Stocks have made little progress this year. After a strong January, major U.S. benchmarks corrected in February and have bounced around since then, with only a handful of sectors showing positive results for the year through April.1 The reason, according to our network of asset managers, is the geopolitical fog of trade and midterm elections.
Solid underlying fundamentals
The good news is that the traditional drivers of stock markets—economic growth and corporate earnings—remain solid. As we highlight in Market Intelligence, the Conference Board Composite Index of Leading Indicators showed a 6.24% year-over-year gain in March, with broad strength across indicators, while unemployment has ticked down to an 18-year low of 3.9%—and earnings results so far this year have also been strong. As of early May, more than half of the S&P 500 Index companies have reported Q1 2018 results, and of those, nearly 79% beat analyst estimates. The blended results of reporting companies, combined with analyst estimates for those still on tap, suggest earnings growth of roughly 23% on a year-over-year basis, the highest earnings per share (EPS) growth since Q3 2010.2 As expected, the change in the corporate tax rate has been a significant driver of profits this year, with after-tax earnings rising at roughly twice the rate of pretax earnings.
A challenging political calendar
Despite this good news—and after moving in lockstep for much of 2016 and 2017—stocks and earnings have gone their separate ways, with stocks languishing this year as earnings forecasts march ever higher. The most often-cited reason among our network of asset managers and researchers is that trade issues and the political calendar are creating a fog the markets can’t seem to penetrate. There are a few key dates to watch:
May 15—The Office of the United States Trade Representatives will hold a public hearing on tariffs proposed against China. This will be an opportunity for interested parties to voice concerns over the proposed tariffs of 1,300 goods representing around $50 billion of additional tariffs, and it may well spark more vitriol and investor angst. Already, it’s been reported that China has stopped buying U.S. soybeans due to the trade tensions.
May 22—The due date for submission of post-hearing rebuttal comments, kicking off a 180-day period for the administration to implement tariffs. This negotiation period could easily drag on through November.
November 6—Midterm elections: All 435 seats in the United States House of Representatives and 35 of the 100 seats in the United States Senate will be up for grabs.
Midterm election years alone can create a challenging environment for stocks, but when you add trade uncertainty into the mix, the bull market could be on pause for a while. Strategas Research Partners recently reviewed S&P 500 Index performance for every midterm election year dating back to 1950. Their observation about those years was that “the market hasn’t made much progress until October.”
In our own analysis, we see five periods in the past 15 years in which EPS growth was 15% or greater, but markets nevertheless experienced an intrayear drawdown due to headline events: 2003, 2004, 2005, 2010, and 2011. The longest drawdown, in 2011, occurred against the backdrop of a government shutdown and the resulting drop in the U.S. credit rating. That period of market retrenchment lasted 10 months, but was followed by 3 years of double-digit returns.3
A silver lining: improving valuations
One bright side to the current malaise is that strong earnings growth and a lack of price movement have already created a healthy valuation reset. At its peak on January 26, the market was trading at a 15-year high forward price-to-earnings (P/E) ratio of 18.50x earnings. Since then, the corrective phase of the markets and the strong earnings growth have brought the market’s P/E ratio down to 16.25x, a 12% reduction that puts the valuations back in line with long-term averages. This valuation reset may deepen in the coming months as investors wait for the geopolitical fog to clear. In our view, any further improvement in valuations against a backdrop of record earnings growth would provide fuel for greater market upside in the future.
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1 Morningstar Direct, as of 5/1/18. 2 "Earnings Insight," FactSet, 2018. 3 Standard & Poor's, 2018.