Clarity amidst volatilityContributor David Lebovitz
Markets seem immune to any sort of holiday cheer. Instead, investors continue to focus on softer global growth, and the potential for tighter monetary policy and political uncertainty to weigh further on the global expansion. Earnings revisions around the world have turned negative, and investors are now asking how much earnings growth will slow from the robust pace seen this year. The market seems to be pricing in more of a slowdown than the fundamentals would suggest, but there has been a clear deterioration in sentiment; until optimism begins to replace pessimism, any rally will likely be short lived.
However, sentiment has not deteriorated across the board. Business confidence and homebuilder surveys have been under pressure in recent weeks, but consumer confidence has remained relatively resilient. Although the forward P/E ratio of the S&P 500 now suggests that consumer confidence should be nearly six index points below its current level, low energy prices, a tight labor market, and rising wages seem to be providing a viable offset to stock market weakness. Slower global growth and policy uncertainty could weigh on business confidence and investment, but solid consumer spending should help keep recession at bay. In fact, recent reports highlighted that retailers enjoyed their best holiday season in six years.
With the forward P/E ratio of the S&P 500 now below its long-term average, stocks look inexpensive relative to their own history, as well as relative to bonds. Financials look historically cheap, and healthy shareholder yields (buybacks + dividends) can provide insulation during what will likely remain a choppy market. Valuation should be the guide for any long-term investor, but in the short-term, the question is whether sentiment has swung too far. Algorithmic trading, leverage, and quantitative strategies have all exacerbated market volatility, and political uncertainty has created downside risk which is difficult to quantify. While we still view the glass as half full, it seems unlikely that we are out of the woods just yet.
The bear case is one that focuses on the potential for a trade war, Fed policy error, and subsequent contraction in corporate profits. However, we see room for softer trade rhetoric in the coming year, and the Fed’s decision to raise rates in December seemed appropriate. Signs of excess in the economy would change our view, but we struggle to find evidence of this in the current environment. If nothing else, the stock market looks far more interesting than it did at the end of September, but fundamentals will matter more as central banks continue to withdraw liquidity from the system. Investors should have a plan in place for the coming quarters, as doing so can lead to clarity amidst a backdrop of volatility.
Consumer sentiment has held up despite the deterioration in multiples
University of Michigan Index of Consumer Sentiment, S&P 500 forward P/E ratio, levels