Secular bull call intact but 3,100 on the S&P may have to wait till 2019

10-25-2018

With the unexpected weakness in stocks through this relatively strong earnings season (+20% growth so far), clients are wondering: is this the end of the bull? Our short answer is no. We continue to see most of the key drivers of this bull market that we’ve discussed previously as very much intact, and consider this pullback as a very normal one in the long-term scheme of things. This said, given the technical damage from this market sell-off, our long-standing target of 3,100 on the S&P 500 is likely out of reach for year-end. There just isn’t enough time to make up lost ground and it’s not yet certain when this current shakeout will end. That said, we view the downdraft as an opportunistic bump in the road. We continue to see the market eventually recovering to higher ground, with 3,100 possible by mid-2019 or so and 3,500 still very much on our longer-term radar. We are recommending longer-term investors use the present weakness to add to equity positions over the next few weeks. Your patience within the panic should be healthily rewarded. A few key points to consider:

  • Market fundamentals are strong but there have been lots of worries in Q3 earnings reports about margin pressure and top-line slowing The main culprits for many companies’ more muted guidance have been a tightening Fed/higher rates, housing and auto softness, and a mounting trade war and tariffs with China. In our analysis, this looks more like a temporary soft patch or at worst a very modest “small R” recession/inventory adjustment in certain industries, not the beginning of systemic financial crisis that could take equities overall into bear market territory. Consensus S&P earnings for next year have come down modestly but remain a very bullish $179, although our present guess is that this number will come down a little further as earnings season proceeds.
  • Valuations also have fallen considerably Cyclical stocks in particular have been slaughtered, although most are not yet at their 2015 price lows. Everything else is pretty banged up, too. Notably, after carrying the major indexes up this year, major tech stocks have been pulling them down. But even if S&P earnings next year are flat before reaccelerating in 2020 (a far worse outcome than we anticipate), the market is trading at a 16.5 forward P/E multiple—a healthy discount to fair value. That makes for a compelling argument to add here.
  • Expect near-term volatility to continue As for the very near term, it’s hard to see a sustained rally for the next few weeks. Ironically, the Fed can’t guide off its recession-worrying planned rate hikes into 2020 until President Trump tones down the rhetoric—perhaps that will come after the midterm elections. This pushes more market friendly guidance out to mid-December, perhaps at the press conference following the all but certain December hike. Similarly, it’s hard to see the China/trade war news improving until post-election, perhaps at the planned meeting between Trump and Chinese President Xi Jinping on Dec. 1 (both sides by then will want a way out of this). As for the election itself, we’re expecting a market friendly “Red Undertow” outcome, with Republicans keeping the Senate and losing the House modestly. But there is a wider-than-usual range of outcomes here depending on voter turnout and near-term news flow that could impact the remaining undecided voters in what likely will be very close House and even Senate races. Other near-term term support could come from share buybacks once the earnings-season blackout periods end and from dividend investors lured back into stocks by improving yields.

The bottom line While the present volatility has some merit given the near-term news flow, little has changed on the longer-term outlook, other than that stocks are suddenly 10-to-20% cheaper than they were a few months ago. Secular bull markets don’t go up in a straight line, and pullbacks like these often prove attractive entry points. Diversified investors should stay patient and consider averaging further into equities through year-end. The PRISM® asset-allocation committee already has added two points to our equity overweight (a move made after the late September/early October pullback to around 2,725 on the S&P) in our stock-bond portfolio model, and has saved powder to burn if we do get another leg down to the 2,600 area. Although the near-term picture is cloudier than usual, our longer-term outlook of 3,500 remains unchanged. We think buying stocks at present levels is likely to reward investors who keep their cool.