There are several myths about market indicators which have the tendency to distract investors from what really matters in assessing investment opportunities. We believe the overall fundamental backdrop is positive thanks to solid economic growth and strong corporate earnings trends. Sentiment and technical indicators continue to suggest future equity strength. This month we will attempt to bust some common myths.
Myth 1: The yield Curve
The yield curve has flattened throughout 2018, causing some to fear that a recession may be right around the corner. This makes sense, as the past nine recessions all saw a yield curve inversion right ahead of the economic contraction. The difference between 2 and 10-year Treasury yields broke below 0.50% recently, reaching 0.41% at one point – the flattest it has been since September 2007.
Though significant, it is important to note that when looking back at the previous five recessions, once the yield curve hit 0.50%, it took a median of nearly a year before the curve inverted. Once it inverted, it took about 20 months until a recession started. All along the way, the S&P 500 Index posted a median return of 21.5% over those 32 months. In other words, there could be years left to this expansion before the yield curve truly becomes a worry.
Myth 2: A Manufacturing Peak
The Institute for Supply Management’s (ISM) Manufacturing Index hit a cycle high back in September 2017, but then made yet another new cycle high in February 2018. Many have posited that a peak in manufacturing suggests an impending recession, but the data do not back this up.
Over the past five economic cycles, it has taken the United States 45 months on average to enter a recession following a peak in the ISM. Meanwhile, the average cumulative S&P 500 price return during those periods (using end of month returns) was 56.7%. Note that this average includes periods of very strong returns in the mid to late 1980s and 1990s - and one period of negative returns in the early 1980s, which is an indication that not every cycle is equal. With ISM manufacturing making a new high so recently, there may still be plenty of time left in this cycle.
Myth 3: Rising Interest Rates
With yields surging around the globe, breaking out to multi-year highs in several cases, many think that higher rates are a bad thing. The data suggest quite the opposite.
We have found that stocks and bond yields historically have been positively correlated until the 10-year gets up around 5%, at which point the correlations break down. In other words, it is perfectly normal for yields to rise along with stocks. Out of the most recent 23 periods of higher interest rates (based on the 10-year Treasury yield), stocks have gained 19 of those times. Recent periods have produced even better performance, as stocks have risen during each of the last 11 periods of rising rates (since 1996). Stocks have done well since interest rates began to move higher in September 2017. History suggests that higher rates may actually be a good thing, and should the 10-year Treasury yield break above the 3% level, the equity market may garner further support. Myth 4: Earnings Slowdown
We are looking for S&P 500 earnings growth to approach the mid-teens in 2018, with many expecting even stronger growth. With corporate profits expanding and making new highs, some are predicting trouble again for stocks as earnings growth potentially slows later this year or in 2019.
Once more, looking at the data shows that double digit earnings growth is a major positive for equity returns. Going back to 1991 there have been 12 calendar years that sported at least double digit earnings growth, and all 12 years the S&P 500 produced positive total returns, with an average return of 16.7%. Should earnings come in comfortably above double digits as we expect, this is yet another reason to expect the bull market to continue in 2018.
Investors should not be distracted by these and other market myths. The overall global economy continues to expand, fiscal policy favors growth for the economy and corporate profits, and we are not seeing any of the same excesses seen at previous market peaks that led to recessions. We continue to anticipate double digit stock market gains this year, with leadership from the value style, small caps, cyclical sectors, and emerging markets.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Investing in stock includes numerous specific risks including the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
- Investing in small cap stocks are generally more volatile than large cap stocks.
- Investing in foreign and emerging market securities involves special additional risks. These risks include but are not limited to currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
- Data provided by LPL Financial, Capital Economics and Strategas Research Partners.
- All investing involves risk including loss of principal.