As regular readers know, we typically release our quarterly newsletter toward the end of earnings season. We do this because we believe corporate earnings to be the most important “pillar of support” for equity valuations, and the commentary provided by company leadership gives us an idea of where the market may be headed and where opportunities may lie. However, looking back on a particularly volatile 2018 and one of the worst Decembers in history, we thought we’d share with you some of our initial thoughts as 2019 begins to unfold.
The bad news first. Unfortunately, a few of the issues that led to the market’s sharp drop in the last three months of the year remain unresolved. Three of the most significant:
The trade war with China has not seen much progress made, despite several high-level talks. Both sides acknowledge a desire to come to an agreement, but it doesn’t seem that investors believe that “talking the talk” will be followed by “walking the walk” just yet. Although we think that negotiating a deal is in everyone’s best interest, we expect this one to take some time to work out.
Earnings growth is slowing. This does not mean that companies are making less money, but that the rate at which they are making more money is lower. Earnings growth rates in 2017 and 2018, while nothing short of spectacular, were also unsustainable. Investors may claim that earnings growth is decidedly “worse” than it was last year, and they’ll be technically correct in doing so, but we don’t see that as a reason to be pessimistic on the health of corporate America. As far as we’re concerned, positive earnings growth means corporate performance is still improving. Market participants may or may not agree with us.
S&P 500 earnings per share
Headline noise is loud, for lack of a better metaphor. The government shutdown, Brexit, Italian budget negotiations, and oil production in the Middle East are just a few of the stories causing worry. While some of the issues do indeed represent legitimate threats to the health of the global economy, they are still noise at this point. The world has never been without conflict, and bad news always sells better than good news. Most of the time, cooler heads prevail. No good investment plan has ever been (nor should ever be) based on the headlines of the day.
Now for the good news. Here are three reasons we’re optimistic that this year can be better than last:
Federal Reserve Charmain Jerome Powell made several novice mistakes late last year when answering press questions regarding the future path of interest rates, precipitating the market’s initial panic in October. Rather than responding with measured commentary indicative of a veteran policymaker, Mr. Powell’s comments sounded flippant, and caused investors to wonder whether the Federal Reserve would continue to raise rates blindly and potentially push the United States into recession. Last Friday, Mr. Powell appeared in a panel discussion alongside former Fed Chairs Janet Yellen and Ben Bernanke, the two very well-respected Fed leaders that preceded him. Whether Mr. Powell received some “coaching” beforehand or not, he appeared much more thoughtful in his answers and was able to reassure the market that the Fed will be careful to review the data when considering the future path of interest rates. Adding to the calming effect were comments from his colleagues, including this one from Mr. Bernanke: “Having our experience 10 years ago, we’re certainly not seeing those kinds of risks.” In other words, a repeat of 2008 is probably not hiding around the corner.
Valuations are reasonable. We’re going to keep flogging this horse because it’s such an important basis for the market’s long-term behavior. Price-to-earnings ratios, a measure of how much an investor is willing to pay for a company’s future profits, declined sharply last year because 1) prices came down and 2) earnings rose. As it stands today, the P/E ratio of the S&P 500 index is 14.2. This compares quite favorably to medium term (5-year) and long-term (10 year) averages of 16.4 and 14.6, respectively (Factset). A below-average figure means valuations are lower today than they have been in the past. While history is no guarantee of the future, we do believe it provides a rough guideline of what to expect. P/E ratios tend to stay near their long-term averages over time, which suggests to us that perhaps, with a little help from a good earnings season, the market can make some positive progress from here.
The bad news mentioned previously is a double-edged sword because much of it has already been “priced in” to the market. For this reason, we believe that resolving the trade war (or even enacting some initial steps to reduce tariffs), reopening the government, and calming some of the political issues in Europe can allow investors to refocus on the good news.
As always, risk tolerance remains a crucial component of the investment process. The market experiences negative returns from time to time, and those negative returns can sometimes persist. If last year’s volatility caused you to lose more than a few minutes of sleep, please let us know so that we may help you readdress your investment strategy.
We’ll provide a more in-depth earnings report along with more of our thoughts on the status quo in our next newsletter, due to be released at the end of February. Until then, please do not hesitate to reach out to us with questions or concerns. We are happy to discuss further.
Peter H Gore, CFA, CFP, MBA Benjamin Sadtler, CFA
The above article is for informational and educational purposes only. Neither the information presented nor any opinion expressed constitutes a recommendation or endorsement by Gore Capital Management nor Cantella & Co., Inc. of a specific investment or the purchase or sale of any securities.