Investors in Search of a New Normal
The headline decline in the S&P 500 belies the extent of the damage at the sector level. Three sectors peaked in January and never fully recovered from the ensuing selloff. From that point through last Friday, materials stocks are in a bear market, down 21 percent. Financials are down 16 percent, and industrials are down 14 percent. Energy stocks peaked in May and are lower by 16 percent since. Communications services peaked in July and are lower by 14 percent. Among the groups that have sold off sharply more recently, consumer discretionary stocks are down 12 percent from their peak, and technology is down 10 percent. Only four sectors have so far avoided the 10 percent correction threshold, including utilities, real estate, healthcare and consumer staples. Their combined 23 percent weighting in the S&P 500 has been enough to keep the index above the correction line, but just barely.
Third Quarter Earnings and Bond Yields are Not to Blame for the Selloff – What is?
Third quarter earnings are not to blame, as results have been about as expected. Roughly halfway through reporting season, the growth rate is now forecast to be 22.5 percent, according to Factset, and a higher than average percent of companies are beating expectations and doing so by a wider than average margin. And fourth quarter projections have held up as well. But that has meant little to investors, however, as good results have been punished alongside the poor.
It would also seem that neither are bond yields to blame for the selloff in stocks. The ten-year Treasury note yield fell 11 basis points last week to 3.08 percent and is lower by 15 basis points from the October 5 peak, while the S&P 500 is lower by 8 percent during that same interim. The two-year Treasury note yield is 9 basis points lower at 2.80 percent.
As healthy as third quarter earnings may be, investors are focused on what happens from here, and concluding that the environment is likely to become less favorable. Investors are skeptical that the Fed will raise rates four more times before the end of next year, but worried that it will, unnecessarily slow the economy in the process. Related to that concern is the outlook for earnings growth next year. Consensus anticipates growth of 10 percent, ordinarily quite healthy. But it still would be roughly only half of this year’s pace. More importantly, some private estimates of 2019 earnings growth are being reduced, some to as low as 5 percent, alongside lowered expectations for economic growth. What the appropriate level is for the S&P 500 if rates move higher than expected and earnings move lower is what investors are trying to determine. Add to the mix the uncertain economic impact of the trade war with China and it’s understandable that sentiment has deteriorated, and volatility has risen, although neither is at an extreme. That same anxiety was seen in high yield credit spreads, which widened to their highest of the year last week, although it remains below average.
Investors Take a Hard Look at Valuations
The ongoing search for the right level for stocks does not necessarily signal the end of the bull market. Valuations have improved enough in this selloff to support an argument that stocks are now fairly valued, even with somewhat reduced forward earnings expectations. The S&P 500 is now down 0.6 percent on the year, but full-year earnings growth is expected to total 20 percent. Factset estimates that the forward 2019 price-to-earnings ratio (P/E) is now 15.2x, based on $178 of expected earnings, 10 percent higher than this year’s expected total of $161, and based on last Thursday’s S&P 500 closing price of 2705. If earnings grow by only 5 percent, the 2019 P/E would still be a reasonable 15.9x. That compares to a five-year average of 16.4x. However, that would still be well above the ten-year average forward P/E of 14.5x. These averages should be viewed somewhat skeptically, however. Distortions created during the financial crisis and its aftermath, both in terms of earnings growth as well as prevailing interest rates mean that these averages are full of noise. What is reasonable going forward depends on conditions that are evolving with less than perfect clarity.
This week will see a surfeit of scheduled economic reports, headlined by Friday’s October jobs report. The Bloomberg consensus anticipates the creation of 193,000 new non-farm jobs and a stable unemployment rate of 3.7 percent. Growth in average hourly earnings remains a wildcard for signs of nascent wage inflation. Also scheduled is the September personal income, spending and Personal Consumption Expenditure (PCE) data, ISM manufacturing, consumer confidence, motor vehicle sales and factory orders. And more than a quarter of S&P 500 companies are scheduled to report their third quarter results, including Apple and Facebook.
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The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
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- Chief Market Strategist, Ameriprise Financial
- More than 30 years of experience in the investment management industry
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