Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The S&P 500 ended 2018 down just over 6% for the year, including a disastrous fourth quarter. Where does that leave investors as we start 2019?
Stovall: In a word, perplexed. Typically, the fourth quarter of the midterm election year posts an average gain of about 7.5% and has risen in price 90% of the time going back to World War II. More times than not, things are good because the uncertainty of the midterm elections has run its course. Well, the opposite was true this year and now investors are wondering what the numbers imply.
There’s an old adage that says, “prices lead fundamentals,” but right now, the fundamentals still look strong whether you look to economic growth in 2019 or you look to earnings increases. So, I think investors are trying to figure out whether they should run for the hills or take advantage of these lower prices.
EQ: While the fundamentals remain strong, investors are constantly reminded of the headwinds that could potentially derail the economy and markets. Is this attention on the market’s downside potential actually adding to the wall of worry itself?
Stovall: Yes, I think it is. There’s an old saying, “if it bleeds, it leads.” So, it’s not a surprise that whether you’re dealing with print, radio or TV financial media, they’re going to be focusing on the negative because that causes investors to get worried and increases their adrenaline output. This, as a result, makes them want to stay tuned to the program longer or tune in again the next day in order to not miss out on anything and ensure that the world itself has not ended.
Yes, you could then say because of the proliferation of the financial media today, that probably has added to the depressing level of investor sentiment at this point.
EQ: It was reported Wednesday that President Trump called December’s market sell-off a “glitch” that would be resolved once a deal with China has been reached. His criticism of Fed Chair Powell with regards to the central bank’s tightening policy and its impact on the market has also been well covered. Is it unusual for government officials to be paying this much attention to the market’s activity?
Stovall: Well, I do think that Fed Chair Powell does pay attention to what happens in the market. He probably pays more attention to what the market is saying than what the President is saying. So, yes, in some regard, market action can influence decisions out of Washington. I think the President also pays attention to the markets and realizes that it’s not very happy with what’s going on with trade and with interest rates.
The President can affect the market’s outlook on trade because he directly controls what’s likely to be happening in that area. But thank goodness there is a wall of separation between the presidency and the Fed, so the Fed will continue to do what it needs to do in order to ensure that the economy will continue to grow at a manageable pace.
I think that investors have to get over the first few weeks or months of the new year, but in that process, we could see a more dovish Fed. We could also see an improvement in trade relations, and get a better picture as to what 2019 earnings growth is likely to be.
EQ: In this week’s Sector Watch, you pointed out that investors experienced declines just about all across the board last year with the exception of U.S. REITs, the dollar and the Health Care and Utilities sectors. What does that say about investors’ mindset?
Stovall: Well, I think investors are playing defense right now. There’s an old adage that says, “when the going gets tough, the tough go eating, smoking and drinking. And if they over do it, they have to go to the doctor.” Traditionally, Consumer Staples and Health Care do well, followed by Utilities because the demand of these products and services remain fairly static whether the economy is expanding or contracting.
Another way to look at investor sentiment is monitoring the American Association of Individual Investors’ (AAII) sentiment survey report. Right now, it shows bears exceeding bulls by more than 22 percentage points, which is the lowest that we’ve seen since the end of the 14% correction that we experienced back in February 2016. So, investors are very nervous, but possibly some should look upon this as a contrary indicator that most of the negative news has already been factored into share price performances.
EQ: On that note, one silver lining you found was that because of the softness across the board, the margin between the S&P 500’s best performing sector and worst performing sector was smaller than usual. Can you tell us more about the significance of this finding?
Stovall: Going back to 1970, whenever the differential between the best and the worst sector was below 42 percentage points, then the implication was that the market could work its way higher in the year ahead. Historically, whenever we’ve had a more concentrated range of sector performances, the market was higher 91% of the time in the subsequent calendar year. In 2018, the difference between Health Care (up 5%) and Energy (down 18%) was about 23 percentage points.
Obviously, there’s no guarantee that will work this time, but I think what it implies is the market will end up bouncing higher in the year ahead because investors weren’t really sure where they should be going and more times than not, investors prefer to err on the side of optimism.
EQ: From a valuation standpoint, the S&P 500 posted record earnings but also experienced its worst decline since the Great Recession. When do the fundamentals start looking attractive from a historical perspective?
Stovall: Well, actually they look good right now. According to S&P Capital IQ consensus estimates, the S&P 500 is trading at a P/E of 15 on forward earnings, and that is an 8.5% discount to the average of 16.4 going back to 2000. So, right now, P/E ratios look pretty attractive. Unless you think that a recession is around the corner and, as a result earnings, estimates will be coming down dramatically, then I think the fundamentals are arguing for investors to buy rather than bail.