US Market Viewpoints: First Quarter 2018Submitted by Castlebar Asset Management on April 16th, 2018
The quiet calm that investors grew accustom to last year ended this quarter as the market has entered a period of increased volatility. The year started off as 2017 ended with stocks enjoying their glide higher. The S&P 500 jumped 7.4% by January 26th only to give back all the those gains as investors became spooked by rising interest rates. The S&P 500 saw its first correction (a 10% sell off) since the first quarter of 2016. Interest rates (10-year treasury yields) jumped from 2.4% at the beginning of the year to a high of 2.94% in late February settling in at 2.75% by the end of the quarter. The jump in rates was a reaction to fears that wage inflation was going to increase faster than earlier thought.
With the selloff this quarter, the S&P 500 had its worst quarter since the third quarter of 2015 and the second worst quarter since 2012. Considering it only declined 1.2% it does put this into perspective that things have been very good since the financial crisis. This quarter saw smaller companies perform better than large cap stocks. Stocks that fall into the growth category produced gains in the quarter while value-oriented stocks struggled.
The top performing stocks were found in the consumer discretionary and technology sectors. Consumer discretionary stocks gained 2.6%. Amazon is the largest company in this sector and it was up 23.7% in the quarter. Traditional retailers also bounced back in the quarter, as Amazon has not quite put them out of business, yet. Technology shares held up well during much of the volatility. Investors looking for growth are migrating towards this sector. The admission by Facebook that an outside firm had compromised 87 million accounts did cause the sector to give back some gains as the quarter finished up. Consumer staples and energy stocks were the laggards in the quarter. Consumer staples sold off 7.5% as inflation and rising rates impacted this group. The energy sector fell 6.7%. Fundamentals for this group are improving, but geopolitical concerns weighed heavily on the sector.
We remain positive on stocks this year and see modest upside from current levels. We believe the primary catalyst for stocks will come from corporate earnings. The S&P 500’s earnings are expected to grow between 15% and 20% this year. There is likely to be some fluctuation with estimated earnings because companies and Wall Street analysts are still digesting the nuances of the tax cuts approved in December 2017. Valuations remain elevated but have contracted since December. The pull back in the market and an increase in earnings have helped bring the forward P/E ratio down to 16.4x. In December the forward P/E was at 18.4x and the 25-year average is around 16.1x. We expected valuations to remain stable or contract as increasing risks take some of the premium out of the markets
Recessions and financial shocks are what cause bull markets to end. Right now, there is little to no evidence of either on the horizon. Recession risk remains low for the next 12 to 18 months. Overall there are no areas of stress in the economy or in the financial markets. Economic growth remains strong in the US and around the world. All leading indicators are showing that the global economy should remain strong into 2019 as well. The recent volatility in the market has caused some concern for investors. Volatility does not signal the end of the bull markets either. These are all supportive of our thought that there is more upside from current levels.
There are increased risks in the market. A short list we are watching are; trade issues, interest rates and profit margins. The trade scuffle, it is nowhere near a trade war yet, between the US and China has caused volatile moves in stocks during March. Time will tell if this is just an aggressive posture to get China and other countries around the world to the negotiating table or if a trade war develops. News flow around trade discussions will likely cause additional volatility in stocks. History shows trade wars rarely result in any winners and inflation can be an unneeded side effect.
Interest rates are on the rise. The Federal Reserve is lifting short term rates and the bond market is seeing interest rates rise for intermediate bonds as well. Increasing interest rates, while normal in a growing economy, poses a risk to stocks for several reasons. As rates increase it becomes more expensive to borrow money for individuals, companies and governments. The cost of doing business slowly goes up which makes buying or building things with borrowed money more expensive. Higher rates also mean that bonds and savings accounts will offer higher rates of return. This could cause some investors to shift money from stocks. Stocks had been viewed as the only game in town when bonds offered lower yields and savings accounts paid virtually no interest. Now that rates are creeping higher there is an alternative for some investors.
Lastly, we are watching companies’ profit margins. Profit margins are how much a company earns on what they sell. Margins are at their highest levels since the financial crisis. If margins can stay around current levels the bull market should continue. However, as labor costs, increased borrow costs and other items creep into the economy, margins usually start to slip. This is something we will watch very closely moving forward because a decline in margins can be a leading indicator for a selloff in stocks.
We don’t believe the bull market is over. The ride is likely to remain bumpy. Investors should expect at least one 10% correction and five 5% corrections each year when owning stocks. That is what happens on average in a normal year. While we are expecting positive returns this year, we are projecting a lower than historical rate of return for stocks over the next five years.
You can read our 2017 Fourth Quarter US Market Viewpoints here.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.