Markets Working on Lateral Movement

May 4th, 2018 by Tanner Wrisley

On January 26th of this year, the S&P 500 hit an all-time high of 2,872.87. We have since come down from there with the market trading in a range from around 2,600-2,800.  Leading up to the end of January, the equity market had risen about 52% in almost two years, while maintaining record low volatility.  Before that were seven more years of a bull run.  This has been an incredible period of growth that now has people forgetting what a normal market looks like.  Historically, after a period of such growth, one would expect a much sharper decline than we have experienced so far this year.  So is that the direction we are headed?  Many analysts are not convinced we are ready to take this dive yet.

Bull markets turn around when stock valuations get too high, and investors feel that equities are too expensive to buy at such high prices.  One metric for valuing a stock, that just about all money managers pay attention to in some capacity, is the price-to-earnings ratio (P/E).  It is simply the price of a stock per share divided by the yearly earnings amount per share.  A high P/E means that the company may be overvalued; the price is too high, the earnings are too low, or some combination of the two.  During market corrections, the average P/E in the market decreases working to correct the valuation.  This usually occurs with decreasing demand for equities, lowering the prices of stocks, and therefore leaving us with a lower P/E.  However currently we are seeing stellar earnings from corporations, which are lowering P/Es while the stock price remains relatively level.

In an article written by Jurrien Timmer, Director of Global Macro at Fidelity Investments, he states that, “strong earnings growth should be able to offset a multitude of problems, including rich stock valuations, tighter monetary policy, and even trade tariffs.”  He continues to talk about how earnings estimates typically start high and then drift lower as the market gets closer to earnings season. However this year “earnings-per-share (EPS) estimates for the past three months have remained rock solid.”  With no sign that EPS estimates were too high, this shows that the market did not overestimate the effect of the recent tax changes.

While impressive earnings may keep the market from crashing for the moment, there is little evidence to suggest that we will be returning to a strong bull market like we have had the past few years.  Timmer continues commenting that, “the high valuation across all asset classes is and will likely remain a big headwind for the markets for the foreseeable future.”  Additionally, at yesterday’s Fed meeting, the FOMC confirmed its plan to raise rates in June, followed by two more hikes before the year’s end.  This was in line with the market’s expectation, but not a great outlook for growth.

The conclusion Wall Street seems to be coming to is that the market will be trading sideways for the time being.  Positive earnings seem to be offsetting high valuations and constrictive monetary policy.  As Timmer finishes, “even a 15% correction is not that big of a deal, statistically speaking… against the backdrop of robust earnings growth and tightening –but-not-too-fast Fed, I would view that as an attractive buying opportunity.”

*P/E is just one metric that helps to value a company and should never be the used as the sole basis for an investment.