Orlando's Outlook: Equity market roller-coaster heading higher


Bottom Line: We believe that the equity market’s brutal but healthy 12% correction over the past three months is now largely behind us, with stocks poised to trade higher over the next two months, fueled by excellent first-quarter corporate profits. Investors pointed to a myriad of concerns, ranging from the imposition of global tariffs, prospective trade wars, the Federal Reserve’s leadership and monetary-policy transition to general chaos in Washington, to justify the decline in share prices. But when the dust settles between now and Memorial Day, we expect to see an earnings-driven rally push stocks higher, perhaps approaching the cycle highs from earlier this year.

Anatomy of the correction It’s been a textbook pullback, to be sure. After surging by nearly 8% through Jan. 26 to start the new year, stocks appeared technically overbought, trading at about 18.5 times our $155 earnings per-share estimate for 2018. The S&P 500 then plunged by 12% over the next fortnight as volatility soared due to our imminent central bank regime change. We enjoyed a powerful 11% rebound into mid-March, followed by the requisite 9% correction to successfully retest the 200-day moving average. Since that oversold equity reading at 2,553 on April 2, with price/earnings (P/E) multiples shrinking to less than 16 times, stocks have begun to grind slowly higher by more than 4% over the past two weeks.

Strong first-quarter earnings season starts this week Consensus expectations are for a powerful 17% year-over-year (y/y) gain for S&P 500 companies. This is the first full quarter for companies to report how much they benefitted from President Trump’s recent tax-law changes, and management’s forward guidance will be an important part of the upcoming earnings season. Given a typical pace of upside surprises, y/y earnings gains could well approximate 22%, marking the best earnings growth in seven years. While all 11 S&P sectors are expected to report solid earnings growth, energy, financial services and technology are expected to boast the strongest gains. Importantly, while we here at Federated were high on the street to start 2018 with an S&P earnings estimate of $155 (versus $130 in 2017), consensus estimates have since risen to $161 per share, which has certainly contributed to the equity market’s more attractive valuation profile at present. So if first-quarter earnings meet or exceed expectations, stocks could rally from last week’s trough by more than 10% over the next two months. 

Fed worries fading New Fed Chair Jay Powell successfully navigated his first Humphrey-Hawkins meetings before Congress in mid-February and his first FOMC policy-setting meeting in mid-March without incident. In fact, we rather liked his plain-spoken approach and steady hand on the monetary-policy tiller. Since then, we learned that John Williams, the highly regarded current president of the San Francisco Fed, will be swapping coasts to head the important New York Fed when current president Bill Dudley retires in June. In addition, President Trump may be close to nominating his choice for the Fed’s open vice chair job, with speculation centering on Dr. Richard Clarida, an economist at bond giant Pimco. Clarida also is a professor of economics at Columbia University and was an assistant U.S. Treasury secretary under President George W. Bush. If this all comes together, the financial markets should be comfortable with the Fed’s new leadership troika.

Labor market should rebound in April True, four nor’easters during March reversed very mild weather in February and temporarily resulted in much weaker-than-expected job creation of only 103,000. But the economy and the labor market remain healthy, with an average job-creation run rate of 195,000 over the past four months, and we expect that April results (to be reported on Friday, May 4) will snap back to trend. Why are we so sure? Because the important labor-market leading indicators of the private ADP report and initial weekly unemployment claims point to continued underlying strength. ADP has now averaged 245,000 jobs each of the past four months, the strongest such stretch in nearly four years, while claims are running at a 45-year cycle low. 

Kabuki dance on tariffs and trade Markets have been stressed over the past three months due to rampant fears about Trump-inspired tariffs and trade wars, particularly with China. But we continue to believe that these tariff threats are a negotiating ploy orchestrated by Trump in an effort to reverse a rapidly widening U.S. trade deficit, which at $57.6 billion in February stands 30% higher than it was just last August, at its worst level in a decade. But investors are beginning to get comfortable, in our view, with new National Economic Council Chair Larry Kudlow’s role in advising Trump on trade. Kudlow is a King dollar, free-trade advocate. As a former Fed staff economist, Wall Street economist at Paine Webber, Bear Stearns and Montgomery Securities, a member of the Reagan administration in the Office of Management & Budget and a longtime CNBC economics commentator, Kudlow has earned significant credibility on this issue.

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