The Bears and the "Algo Traders" have had things their way during the first four months of 2018, with stock market volatility soaring and corrections being turbocharged by the money flows into and out of ETFs. Admittedly, investors were overly enthusiastic during January, since 2017 had been an exceptionally good year for stocks, and the economic outlook for this year is even brighter. The February-April correction has left the S&P 500 flat for the year to date in the face of first quarter corporate earnings that so far are running 25% above their year-ago level. Clearly, the mood of investors has shifted to extreme caution, as the Fed has made it clear that gradual interest rate hikes are in store for at least this year and next. Indeed, monetary accommodation needs to be gradually reduced, lest a self-sustaining, low inflation expansion turns into an inflationary boom/bust.
The rise in interest rates, coupled with a significant narrowing of the yield spread between 10-year and 2-year Treasuries has kept the lid on stock prices, despite the strong profit gains. We have noted for several months that P/E valuations for the overall market and individual issues would inevitably contract as interest rates move higher in response to faster growth, the change in monetary policy, and the need to finance a widening Federal deficit.
Our working hypothesis has been that, at best, stock prices this year will parallel corporate earnings growth. So far, however, that has proved to be overly optimistic as the S&P 500 has shown no gain. Besides the rise in rates, part of the reason for this rapid compression of P/E multiples stems from a litany of geopolitical concerns, particularly fears of an all-out trade war, as the Administration threatens to impose high tariffs or quotas on imports from both allies and foes alike. Though much of the rhetoric is likely to be a negotiating tactic, there are clearly fears that if tariffs are implemented, retaliation by our trading partners would be inevitable and would hardly contribute to a reduction in trade imbalances. Moreover, any disruption of our highly efficient system of supply chains would both hamper growth and increase price inflation. Add to the trade issues all the geopolitical concerns surrounding North Korea, Russia, and the Middle East as well as the chaos in the White House and one can understand why the forward P/E of the S&P 500 has declined from about 18 to about 16 in the face of a modest rise in the 10-year Treasury yield from 2.5% to about 3.0%. The forward earnings yield is still at 6.0% compared to a BBB bond yield of 4.6%. This spread should limit downside risk.
A glance at our Fair Value tables, which we constructed more than 25 years ago, is also revealing. (Copies are available to anyone interested.) The tables show that for sustainable annual profit growth between 5% and 10%, and with Equity Risk Premiums of 2%-4%, a 100 basis point rise in the discount yield from 2.5% to 3.5% results in the Fair Value P/E of the market declining by 18% to 23%. Of course, Fair Value is merely an equilibrium around which stock prices fluctuate above and below in response to a multitude of factors. However, we believe this explains the lackluster performance of the broad market's valuation year-to-date as much as fears of a trade war.
The implications going forward are less clear, but the message is that stock prices will probably not parallel earnings gains as long as interest rates are rising. Once rates stabilize, there will, in all likelihood, be a catch-up in valuations, provided a recession is avoided and earnings continue to rise, even at a modest pace.
That said, the U.S. is running short of skilled labor (anti-immigration and poor education policies don't help). Unless worker productivity picks up soon, economic growth will inevitably revert to the sum of labor force growth + productivity, indicating potential output growth below 2% per annum. In this instance, any greater increase in profits would come at the cost of higher inflation, which would bring forth a hostile Federal Reserve and perhaps sufficient tightening of monetary policy to cause a recession. At this point, it is our best judgment that 2018 will end up being a worthwhile year for equity returns, driven by strong profit growth, share buybacks and dividend increases. Beyond this year, however, much will depend on whether or not productivity picks up sufficiently to sustain non-inflationary growth. Time will tell.
