Aggressive or Defensive

 

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October 2018 was a very volatile month, with the S&P 500 down about 10%.  A statement by Chairman Powell of the Federal Reserve indicating that the Fed would continue to raise rates steadily and may even overshoot triggered the volatility.  That comment spooked the market in early October.  Central banks around the world had predicted that they would raise rates as well.  At that point, everyone was worried about a flattening yield curve.  Soon after that long rates rose, indicating that the possibility of a recession had faded.

The stock market has been ahead of itself, led by the FANG stocks (Facebook, Amazon, Netflix and Google).  These and other growth stocks have led the market up mainly on momentum, not fundamentals.  Small cap stocks have done better.  The stock market was overpriced.

In late October, the stock market headed down when interest rates spiked.  The 10-Year Treasury climbed to 3.25%.  This along with some earnings disappointments and the realization that earnings growth will not be as robust in 2019 as the tax cut effects roll off caused a correction.  Another factor is that investors have very good paper profits from the long bull market.

These things, in addition to the tariff war between the U.S. and China, made the market very skittish.  As we said in the attached Market Update, corrections are normal in bull markets, especially toward the end of a very long market cycle like the one we have experienced.

The Stock Market (from the FACTSET “Earnings Insight November 2, 2018”)

Key Metrics

  • Earnings Scorecard: For Q3 2018 (with 74% of the companies in the S&P 500 reporting actual results for the quarter), 78% of S&P 500 companies have reported a positive EPS surprise and 61% have reported a positive sales surprise.
  • Earnings Growth: For Q3 2018, the blended earnings growth rate for the S&P 500 is 24.9%. If 24.9% is the actual growth rate for the quarter, it will mark the second highest earnings growth since Q3 2010.
  • Earnings Revisions: On September 30, the estimated earnings growth rate for Q3 2018 was 19.3%. All eleven sectors have higher growth rates today (compared to September 30) due to positive EPS surprises and upward revisions to EPS estimates.
  • Earnings Guidance: For Q4 2018, 46 S&P 500 companies have issued negative EPS guidance and 24 S&P 500 companies have issued positive EPS guidance.
  • Valuation: The forward 12-month P/E ratio for the S&P 500 is 15.6. This P/E ratio is below the 5-year average (16.4) but above the 10-year average (14.5).

Looking Ahead: Forward Estimates and Valuation

Guidance: Lower % of S&P 500 Companies Issuing Negative EPS Guidance for Q4 than Average

The term “guidance” (or “preannouncement”) is defined as a projection or estimate for EPS provided by a company in advance of the company reporting actual results. Guidance is classified as negative if the estimate (or mid-point of a range estimates) provided by a company is lower than the mean EPS estimate the day before the guidance was issued. Guidance is classified as positive if the estimate (or mid-point of a range of estimates) provided by the company is higher than the mean EPS estimate the day before the guidance was issued.

At this point in time, 70 companies in the index have issued EPS guidance for Q4 2018. Of these 70 companies, 46 have issued negative EPS guidance and 24 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 66% (46 out of 70), which is below the 5-year average of 70%.

2018 Earnings Growth Estimate is 21%, But 2019 Earnings Growth Estimate is 9%

For the third quarter, companies are reporting earnings growth of 24.9% and revenue growth of 8.5%. While analysts currently expect earnings to grow at double-digit levels for Q4, they also expect more moderate growth in early 2019.

For Q4 2018, analysts are projecting earnings growth of 15.0% and revenue growth of 6.8%.

For CY 2018, analysts are projecting earnings growth of 20.6% and revenue growth of 8.6%.

For Q1 2019, analysts are projecting earnings growth of 6.0% and revenue growth of 6.6%.

For Q2 2019, analysts are projecting earnings growth of 6.5% and revenue growth of 5.1%.

For CY 2019, analysts are projecting earnings growth of 9.4% and revenue growth of 5.4%.

Valuation: Forward P/E Ratio is 15.6, above the 10-Year Average (14.5)

The forward 12-month P/E ratio is 15.6. This P/E ratio is below the 5-year average of 16.4, but above the 10-year average of 14.5. It is also below the forward 12-month P/E ratio of 16.8 recorded at the start of the fourth quarter (September 30). Since the start of the fourth quarter, the price of the index has decreased by 6.0%, while the forward 12-month EPS estimate has increased by 0.9%.

