October has lived up to its turbulent reputation and given us a fair amount of movement to analyze. It can be difficult to know why the market has moved in any given time frame. The good news is that the recent pullback in the market is expected to be temporary by the majority of analysts. Here are some of the factors affecting current market behavior.
You’ve likely heard news about the federal funds rate recently. This is a common interest rate banks charge each other for overnight loans. This rate then affects the rates consumers pay when banks lend to them. The Federal Open Market Committee implemented 3 rate increases of 0.25% each to the federal funds rate in 2017. There have been 3 more 0.25% increases in 2018, bringing the current rate up to 2.25%. They would like to see this rate closer to 3% in order to give the committee room to lower the rate during the next economic slowdown.
Both housing and auto sales have been impacted by these higher rates. 30-year mortgage rates are up a full percentage point in 2018, as compared to year-end 2017. Rising rates allow investors to shift their stock exposure, while still earning some interest. For example, we’ve seen 1-year CD’s and other short-term savings vehicles increase yields to around 2% annually. Investments leaving stocks does place downward pressure on stock prices. The rate increases have been measured and expected. They are largely priced into the markets, but investors should not be surprised when the market moves some with each new rate increase.
Bond funds have a portion of their portfolio maturing throughout the year. As a bond bought 2 years ago matures, it is replaced with a bond yielding higher interest. The bond funds we typically use in client portfolios have seen their interest income increase. This will likely continue in 2019 as newly released bonds will continue to pay higher rates. Rising bond yields mean retired clients can more comfortably cover a 4% withdrawal rate.
The biggest driver of stock market performance is earnings, and expected earnings growth. 2018 is shaping up to be one of the best years on record for profit growth in several decades. We have seen earnings releases with growth in same store sales, overall revenue, and/or earnings followed by a stock price drop. Although this is typically unusual, it is rational in the current environment. The most recent tax cut boosted corporate earnings, providing a nice tailwind in an already positive earnings environment. However, that was a one-time boost that will not be repeated.
As of November 2nd, 74% of S&P 500 companies had reported 3rd quarter results.2 78% of companies reported greater than expected earnings, and 61% greater than expected sales. The blended third quarter earnings growth rate is 22.5%. That is up from 19.3% at the end of September. Financial news often mentions the “PE ratio” when talking about overall markets. PE stands for price-earnings and reflects what an investor is willing to pay for a stock based on the earnings. A stock with a PE of 10 means investors are willing to pay 10 years’ worth of the company’s earnings in order to own the stock today. If a company is earning $100 annually, then the investor is willing to pay $1,000 for the stock. The PE ratio for the S&P 500 is 15.6. That is right in the middle of the 5-year and 10-year averages of 16.4 and 14.5 respectively. None of this data points to an overvalued market.
2019 earnings are forecast to be about 10% higher than 2018.7 This is about half of what we saw in 2018, but higher than what we’ve seen in most years since the immediate recovery from the 2008-2009 recession. The 10% growth in earnings is expected to provide a combination of some stock price growth and some lowering of PE ratios.
The Rest of the World
Foreign actively does effect the markets, and is the cause of some of the recent pullback. Budget issues in Italy, and the EU in general, escalating tension between Turkey and Saudi Arabia, the trade dispute with China, and concerns over the Chinese economy have all affected the U.S. stock market recently.3 We should not be surprised over market moves as the Brexit process continues. Activity in the Middle East will continue to affect oil prices, and how those prices impact the overall market.
International holdings represent a much smaller area of stock market exposure in client accounts than U.S. holdings. This sector had strong performance in 2017, but declined this year. Underperformers in one year often outperform the next, and is part of why we maintain diversified portfolios. We do not see any areas of great concern internationally in terms of stock market effect.
Most U.S. investors today recall the market decline of 2008-2009. Many also recall 2000-2002. This understandably leaves some investors nervous when the market declines. Both of those markets were impacted by bubbles bursting. For example, tech stock valuations were far greater in 2000 than they are now, with a NASDAQ PE ratio of 175 in March 2000.4 The current PE is around 20.5 While investors have various concerns over the future of the market, valuations are not extended.
Markets will decline in value and that can be nerve wracking. This is why we design portfolios that are blends of equity, bond, value, and growth securities for clients. The S&P 500 declined by about 9% from October 9th through October 29th.6 Client accounts with a diversified portfolio did not see this level of decline. As of November 5th, the S&P 500 had regained about half of the drop, and is widely expected to continue to recover lost ground. Analysts continue to see companies making money, and opportunities to share in this environment through the rest of 2018 and well into 2019. We do not see any reason to exit the market at this time, but rather view this as normal cyclical activity.
- FactSet, Earnings Insight, 11/2/2018
- Valueline, Investment Survey issue 13, 11/9/2018
The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase