primarily because there hasn’t been any evidence yet, in an aggregate sense, to suggest tariffs are driving a slowdown in earnings growth.

Granted some companies have discussed their concerns about tariffs hurting their bottom line, but in spite of these concerns the stock market has traded up from the trade concerns. It would be remiss not to add, too, that the stock market isn’t assigning a big economic impact to the trade actions seen thus far; moreover, it remains swayed by the belief that these trade disputes will get settled in a favorable manner. The culmination of the Canada/US trade pact has solidified those beliefs.

That is the psychology of the market and the data have not threatened its mental fortitude on the matter—yet.


Simply put, the tariffs have not shown up in the data in a discernible way, yet the benefit of the lower tax rates has.

That’s an important distinction because the stock market is driven by earnings growth. That key understanding can get lost at times in a more colorful market narrative, but whether that narrative includes a trade war, an act of terrorism, a big move by the dollar, a political change, or a rate hike by the Federal Reserve, the market’s main consideration is always what those types of happenings might mean for the earnings growth outlook.

The next several months will provide plenty of colorful sidebars that should work their way into the market’s assessment of the earnings growth outlook.

There will be three more FOMC meetings, two of which are currently expected to conclude with a rate hike; there will be the midterm elections, which could result in a shift of control in Congress; there will be more trade actions—for better or worse; there will be several inflation and employment reports; and there will be the third quarter earnings reporting period.


Market participants are already cognizant that the pace of earnings growth in the second half of the year isn’t going to match the pace of earnings growth in the first half of the year. To be fair, the earnings growth is still projected to be quite strong with 19.9% growth in the third quarter and 17.5% growth in the fourth quarter, according to FactSet.

There aren’t many people who would find fault with that, but if one allows oneself to look past the near horizon, one will see a more moderate pace of projected earnings growth in the first quarter (+7.2%) and second quarter (+7.5%) of 2019.

Chalk that up to tough comparisons, but don’t necessarily write it off as a bad thing. Earnings growth is not a bad thing. It is the pace of earnings growth and the trend in earnings growth estimates that call into question how much one is willing to pay for those earnings.

Investors today are already paying up for future earnings. FactSet data shows the forward 12-month P/E ratio for the S&P 500 is 17.0, which is an 18% premium to the 10-year average.

This record bull market doesn’t necessarily have to end soon, but it does look destined at least to produce more modest returns. That’s because the market is already trading with a full valuation before interest rates go any higher.

Interest rates should be going higher, too, if wage growth continues to pick up and foreign central banks back off their crisis-era monetary policies.

No one knows for sure what the future holds, yet interest rates are going to play a key role given the influence they have on economic activity, loan demand, corporate financing, government spending, and the earnings outlook.


It is not unrealistic to think this stock market could finish 2018 with a flurry. By many accounts, it has already done much better than a lot of pundits and money managers thought it would.

Accordingly, it could draw some added support from performance chasing, as fund managers trailing their benchmark try to catch up, and retail investors, fretting about missing out on further gains, get in on the action.

The outcome of the midterm election, however, is a volatility risk event, because it carries the potential to change the political calculus in Washington that generates heightened uncertainty.

That could mean something bigger for the market in November, but to this point the stock market hasn’t gotten too caught up in politics since it has been wrapped up in data that has matched its confident view of the economy and earnings.

2018 has been a good year so far for investors. 2019 will be a more challenging year simply because interest rates should be higher, and earnings comparisons are going to be challenging. Regarding this last point, this year we have been comparing 2018 results with those of 2017 when corporate tax rates were as high as 37%. In 2018 corporations are paying taxes at only 21%. The comparisons will get more difficult in 2019 when we are comparing “apples-to-apples” with respect to the tax rates in the year-over-year results.

That’s what the data are suggesting today, which is why it may be prudent to re-think one’s exposure to highly-valued stocks and highly-leveraged companies.

As always, we look forward to seeing and hearing from you this quarter, and we look forward to your comments and feedback.

Warm regards,

John P. Swift, CFA, CPA
CEO & Chief Investment Officer