At the sector level, the Consumer Discretionary (20.1) sector has the highest forward 12-month P/E ratio, while the Financials (11.6) sector has the lowest forward 12-month P/E ratio.

Targets & Ratings: Analysts Project 16% Increase in Price Over Next 12 Months

The bottom-up target price for the S&P 500 is 3188.68, which is 16.4% above the closing price of 2740.37. At the sector level, the Energy (+26.8%) sector is expected to see the largest price increase, as this sector has the largest upside difference between the bottom-up target price and the closing price. On the other hand, the Consumer Staples (+4.9%) and Utilities (+4.9%) sectors are expected to see the smallest price increases, as these sectors have the smallest upside differences between the bottom-up target price and the closing price.

Overall, there are 11,048 ratings on stocks in the S&P 500. Of these 11,048 ratings, 53.3% are Buy ratings, 41.3% are Hold ratings, and 5.4% are Sell ratings. At the sector level, the Energy (63%) sector has the highest percentage of Buy ratings, while the Consumer Staples (41%) sector has the lowest percentage of Buy ratings.

Prices/Earnings Ratios (P/E Ratios)

On November 7, 2018, the P/E Ratios of the key indexes were as follows:

        Dow Jones Industrial Average

             21.51x Trailing 12 months, 15.97x Forward

        S&P 500 Index

             21.96x Trailing 12 months, 16.59x Forward

        NASDAQ Composite Index

             22.87x Trailing 12 months, 19.18x Forward

The trailing numbers are high versus historic P/E Ratios.  The forward estimates are high compared to historic forward estimates.  The forward 12-month P/E Ratio of 15.6x according to FACTSET is below the 5-year average of 16.4x but above the 10-year average of 14.5x.  In our opinion, this is not a valid comparison because it is a short period where P/E’s have been high.  The trailing P/E Ratio of 21.96x is high compared to the long-term average of 14.5x.  When you consider the concept of “regression to the mean”, the trailing P/E Ratio will have to drop considerably from the levels of the last few years to average 14.5x.

Value Versus Growth

As we have pointed out, growth stocks have outperformed value stocks in 2017 and 2018.  We expect value stocks to outperform growth stocks in the future.  Of course, the exact timing and amount is impossible to predict.

The Fed and Interest Rates

The Fed has indicated that it will continue to raise rates to get to 3.1% by the end of 2018.  The 10-Year Treasury is 3.20% now.  Still not a flat yield curve but flattening.  Some at the Fed and fixed income experts think the Fed should slow down on raising rates next year.

Inflation

The market is worried about wage inflation but we are not seeing it yet.  Most experts agree that we are not seeing it for the following reasons:

  • The U.S. is much more of a service economy than a manufacturing economy as it was the last time we had high wage inflation in the 1970s.
  • Unions are not very strong like they were in the 1970s.
  • Even though we are at historic low unemployment rates, wage increases are not causing inflation.

Gross Domestic Product (GDP)

GDP growth is expected to slow going forward as the global economy slows.

China

GDP is still slowing.  The trade war is starting to affect U.S. companies that do business in China.

Conclusion

We waited to publish this Review & Outlook until after the mid-term election.  As we all know the Democrats have taken a majority in the House while the Republicans keep the majority in the Senate.  The market historically likes gridlock.  We saw a big move up in the stock market the day after the election and not much of a move in the bond market.  The U.S. economy continues to do well while the rest of the world economy is slowing.  The question is will this affect the U.S. market?  We have been concerned about the roll off of the corporate tax cut and the possibility of investors selling stocks before the end of the year.  We saw some of that in October.  Earnings increases will be in the single digits next year after being in the 15%-25% range in 2018.  A slowing economy along with lower earnings growth can cause investors to take profits.  The Fed has indicated that it will continue to raise rates to normalize the Fed Funds Rates.  This may be a drag on the stock market as well.  It may be time to become a little more defensive because of these factors.  Next year should be an interesting year.

 

Jamison Monroe
Chairman & CEO
Director of Consulting