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“The future ain’t what it used to be” Yogi Berra

| January 11, 2019
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Investor pessimism soared, and the stock market dropped as “the future ain’t what it used to be”

Extreme negative sentiment dominated the markets causing the S&P 500 to drop 19.8% by late December from the September highs.  The negative price action contrasts with the very strong fundamentals for 2018, as S&P 500 earnings are expected to be up 23%: driven by 10% sales growth and 15% pretax profit growth; the solid pretax growth showed that the fundamentals were robust even without the tax cut.  Future S&P 500 earnings also look fine as Wall Street strategists expect 2019 earnings of $173, growing 7% on top of the 23% growth in 2018.

Momentum and rules-based trading strategies plowed out of stocks, selling as they expected the Federal Reserve’s overly tight monetary policy and Tariff Wars between the US and China would increase the chances of a synchronized global recession.  As these trading strategies are very short term focused since they don’t look that far into the future, should these two fears subside, these rapid-fire trading strategies can plow back into stocks as quickly as they left.

Could much of the bad news be priced in already, making stocks cheap?

Yes, I think so and here is why:

  • Earnings drive stock prices over the long term: in 2018 we didn’t get rewarded for the 23% growth in earnings and price action was driven by a high level of pessimism in the SHORT TERM, especially during the last week of December

 

  • The short-term negativity by traders can be seen by the sharp contraction on the Price/Earnings(P/E) multiple for 2019 S&P 500 consensus earnings estimate of $173
    1. September 21, 2018 S&P 500 HIGH of 2,941; 2019 P/E 17.0x (2,941/173)
    2. December 26, 2018 LOW of 2,347; 2019 P/E 13.6x (2,347/173)

 

  1. So, the forward P/E contracted from 17x to 13.6x in 3 months, accounting for 100% of the 19.8% pullback in the S&P 500…that is discounting a lot of BAD NEWS!

Where can we go from the extremely pessimistic December 26 low?

Let’s see what upside we have on stocks based on the 2019 earnings estimate of $173.  Since the recovery from the Great Recession, the market P/E has ranged from 15x to 18x:

  • 7% return on a P/E of 18x
  • 6% return on a P/E of 15x
  • 6% return on a P/E of 16.5x (average of the range)

For some perspective, the average median P/E since 1954 has been 17x.

What needs to happen for the markets to become more optimistic?

One, the Federal Reserve must show the markets that they are vigilant as Federal Reserve Chairman, Jay Powell, has been very nonchalant and shown a total lack pf empathy toward the market’s concerns by using phrases such as, “money supply policies are on autopilot” and “tariffs are a non-factor when we drop them into our models”.  He has wised up a lot since the markets dropped 20% very quickly and indicated at a conference last week with the two previous Fed Reserve Chairs, Ben Bernanke and Janet Yellen, that the Federal Reserve is on top of things and will quickly act based on economic conditions.

Lastly, we need the Trade War between the US and China to be resolved and/or tensions deescalated.  No one wins on Trade Wars as tariffs are a tax paid by importers and/or consumers buying the goods.  Both sides are now feeling the pain and more motivated to declare their respective “victories” to their constituents and move forward. 

No one solution is right for everyone

At Chatham Wealth Management, one size does not fit all as we customize each portfolio to meet your needs, and more importantly, your risk appetite.  While high short-term volatility stresses everyone, we hope to put things into a strategic perspective so that we can make the best strategic investment decisions for you, rather than react to short term price movements.  In past writings, I had highlighted that ultra-short-term bonds have become attractive investment options, offering above average interest rates and low volatility.  In another strategic outlook, I had pointed out the risk inherent to tech stocks due to rapidly rising interest rates.  In each of these instances we have discussed with clients how to implement these strategic views that would be optimal for their unique situations.  Again, all of us at Chatham Wealth Management are available to discuss with you “Where do we go from here?”

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