Everybody Take a Deep Breath…
The past two weeks have tried the nerves of the average investor, though a quick look at history would have provided reassuring perspective during the market’s gyrations. The S&P 500 dropped nearly 12% in just ten trading days, while market volatility spiked. Some investors fled both equity and bond markets. The SPDR S&P 500 ETF (SPY) saw net fund outflows of $24 billion, a whopping 8% reduction in fund assets, during the week ending February 9 when the market reached its trough. By February 14, investors reduced holdings in bond funds by $14 billion. Some moved into Treasuries, while others moved into cash. Yet, six weeks into the year the S&P 500 is back where it started. Investors have been reminded that volatility never dies, even if it goes to sleep for a while. That may be causing investors to rethink longer-term investing strategy. It shouldn’t.
So let’s take a deep breath and step back from the turmoil of the past two weeks. This wakeup call reminds us of the latter half of 2015 when a combination of events led to a similar jolt to market complacency. Then, the market recovered quickly following each sell-off and went on to reach new highs. Volatility, as measured by the VIX and shown in today’s chart, remained elevated for several months (and may do the same this time around). Despite that, investors have benefited from a 33% appreciation in the S&P 500 in the two years since that tumultuous second half of 2015. And in 2018, the underlying market fundamentals are in some ways better than they were in mid-2015.
Quite naturally, it was the market’s strong rally in 2016 and 2017 that compounded investors’ concerns over the unusually long bull market. By late January, the price-to-earnings ratio for the S&P 500 had peaked at 18.7 the day before the selloff began. That 12% pullback in valuations pushed the S&P 500 down to 16.7 times 2018 earnings by the time the market troughed on February 9th. Was 18.7 really too expensive if 16.7 was too cheap? We saw last week’s recovery bring the S&P 500 up to 17.3 times 2018 expected EPS and 15.1 times 2019 expected earnings. But these are still attractive valuations: since inflation remains below 2.5%, the market is cheaper than during past episodes of low inflation, when the market traded on average at 19.5 times forward EPS.
As we have written on numerous occasions, earnings growth and a low-inflation regime provide fundamental support for stock valuations. Most companies have now reported fourth quarter results, and a great majority (75%) beat EPS estimates and about half raised outlooks for 2018. Although stocks recovered to levels seen at the start of the year, valuations are cheaper than in early January. The corporate tax cut and broad-based improvements in end markets increased earnings outlooks for both 2018 and 2019. This growth in earnings has been and will continue to be the key positive driver of valuations.
Structural risks remain and chief among them is the prospect of rising interest rates as the U.S. economy faces both rising inflation and an expanding federal deficit. In addition, businesses and consumers face a looming risk of more protectionist trade policy, and we should expect an uptick in geopolitical instability once the Olympics hiatus concludes. Portfolios should be positioned to prepare for such risks, but fleeing the market can compromise long term returns, as investors who fled after the 2015 turmoil found out, and as those who contributed to the 8% decline in SPY funds learned a mere week later as the S&P rebounded 6%.
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