Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Stocks took a dip Tuesday after President Trump directed some sharp rhetoric toward North Korea, and opened the possibilities of a nuclear conflict. For the most part, investors have ignored this simmering situation for months. Is this now a legitimate headwind or just market noise?
Stovall: Well, I think that the velocity of the headwind might be picking up, but investors can actually take comfort in the muted degree by which stocks, gold and the dollar have responded to the increasingly threatening rhetoric. However, it’s early yet, and we might end up seeing a greater impact on equities and alternative assets should the rhetoric continue to heat up.
EQ: Obviously, investors have not really had to face a situation like this before, and it could pose as a potential exogenous shock to the market. Is it possible for investors to plan around something like this?
Stovall: No, you can’t. Usually, shocks to the market or shocks to the system during bull markets are quickly recovered because investors tend to sell first, and then ask questions later. The question they typically ask is, could this throw the US or the world into recession?
Well, should there be a nuclear strike someplace in the world, then yes, there is a much greater potential for economic turmoil than, for example, a tsunami in Japan, as we saw several years ago. So, I would tend to say that we will need to have cooler heads prevail in order for the market activity to simmer down.
EQ: The market may be more susceptible to headline-driven volatility right now because, as you pointed out in this week’s Sector Watch, we are in the dog days of summer. So, with that in mind, should we expect things to slow down here?
Stovall: Well, because we are in August, which is traditionally a vacation month, volume is very light. Traditionally, when you have light volume, you therefore have fewer traders on both sides of the trade, and as a result, you could end up having higher volatility. So, I think right now, the market is susceptible to headline risk, especially because the market is currently seeking a new catalyst as second quarter earnings season is wrapping up.
EQ: You pointed out in this week’s report that second quarter earnings season actually served as a pretty nice catalyst with the results coming in quite strong. More importantly, as you put it in this week’s report, “Peter was not borrowing from Paul.” Can you elaborate?
Stovall: That means that if you have very strong, better than expected earnings growth in one quarter, then you tend to expect that the remaining quarters—or even the full year—to go down in growth expectations.
So, the initial second quarter results were for a gain of 6.2%, and today we’re looking for an advance of 10.7%, which represents an outperformance of 450 basis points. Yet, if you look to full-year 2017 earnings, they too have gone up from the initial estimate for 10.6% to 11.0%. We did see a slight reduction in third quarter earnings estimates, and ditto for the fourth quarter, but on the whole, we ended up seeing the full year go higher. So, the implication is that we’re still in a solid upward trajectory of earnings growth.
EQ: With such an outperformance and encouraging trend of earnings growth, is it feasible that fundamentals can catch up to valuations given that we’ve had such a strong run in stocks?
Stovall: There certainly can be a correction in time, as well as a correction in price. Right now, valuations on the S&P 500 for the coming 12-month period is pretty much the same as it was before the earnings reporting period in that we’re trading at 18.2 times next 12 months estimates. That’s a 12% premium to the 16.3 average going back to 2000. So, because prices have advanced in this second quarter earnings reporting period, that means that the P/E ratio has pretty much stayed where it was at the beginning of the quarter.
EQ: That said, you advised investors to take a Goldilocks approach, at least in the near term, and not get overly bullish right now. What are a few things that they should be watching for to see whether the market will resume moving higher?
Stovall: Yes, I did say that because earnings growth has been very strong, inflation has remained low, GDP estimates have improved, and the Fed might be sitting on their hands for a while, that people would therefore get comfortable, conjuring up the image of Goldilocks. Of course, I remind people that Goldilocks was caught napping while surrounded by bears.
So, because we have gone so long without a decline of 5% or more, rather than blindly celebrating this favorable turn of events with earnings, inflation and so forth, investors are better off accepting a dose of caution to their optimism. Remember, we are in a challenging period for the market, which is traditionally the August and September timeframe. So, don’t go too far out on the risk curve, and you might want to heed the warning from an Old Milwaukee Beer commercial that states, “It doesn’t get any better than this.” Usually, if it doesn’t get much better, then Wall Street tends to take some profits until it sees a brighter glow on the horizon.