We’ve spent a good deal of time over the last several weeks speaking with, and listening to, a broad swath of investors and opinion makers in the global financial markets. Our conclusion from these discussions is that despite a very bullish backdrop for equities, most investors are cautiously positioned or outright bearish. Meanwhile, over the course of the market correction since February, Federated added twice to its longstanding equity overweight in its PRISM® stock-bond portfolio models, and we enter the summer at 80% of our maximum equity overweight. We’re also maintaining our year-end 3,100 target for the S&P 500.
We continue to hold the positive market view that we’ve outlined over the past few months based on a strong economic backdrop, solid double-digit earnings growth this year, expected high single-digit growth next year, a supportive Federal Reserve normalizing interest rates gradually against modest inflationary forces and valuations that are fair to cheap.
So why is the market struggling to advance? We believe there are five bearish narratives—or market myths—depressing sentiment and creating just the wall of worry this market needs to move above its trading range since February.
Myth 1: "What goes up must go down." Few people actually say this, but almost everyone seems to believe this fundamental law of physics applies to any stock market that has had a big run. Underpinning current investor caution is the presumption that following the 34% rise in the S&P between the 2016 elections and its Jan. 26, 2018, peak, a serious market pullback is almost inevitable. But the data suggests otherwise. We examined previous 16-month periods over the last 30 years during which the market experienced a similar rise of 30% or more. On a rolling basis that captures a dozen or so continuous bull runs, there have been 68 such instances. Looking ahead 12 months following these spectacular rises, the market rose further—another 15% on average. In other words, what goes up may...keep going up!
Our explanation would be that when a market rises 30%, it typically does so for a big, positive structural reason likely to improve fundamentals and further stock gains. In the present case, the market rose more than 30% on the back of President Trump’s election and the promise of improved economic and earnings growth from the implementation of his agenda. And that is exactly what happened: regulatory reform and corporate tax cuts fueled an economic and earnings reacceleration. We believe these same policies—and the animal spirits they’ve unleashed—are likely to produce continued gains for the economy and earnings in 2019 and 2020.
Myth 2: "Sell in May and go away." There is some statistical truth to this narrative. Over the last 30 years, the average market returns over the period from May 31 through Aug. 31 have been exactly 0%, while the full-year average returns have been a healthier 10%. So blindly “selling in May and going away” every single year might have helped a little, though possibly not after transactions costs and taxes.
But when you examine more carefully what was going on behind the curtain in the May through August returns, you find that the unimpressive average return of 0% over these months was rooted in five very poor years for summer investing. They included three recessions and the first Greek debt crisis. Absent these five years, the May through August results were actually a reasonable 2%, or 8% annualized. In May 2018, the fundamental news remains very positive with no recession remotely in sight. Nor does a renewed European financial crisis seem at all likely. And the Fed’s plans to very gradually shift to less monetary easing are historically well telegraphed. From our perch, the kinds of market concerns that might cause a May-August selloff are already safely in the rearview mirror: February’s wage inflation scare, March’s trade war scare and April’s internet regulation/Facebook scare. So even if we hit a little turbulence following our bounce off the March lows, we’d expect to exit the summer higher than where we are entering it. Indeed, this summer could very well be a new dawn of the bull.
Myth 3: “Inflationary forces must soon accelerate and force the Fed’s hand.” This bugaboo is one we’ve been fighting for some time. It’s true that inflation is grinding higher as the economy improves and labor becomes scarcer. But the major deflationary forces at work in the global economy remain very much in place—including the “Amazon economy,” growing automation/robotics, retiring baby boomers being replaced by lower-wage millennials, a global labor pool and still high levels of discouraged workers finally reentering the workforce.
Further, wage inflation does not necessarily translate into broad core price inflation, which is the measure the Fed is concerned with. Wage hikes can be, and often are, funded from other sources besides raising prices for a company’s products: productivity gains, margin erosion, or more recently, newly found earnings from the Trump corporate tax cuts. At Federated, our bottom-up stock analysts confirm that all of these non-inflationary sources of funding wage gains are being utilized by companies across the economy.
