Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Tech stocks took an unexpected dip to close out last week, sparking concern that investors could be preparing to rotate out of the market’s hottest sector. That sell-off doesn’t seem to have extended much beyond that initial dip since, however. Could this potentially be the beginning of a rotation out of Tech, or was this just a blip for the sector?
Stovall: I think, obviously, in the short term it was just a blip for the sector. But through the end of May, the Information Technology sector was up more than 21% on a year-to-date basis, and the second-best performing sector was Consumer Discretionary, which was up 11.8%. So, the Tech stocks were well ahead of the best performer, and with Energy down 13%, the difference between the best and the worst sector was a lot wider than it normally is. I don’t think anybody can really be surprised that investors decided to lock in some of the profits in Tech, but because we are still looking for about a 12% gain in earnings this year for the S&P 500 Technology sector, and valuations are trading in line with the market itself, we’re probably not going to see a dramatic sell-off in Tech stocks anytime soon.
EQ: The Fed raised rates by 25 basis points as expected during its latest meeting, and maintained the course regarding future rate hikes and its balance sheet normalization program. What were your thoughts on the announcement?
Stovall: It was pretty much as expected. The Fed, with their dot plots, said they’ll probably see one more additional tightening this year, and also look to raise interest rates three times in 2018. They thought that economic conditions were balanced, with the tight labor market offsetting the weakness in Q1 GDP, and a temporary slowdown in inflation. So, Wall Street really is now listening quite closely as to what they plan on doing to unwind their balance sheet, because the Fed is essentially doing what it said it would do regarding interest rates.
EQ: The Fed has largely now become predictable, and intentionally so. That said, for many years, it was a primary driver of market volatility in terms of how investors reacted to their comments. Is there still any significant uncertainty surrounding the Fed these days?
Stovall: I don’t think so. I think the Fed has done a very good job of telegraphing its intent and telegraphing its actions, as well as its future possible actions. I think that’s what the Fed wants to do, not just with additional rate hikes but also with the unwinding of their balance sheet. Their goal is to keep employment and economic growth on an even keel. They don’t want to have to worry about injecting volatility into the overall stock market.
EQ: In this week’s Sector Watch, you noted that investors should keep an eye on inflation data, which also came out this week. You found that a low inflation environment is typically good for elevated stock valuations. Can you elaborate on the relationship here?
Stovall: Basically, inflation and valuations are a two-sided coin. You can’t really say P/E ratios are expensive unless you put it into context with inflation. Since 1958, looking at the Core CPI, normally the Fed funds rate is about 1.4 percentage points above the rate of inflation. At the same time, what we’ve traditionally seen is if the sum of P/E ratios and inflation equals 20, then you have a fairly valued market. That’s why that rule is called “the Rule of 20.”
But also, if you look at where we traditionally have been in terms of P/E ratios and inflation rates, we’re in the second-lowest quintile since World War II. Whenever we have been this low, the P/E on the S&P 500 has actually been about 3% higher than where it is today. So, while this granted is the second-longest and the second-most expensive bull market since WWII, we’re also dealing with an exceptionally low level of inflation, which helps support these higher P/E ratios.
EQ: So, could you potentially make the argument that stocks might actually be undervalued through this particular measurement?
Stovall: Yes, but it also depends on the time frame you’re looking at. The Rule of 20 says that if you look to inflation and earnings, it will tell you where the market should be trading, but that could be inflation and earnings as it is today, as it is the end of 2017, or the end of 2018. You just put in different assumptions. Right now, the implication is that the market is expensive based on P/E and inflation, using the Rule of 20. Yet, we have as much as a 7-plus percent growth potential if you look out to 2018. Granted, a lot can happen in the next 18 months. We could see earnings come in much stronger than anticipated, as they did last quarter in which analysts thought earnings would be up by 10% and they ended up climbing 15.5%. So, we’ll see what happens to the 6% earnings growth that is currently forecasted for the second quarter.
EQ: You noted in this week’s Sector Watch that investors could be ready to move back into the US markets as the dollar could be getting ready to move higher. Where should investors look to if that is the case?
Stovall: Well, it did seem to be sort of a domino effect when the UK elections ended up showing less support for Theresa May’s party than the polls had implied. That, I think, triggered a flight to safety into the US dollar, causing investors to move out of some recent purchases of international equities. As a result, small-cap stocks strengthened because they really have limited-to-no international exposure. That could have also been the trigger for the Tech sell-off, because Technology is the sector that has the greatest international revenue exposure. As a result, there was a lot of rotation into areas that had not done very well up until that point, particularly Energy, Financials and Materials.
I think the real question is how strong the US dollar is expected to become. But we did certainly see DXY strengthen right after that unexpected UK election outcome.
