Are we out of the woods yet? After the recent correction from a record high in S&P 500 Index, stocks have staged an impressive comeback. The S&P 500 put together its best week since 2013, rallying more than 5% off the lows to bring its session win to six. We now consider what this means moving forward, including what higher interest rates and rising inflation might mean for stocks.
Whether we are out of the woods yet is a tough question to answer with any confidence, but when we weigh the evidence, it appears the odds are good that the worst is behind us.
The stock market fundamentals are supportive. U.S. economic growth is solid despite the recent retail sales shortfall, which we attribute to temporary factors. Consumer and business confidence remain high, as personal spending and capital investment are both likely to get a boost from the new tax law. Inflation is rising but remains relatively low when compared to historical averages. It may also not be as strong as the January Consumer Price Index (CPI) data suggested due to weather and other seasonal factors.
Earnings season has been excellent, with a 15% increase in S&P 500 earnings in the fourth quarter and an 8% increase in revenues, both nicely above prior expectations. The new tax law has not even kicked in yet, but analysts have increased their 2018 estimates for S&P 500 profits by $10 per share (nearly 7%) since January 1. Companies are just starting to announce how much in overseas cash they are repatriating back to the United States due to the new tax law. A good portion of that cash is expected to be directed to share repurchases, boosting earnings per share.
There are some technical indicators supporting the view that the worst may be over:
- The S&P 500 broke back above its 50-day moving average (MA) and managed to close above the 200-day MA throughout its latest correction. The 200-day MA remains upward sloping, indicating a continued bullish technical trend.
- On February 5, when the Dow Jones Industrial Average dropped 1175 points, or 4.6%, the number of S&P 500 stocks declining relative to those advancing was greater than 40:1, indicative of extreme panic selling. The low percentage of stocks above their 50-day MA, below 20% on February 8, is another indicator of extreme selling pressure.
- After entering oversold territory on February 8, based on the 14-day Relative Strength Index, the S&P 500 subsequently reversed and moved strongly higher while maintain its bullish trend, a pattern that has often proven to be a bullish technical signal.
- Historically, when the weekly S&P 500 price closes 3% or more above its intraweek low, it has been a bullish short-term signal. This happened on February 9.
The combination of solid fundamentals and the technical evidence suggests to us the recent lows may hold. However, that does not rule out the likelihood that the return to normal volatility brings more daily moves of 1% (or more) and 5-10% pullbacks over the course of the year.
The latest downdraft was triggered primarily by accelerating wage growth that sparked fears of rising inflation and a more aggressive Federal Reserve (Fed). As such, we think it is helpful to examine the historical relationship between stocks, inflation, and interest rates.
When the 10-year yield has been below 5%, the stock market and interest rates have tended to move together (positive correlation), meaning stocks can go up despite rising rates. When rates are relatively low, rising rates usually indicate improving growth, as is evident today. At higher interest rate levels, rising interest rates have tended to spook investors as the Fed gets more aggressive and borrowing costs rise (negative correlation). With the 10-year yield not having eclipsed 3% during this latest bond market sell-off, we think there may be a way to go before the level of interest rates impairs economic activity and/or the stock market, even if the relationship reverses at lower rates than what we have seen historically.
The exception would be if rates spike again, because the speed at which rates move can be as important as the level. While we expect no more than a gradual increase in the 10- year yield, this is something to watch.
With inflation at low levels, the price-to-earnings ratio (PE) for the S&P 500 tends to be higher, and vice versa. With the CPI right around 2%, we think stock valuations at current levels of about 17 times the next 12-month earnings estimates are reasonable. If the S&P 500 delivers the consensus earnings number for 2018 ($157 per share), then it would only take a trailing PE slightly over 18 to get to a fair value S&P 500 target range of 2850-2900 at yearend. That is about a 4-6% upside from here. Keep in mind that the average PE when inflation is below 3% has been 18 times. At current inflation levels, stock valuations seem reasonable.
After years of years of depending on the largess of monetary poly makers, investors can now focus on fiscal levers that we believe will support consumption and spur new business investment over the next few years. The combination of improved fundamentals and fiscal legislation may sustain momentum in the economy and equity markets this year and potentially beyond.
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.
- Data provided by LPL Financial.
- All investing involves risk including loss of principal.