After six weeks of steady gains, the equity market seems to have turned the corner. For now, steady economic growth, muted inflation, and exceptionally strong corporate profits have helped overcome investor concerns about rising rates, an overheating economy, trade wars, and other geopolitical issues. It remains to be seen if the lows of this correction have already been established, but the recent rally is encouraging, and we think the pullback will over time give way to new market highs.
Ultimately, markets follow earnings. If earnings go higher, then the market eventually will too. Importantly, the improvement in earnings underway hasn’t been about tax reform, as the recovery in corporate profits can be traced back to the midpoint of 2016 when global economic conditions began to strengthen (see Figure 1). Revenues are typically a good indicator of the economy’s health, and the first quarter’s 9% sales growth was the best in years. These strong numbers signal that, despite the tepid start to 2018, global demand remains strong and should continue to support profit growth once the one-time effects of tax cuts roll off.
Of course, it’s not just earnings that matter, but the valuations associated with those earnings. Sometimes, the market can get ahead of earnings growth—as it appears to have done earlier this year—and a consolidation period like we’ve experienced is needed before prices can move higher again. While many investors feel that the U.S. equity market remains overvalued, we now see valuations as full and fair.
Viewing the topic in the context of today’s low interest rates may be more helpful. Yes, price-to-earnings ratios remain somewhat elevated by conventional metrics, but they turn out to be close to the long-term historical average over periods of low interest rates. We think this historical matching of low rates and higher valuations makes intuitive sense: Lower payouts from bonds decrease the relative attraction of fixed income and make equity risk more attractive (see Figure 2). Interest rates should continue to move higher in the quarters ahead, but there appears to be more room to run before they begin to pressure equities.
So, is the correction over? If this turns out to be a typical correction, as the market behavior so far seems to suggest, then it very well may be behind us. But that doesn’t necessarily mean volatility is likely to subside. Although earnings should continue to grow and lift equity prices higher, the list of market risks is unlikely to shrink as we progress through the later stages of this business cycle. Geopolitical tensions and inflation scares are likely to continue to be a source for volatility in the short term, while broader policy risks, particularly Fed tightening, pose a threat to investor sentiment and eventually the economic expansion.
A more challenging investing environment such as this will require a more disciplined and patient investing approach. We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise, and to be on alert if conditions deteriorate. Recently, we have moved up in quality in both our fixed income and equity portfolios to prepare for the volatility we have been experiencing. At the same time, there are pockets of value in the market, and we seek to selectively take advantage of those opportunities. Corrections are always unnerving, and the next few months could continue to be choppy, but for now a U.S. recession still appears a ways off, which should keep profits growing and the bull market intact.
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