by Brad M. Weafer, CFA, Chief Investment Officer

Recent equity market volatility arrives against a constructive backdrop for U.S. stocks. 

In these pages, our primary focus is economic and corporate fundamentals. This is not by accident. Corporate profits drive stock prices over long periods of time. However, in the short run, sentiment and investor emotion calls the shots. This is easy to forget given the complete absence of volatility in equity markets we have experienced this past year. We have been served a vivid reminder since the start of February with the S&P 500 falling 6% in six trading days. Fundamentals don’t change that quickly, but fear can manifest fast. This holds especially true when it strikes at our personal finances. 

It is human nature to try and identify specific reasons or catalysts to help explain stock market corrections. Often, however, it’s just a swift change in sentiment that feeds on itself. A week ago, enthusiasm was high, and the S&P 500 was up a blistering 5.7% in January, annualized that would be an 85% rate. This was clearly not a sustainable pace. It sounds hackneyed, but we were “due” for a correction and given how calm markets have been, it is no surprise that investors might panic a bit when things got more challenging. No surprise when in the first week of February, Bank of America/Merrill Lynch reported that clients had the highest level of net sales since June 2016 and the ninth largest in their data history (going back to 2008). Clearly, investors reacted emotionally and swiftly. Taking a step back, we observe that although it was painful, the market’s decline only brings us back to levels where we started the year. That does not make it feel any better, but it is worth putting in perspective. 

With all that in mind, how do we position portfolios looking forward? We continue to advise clients to stick with their long-term investment plans and bring portfolios in balance with their acceptable risk targets. Equities have outperformed fixed income over the course of the last year by almost 24%¹. The major premise of prudent asset allocation suggests rebalancing out of the better performing asset class and into the worse performing asset class. Realizing gains from stocks and adding to fixed income allocations reduces overall portfolio risk. That is sound advice in any market environment.

Despite our suggestions to prudently rebalance around asset classes, we remain positive on U.S. equities. Recent economic data suggests continued expansion, not just in the U.S., but globally. The Conference Board Leading Economic Index notched new cycle highs in the latest reading. In addition, recently enacted U.S. tax legislation should provide, at a minimum, a short-term boost to economic growth. The Atlanta Federal Reserve’s forecasting model is currently calling for 4% GDP growth in the first quarter of 2018. Earnings growth also continues to impress. With 50% of companies having reported results for fourth quarter of 2017, FactSet reports 75% of S&P 500 companies have reported earnings ahead of expectations at a blended growth rate of 13.4%. The new tax bill is an additional boon for corporate profits. Consensus earnings estimates for the S&P 500 have increased by 6% since the start of the year largely as a result of the tax change (see Figure 1 below). This forecast implies 17% annual growth in 2018. At recent prices, this has the S&P 500 trading at 17 times current year earnings. This is still ahead of historical averages, but not egregiously so considering the level of interest rates. Many other metrics of valuation urge some caution but the fundamental backdrop is supportive and it is difficult to find historical examples of sustained bear markets when earnings were rising.

 

 

 

With equity markets, there is always the risk of the unexpected. Case in point, there is no obvious trigger for this last week’s correction. From our perspective, the case for U.S. stocks is still constructive and we continue to look at short-term volatility as an opportunity to find new bargains in the securities of excellent companies. As Einstein put it, “In the middle of every difficulty lies opportunity.”

As always, we encourage you to call us with any concerns or questions. 

 

¹For the trailing 12 months as of February 5, the S&P 500 returned 26.4% and the Barclays intermediate corporate index returned 2.7%.

Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.

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