As of 5/9/2018
- First quarter S&P 500 earnings are on pace to grow almost 25%
- 78% of companies beat analyst earnings estimates — the highest percentage in nearly ten years
- Bullish sentiment has cooled, adding to the market’s indecisive movements
- Global trade tensions could continue to contribute to market volatility
- Historically, the combination of increased government spending and higher interest rates has been good for stock prices
- Yet other factors may cause stocks to move in a sideways direction in the near term, but that’s not necessarily a bad development for investors either
Data Source: FactSet
Earnings hit a home run
Stock prices have been volatile this year as investors worry about trade disputes, rising interest rates, and the threat of higher inflation, among other factors.
Yet underlying fundamentals remain sound. Companies surpassed lofty earnings expectations in the first quarter. Sales trends were particularly strong during the period, indicating there is more to the earnings story than just the benefits of significantly lower corporate tax rates.
While solid earnings results have yet to translate into higher stock prices, companies confirmed our belief that corporate fundamentals are strong.
Investors must now weigh what could be conflicting forces that will be at play in the coming months.
A historic reason for optimism
On the heels of robust first quarter financial results, the current U.S. policy environment could provide support for equity prices as well.
On seven different occasions since the mid-1950s, U.S. fiscal conditions have been increasingly stimulative (i.e., lower taxes and increased government spending) at the same time monetary policy has tightened. The recent corporate tax cut is the most notable stimulus. In the meantime, the Federal Reserve has been slowly raising short-term interest rates.
According to BCA Research, the S&P 500 Index has risen on average 16.7% during periods where fiscal policy is more stimulative and interest rates are rising. Although history is not a guarantee of future results, these cycles have historically lasted 12 months on average. Investors would be wise to consider this point as interest rates, inflation, and economic growth continue to shape market sentiment and influence stock prices.
Potential headwinds create uncertainty
It is also worth mentioning that stretched equity valuations and elevated trade tensions have cooled bullish sentiment across the market.
We believe the decline in optimism from extreme highs is a healthy market development. Optimism is fickle and tends to ebb and flow over time.
The recent dip in bullish sentiment may actually put the market in a healthier state over the long run.
According to data from BCA Research, equities tend to perform the worst when sentiment levels are deteriorating from bullish levels and perform the best when sentiment levels are rising from bearish levels. While macro concerns may be weighing on sentiment and stock prices at the moment and could do so over the near term, it is important for investors to take a step back and see the forest for the trees.
Don’t be surprised at a pause in the markets
Unemployment is at multi-year lows, consumers are on solid footing, corporate earnings are growing at double-digit rates, and extreme optimism levels have faded. Although the debate about trade, profit sustainability, and higher interest rates could act to rattle investors and elevate the noise around stocks, we believe the fundamental backdrop is supportive of equity prices.
With all that said, the changing landscape for trade, higher interest rates, and mixed economic data globally could keep stock prices in a trading range over the near term, with no sustainable up-or-down movement.
In our view, stocks could have difficulty topping their January highs without a positive catalyst to increase buying momentum. If tensions ease on the geopolitical front or trade pressures with China fade, it could send U.S. stock prices higher. However, it may be some time before we see meaningful resolution on either front. Importantly, we foresee a small probability that stock prices will drop below their February lows (23,860 on the Dow Jones Industrial Average).
More broadly, recession risks are muted, fiscal and monetary policy is stimulative, and earnings are growing. We believe these factors are reasons to be cautiously positive about stocks. Healthy markets take a breather now and again to consolidate rapid price gains. If the market should pause over the next few months, investors may welcome the opportunity take a vacation as well.
As of May 9, 2018
Data source: Morningstar Direct