The Fed itself is well aware of these forces and Fed governors have frequently pointed them out when explaining why they intend to move very slowly on rate tightening. So while we expect the broad inflation gauges to rise gradually in the present expansion, we do not expect a scary inflation spike any time soon.
Myth 4: “Stocks are expensive.” Of all the myths scaring the average investor, this one goes alarmingly unchallenged by the news media whenever the latest market pundit states it as a matter of course. We’ve examined this myth from all angles and the only way to make the case that the market is somewhat pricey is by using a well-polished rearview mirror.
The most famous of the backward-looking measures that has been adopted into the lexicon (even though it has been flashing “overvalued” all the way up from the 2009 market lows) is the Shiller P/E ratio. The methodology behind this ratio seems reasonable on first glance: the current price of the market is divided by the average earnings of the last decade. The problem with this, and other similar measures, is that the Shiller ratio compares present prices to trailing earnings, in this case, trailing 10-year earnings.
When on a trailing 10-year basis you have two major recessions in the rearview mirror (such as in 2010) or a tepid recovery from the deepest recession in 50 years (such as now), the backward-looking P/E ratio will look high. But as with all cyclical stocks, the time to buy them is when the trailing P/E is high, and earnings are depressed and likely to rebound higher, not when it is low and earnings are at a cyclical peak. We think this it tells us little about the future market direction. We prefer to value the market relative to the earnings we see in front of us, especially in a situation such as we have today where the next 12 to 18 months are very visible. On a forward 12-month basis, the market multiple is at 16.8, closer to the long-term average, nowhere near a peak. And relative to the alternative, the 10-year Treasury bond yield, the forward multiple is considerably below its long-term average. Bottom line, for a forward-looking investor, the present market valuation is far from expensive, and might even be viewed as cheap relative to bonds.
Myth 5: “We are late in the business cycle.” This last myth may be the grand foundational brick upon which this market’s great wall of worry is climbing. In their enthusiasm for a simplifying assumption that can underscore all other analyses, economists seem to have collectively agreed that the economy somehow has a circadian rhythm that produces a “cycle” that eventually ends in a Fed-induced recession. It is also assumed that this cycle has a fixed length and that the present cycle is way past its due date.
We’ve examined this theory in other memos, so let me summarize here. We’ve had 11 economic expansions since World War II, each driven by different forces, of varying lengths and varying speeds. Most ended in a Fed-induced recession. We do not accept that the average of a mere 11 data points produces any meaningful insight to how long any given expansion should be or can be. The present one, however, has a number of fairly unique traits that suggest it could last very long.
First, it started in a deep financial crisis that set a very low base and importantly scared a generation of investors, corporations and policymakers against the kinds of excesses that often lead the Fed to end the expansion. Second, the first eight years of this expansion encompassed one of the most tepid recoveries on record, averaging just 2.2% per year compared to the 4.3% average annual growth rate of previous expansions. Indeed, if measured in speed and not length, one could conclude we are early cycle, not late cycle. Third, inflationary forces and the Fed both seem pretty well contained. In particular, the Fed has been very transparent regarding its intention to err on the side of caution in raising rates. As a result, we believe the risk of a policy error, which is how this expansion will eventually end, is still a long way off.
We continue to expect healthy market returns in the months, even years ahead.
As stated earlier, we are holding to our year-end S&P target of 3100, with a 12- to 24-month target of 3,500. A 3,500 level, 30% above the present market value, would reflect a multiple of 20 times our 2019 S&P earnings estimate, which we believe is quite attainable sometime in 2020, if not sooner. Federated’s PRISM® committee added an additional two points to equities in our moderate-risk portfolios during the February and March corrections, and we now sit poised on the edge of summer with our balanced portfolios at 80% of maximum equity targets. So our recommendation for investors is to look forward and enjoy the summer. Even if we do hit a little near-term turbulence after the bounce higher we’ve enjoyed, we should be considerably above present levels by the time the leaves start turning orange again.