In September of this year, the current bull market in US stocks will officially earn the distinguished title of the “longest in US history.” Of course, that assumes it will not have a 20% decline within the next two months. Given the duration of this stock and economic cycle, it’s understandable for investors to wonder whether a downturn is imminent. While we view the market in the later stages of an economic cycle, we also see reasons for optimism. We believe the market is a tapestry of fundamental, economic, and technical indicators. Below are succinct viewpoints for each one of these categories and our outlook for the remainder of the year.
Corporate earnings and revenues will ultimately drive the price of equities. Earlier this year analysts were expecting S&P 500 earnings to grow at a rate of 15% and they appear to have erred on the low side. In the first quarter of 2018, we saw earnings growth that exceeded 20% and Q2 earnings growth rates seem to be on the same trajectory. With over half of companies in the S&P 500 reporting for Q2, we see earnings growth of 22% and revenue growth of 8%. Using these earnings growth rates, the market is currently trading at 19 times the previous four quarters worth of earnings and 16.9 times analyst projections for next year. These valuations are slightly above the market’s average P/E multiple of 16, but we wouldn’t consider them excessive. We project earnings will continue to grow at a double-digit growth rate for the remainder of the year due to burgeoning consumer spending, accommodative tax policy, and cost efficiencies from technological advancement.
As we have noted previously, the U.S. economy continues to be in a modest expansion relative to the recession that preceded it. This moderated growth rate may leave the economy vulnerable to exogenous shocks from geopolitical events or inflation, but we also believe it has created a prolonged recovery. This recovery is visible in a plethora of data points that reflect our economy is far from collapsing. Below are some of the recent indicators we are watching:
- The U.S. economy has grown at an approx. 2.9% rate over the past 12 months. Real GDP in the 35 quarters since the recession of 2009 has averaged 2.25%.
- The monthly index of leading economic indicators has shown increases in 96 of the last 108 readings.
- June marked the 93rd straight month employers added to payrolls, the longest streak on record. Wages have inflated 2.9% over the past 12 months. Payrolls grew by better than 2.5% annually in the 1960s, 1980s, and 1990s.
- Business Inventories have increased by 4.4% over the past 12 months, but business sales have grown at a faster rate of 8.6% reducing the sales to inventory ratio to 1.34.
- Household debt as a percentage of disposable income sits slightly above 10%. This number exceeded 13% in 2007.
- The U.S. savings rate has declined over the past 12 months to 3.2% but remains higher than the 1.9% posted in 2005.
- Consumer spending has risen by 5% over the past year.
- The nation's trade gap narrowed sharply in May, to $43.1 billion from a revised $46.1 billion in April. This contribution to GDP may prove to be unsustainable due to a rush of foreign purchases made before the enactment of tariffs by the US government.
The last economic indicator we want to emphasize is US inflation. Historically speaking, inflation continues to remain at bay, but we are beginning to see clouds forming on the horizon that could bring inflationary pressures and rising interest rates. The Federal Reserve met its inflationary target of 2% and plans to raise rates two more times for a total of 4 rate increases in 2018. These increases by the Fed have already impacted the short end of the yield curve and increased borrowing costs. They have also increased the potential of an inverted yield curve (a potential precursor to a recession). Outside of monetary policy, inflation is also being stoked by 1) a job market that is almost at full capacity 2) a housing market where prices are on the rise and inventories remain low 3) rising petroleum costs created from reductions in capital expenditure on exploration & increasing global demand for oil, and 4) increases in material prices from an escalation in the use of tariffs on global trade. All of these issues play into our recommendation to position stock and bond portfolios in holdings with below average interest rate risk.
The S&P 500 hit it’s all time of 2872 on January 26thof this year. For the past six months, it’s been running to stand still, stuck in a moment that seems like it can’t get out of. It is common for bull markets to pause during a recovery but it would be very positive from a sentimental standpoint to see the S&P 500 make new highs by the end of the year. Currently, the market breadth has been exceptionally weak with technology and consumer discretionary stocks accounting for the majority of the S&P 500 YTD 6.5% gain. For this bull-run to continue into 2019, we want to see participation from the majority of S&P 500 sectors.
After an initial sell-off at the beginning of the year, the yield on the ten-year Treasury bond has also been trading in a range of 2.75 to 3.25 YTD. We expect this rate to increase gradually as inflationary pressures mount and foreign central banks tighten monetary policy.
Given the constructive economic backdrop in the first half of 2018, we believe there is a very low probability of a recession in the next 6-12 months. Stocks should provide superior returns to bonds (mirroring long-term earnings growth of 6-9%), and bonds should provide their coupon with very low correlation to equities. It is important to remember that bull markets do not run for a specified time frame. The length of this current run will eventually lose steam, but the fundamental, economic, and technical data points do not suggest it will be this year.
Authored by Jonathan Winzeler, Chief Investment Officer