After 2017, where all asset classes appreciated with record low volatility and with evidence that the global economic picture was brightening, we began 2018 commenting that our biggest worry was a lack of things to worry about. That quickly changed as S&P 500 stocks experienced a 10% correction in the quarter, finishing with the first decline in nine quarters at -0.8% in Q14. While the pullback has been blamed on broken “low-volatility” trades, concerns over trade scuffles and threats of tariffs, rising Federal Funds rates and due to a breakdown of popular “FANG”1 stocks, perhaps the culprit is merely complacently and serves as a reminder that market corrections are normal, healthy, and to be expected. As we’ve written many times, the average intra-year drawdown over the past 40 years has been -13.7%2, making a repeat of 2017 highly unlikely.
After experiencing only 8 daily moves of 1% or more in 2017 and where the largest drawdown was a record-low 3%, S&P 500 stocks have already experienced 23 days of 1% daily moves in 20181. The correction has seen 27% of S&P 500 stocks down more than 20% from their highs, and has seen the index finally breaking below its 200-day moving average early in April, the first time that average has been breached in 442 days, the 6th largest streak in history1. Clearly, volatility is back as we, and all prognosticators predicted.
Q1 total returns for some of the more important indices include the following4:
- S&P 500: -0.8%
- Russell 2000: -0.1%
- Russell 1000 Growth: +1.4%
- Russell 1000 Value: -2.8%
- NASDAQ 100: +2.6%
- MSCI Emerging Markets: +1.4%
- MSCI EAFE: -1.5%
- Barclays US Aggregate Bond: -1.5%
- BofA ML US High Yield: -0.9%
Results were mostly negative in the quarter and modest in magnitude, downplaying the pullback as equities were sharply higher earlier in the quarter. While there have been some modest disappointments in certain economic reports, we attribute these more to unrealistically high expectations rather than to a change in trend regarding the synchronized global economic picture. We continue to believe the economic picture is healthy and while we are closely watching for inflationary pressures, the economic backdrop continues to lead us to favor equities over fixed income asset classes. With the tax cuts in the U.S. now being factored, earnings estimates have been rising all year, with Q1 expectations now sitting at +17.3% for S&P 5003, compared to expectations of 11% gains as we entered the year. With the pullback and with rising earnings estimates, U.S equities now trade at 16.1x forward earnings for the S&P 5004, down from the recent high of 18.5x. Elevated investor psychology has also been reset, as the Put/Call ratio on S&P 500 stocks is now up to a cycle-high of 95th percentile1, a bullish, contrary indicator.
The increased volatility has been conducive to several normal “rebalancing” trades in Fundamentum portfolios in 2018. Targets allocations have also been adjusted during the quarter as follows:
Fearing overheating and concerned about inflation pressures, a basket of “inflation hedges” were added to the Tactical and Enhanced Index Portfolios in January, where proceeds came from existing fixed income holdings.
With the 10% pullback in February to the S&P 500’s 200-day moving average, equity targets were boosted modestly in our Tactical Strategies with the proceeds again coming from fixed income holdings.
In the Global Individual Equity Strategy, the February lows presented a nice opportunity to rebalance and add names that have strong competitive positions at prices we liked, given the weakness. We took profits in Valero (VLO), Schlumberger (SLB), Lowe’s (LOW) and Bristol-Meyers (BMY), and used the proceeds to add McDonald’s (MCD), Starbucks (SBUX), and Siemens (SIEGY) to the portfolio.
Bottom-up estimates for 2018 now call for nearly 19% earnings growth for the S&P 500 companies and EPS of $1583. For some time, we’ve thought the outlook for 2018 would be more dependent on the denominator (AKA interest rates) as our confidence level in the numerator (earnings) is relatively high. That remains our view today, after the pullback, especially as valuation is being impacted by political tussles over trade. We will continue to monitor trends in the inflation picture, as it continues to be the important driver to the outlook for long-term interest rates. If inflation (and interest rates) remain in modest uptrends, we believe equities can appreciate with earning growth, especially at the lower multiple we sit at today. Despite the choppy action we are seeing today, this environment may make for an above-average year for U.S. equities in 2018. If history repeats itself this year, 2018 returns could be back-end loaded as equity returns have typically been modest in the first half of midterm election years.
The outlook for 2019 and beyond becomes more challenging in our view. Longer-term (5-10 years) equity and fixed income returns are best explained by valuation starting levels, and on that measure, we believe longer-term returns are likely to be below-average given today’s higher valuation starting points. For 2019, following what is likely to be an economic stimulus from the tax cuts and with Fed Funds rates targeted to be upwards of 1% higher than current levels, the economic and earnings comparisons will provide stiffer competition.
Fundamentum Investment Committee
April 4, 2018
- Strategas Research Partners
- JPMorgan Asset Management
- Morningstar Direct
- Facebook, Amazon, Netflix and Google
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