After closing the book on the 3rd quarter, the markets have begun to look ahead to what 2019 will hold, and while we intend to offer a few of our insights for the future, we often find it easier to see where we are going only after understanding where we’ve been.
2018 thus far has provided a mix of very bullish headlines and yet muted returns for diversified investors. Headlines have included 2nd Qtr. GDP growth of above 4%, the lowest unemployment rate in decades, earnings growth of greater than 20% in the 2nd quarter for the S&P 500 (Factset), and Consumer Confidence levels not seen in 18 years (WSJ). And yet, returns for broadly diversified investors have been much lower than the preceding headlines might suggest After considering the volatility seen in the first days of October, which saw US Stocks fall over 6% from their September 30 levels, many, if not most, diversified portfolios are in the red for the year at the time of this writing.
From this dichotomy of good headlines and low returns arises the question: How and why did this happen?
While the “why” is a bit nuanced, the “how” is fairly straight forward: Stocks Got Cheaper. Since the start of the year, the Forward P/E ratio on the S&P 500 has dropped from above 18X to 15.7X as of 10/14/2018 (Factset). The narrative is further shown by emerging market stocks, which have dropped from 13X to 11X (yardeni research). This equates to stocks becoming 12 and 15% “cheaper” all else being equal.
While the “why” is a bit more vague, we believe a primary driver of this “cheapening” has been rising interest rates. Whether looking at average mortgage rates topping 5% (CNBC), 10 year treasury rates reaching 3.25%, or a fed funds rate now at 2%, interest rates have noticeably moved up in the last 2 years. Because bonds are “competition” for investor dollars, this has caused some dollars to flow from stocks to bonds as rates have risen. Rising rates have also been cited by pundits as the cause volatility sell off in the markets in October.
With all this as back-drop, the most important question comes to the light… Where do we go from here?
In our view, the global economy, and the US economy in particular, continues to look strong. We do not see anything on the horizon that is likely to cause a near term recession, which should support continued late-cycle earnings growth. Also, while bond yields have risen, absent declining earnings which we do not see in the next 1-2 years, stocks continue to look more attractive than bonds.
2018 thus far has proved to be a year of adjustment for markets, as both stocks and bonds have gotten cheaper, which have increased our expectations for investor returns looking ahead in the short term.
While we see growth ahead, we continue to be ever-mindful of the potholes that can derail a portfolio or financial plan, and for that reason continue to profess the time-tested benefits of broad global diversification regardless of what the best or worst performing asset happens to be in any 1 month, quarter, or year.