2018 1st Quarter Letter

The first quarter of 2018 experienced some of the highest market volatility in years. During this time, the S&P 500 suffered its first 10% correction since January 2016. As the quarter began, investors drove stocks higher on the hopes of an improving earnings picture. Investors shifted their focus in February to worries over geopolitical risks and higher interest rates. After recovering in late February, the market then declined into the quarter end as investors grew concerned over protectionist trade rhetoric. 

The recent volatility in the stock market is not surprising when the narratives investors have applied to the market are so conflicting. It is counterproductive and outright confusing to investors when worries over higher inflation and interest rates are highlighted one week and concerns over a potential recession arise shortly thereafter. Despite these conflicting narratives, we feel over time the market is likely to discount the improving level of corporate earnings as reflected in the S&P 500.

While the stock market is always susceptible to geopolitical events, their effect tends to be short-term in nature.  For long-term investors, the primary determinant of stock prices is growth in earnings per share. While the economic backdrop and direction of interest rates are key factors, stocks are ultimately priced as a multiple of earnings. From 2014-2016, the S&P 500 averaged annual earnings per share of approximately $118. Last year, S&P 500 earnings grew 12%, reaching $132. This is the primary reason stocks have moved higher over the past 12 months. As economic growth has accelerated and regulatory burdens on companies have decreased, estimates for S&P earnings have risen further in recent months. 

At the start of the year, the consensus estimate for S&P 500 earnings was approximately $150. Despite the corporate tax cut, lower regulations, and an improving job picture, investors were hesitant to apply a higher growth figure for S&P 500 earnings. Conflicting worries over trade, economic momentum and inflation have distracted investors from the rapidly improving earnings outlook. Strategists are now modeling $155-$160 for 2018 S&P 500 earnings, and $170-$175 in 2019. These figures reflect a significant acceleration in corporate earnings and have allowed stocks to rise without seeing their valuations become excessive. Based upon these revised earnings figures, the S&P 500 currently sells for approximately 16x earnings, which is close to its historical average. 

Corporate earnings will likely remain strong in 2018 due to the number of positive earnings revisions. For Q1 2018, the estimated earnings growth rate for the S&P 500 is 17.3%, which would represent the highest earnings growth since Q1 2011. At the beginning of the year, the estimated earnings growth rate for Q1 2018 was 11.4%. Ten sectors have higher growth rates today (compared to December 31) due to upward revisions to estimates.  

While the Fed has begun to tighten short-term interest rates, the market now seems comfortable that higher interest rates will accompany a greater rate of GDP growth. Even though short-term rates are rising, they remain at extremely low levels, particularly this far into an economic recovery. The level of liquidity in the banking system in the form of net-free reserves and the steady growth of M2 money stock should provide a solid foundation of liquidity for the economy for the next several quarters. 

Based on earnings expectations for 2018 of $155, the S&P 500 market multiple is valued at approximately 16.9.x earnings. Robert Bender & Associates’ PEG ratio, which measures the price-earnings ratio of a company relative to its growth rate, now stands at 1.51x for 2018. The number of new highs on the New York Stock Exchange fell to 85 in recent weeks. Typically, investors have become cautious when the number of new highs approaches 800. We feel the overall market multiple could remain steady in 2018 as earnings growth keeps pace with the stock market.