As expected, the global selloff of stocks finally caught up with the US stock market in October. In the month, the Standard and Poor’s 500 declined 7%. The Nasdaq was worse; declining close to 9%. Both are now essentially flat for the year-to-date. This performance was one of the worst on record for the month of October. So, we have had the correction that we have been looking for. Now what?
In the short run, the US stock market is now in a much better place than six weeks ago. In September, Investor sentiment was at record bullish levels with 62% of investment advisors optimistic. Now, with the October decline, sentiment has followed the market down. Investor Intelligence today reports 44% Bulls. That is a much more “normal” reading. That means there is now a small amount of buying power on the sidelines, where before there was very little.
However, the decline was so swift and exacerbated by algorithmic traders and ETFs, that real longer term investors have hardly reacted. It is great that the market has started a bounce from “oversold” levels. And after the elections, it might continue even into January. But, I think it is a stretch to think we can rally to new highs on this move. A move to new highs would need to start with more fear and more money on the sidelines. The S&P 500 might be worth a trade of 5%-7% over the near term. Over the more intermediate term, the major problem for the US stock market remains the monetary factors.
The Federal Reserve is raising short term interest rates. The yield curve is relatively flat (short term rates are almost equal to long term rates). And, more importantly, the Fed is allowing $50 billion of government bonds to mature and roll off their balance sheet each month. At the same time, the Federal deficit is requiring the government to issue at least a similar amount of new bonds each month. Lower demand plus increase supply equals lower prices for bonds.
In the recent stock selloff, prices of US Treasury bonds did not improve as they have in almost all corrections over recent years. The ten-year maturity US Treasury bond began the month yielding 3.06%. At month end, the yield was 3.16%. Long term interest rates are going up. So, liquidity in the system is drying up while bond yields are becoming more competitive with the future returns from stocks. Which brings us to valuation.
We are long past the point in the cycle where you can expect a 20x price/earnings ratio for stocks based on forward earnings. If the ten-year US Treasury achieves a “normal” 4% yield sometime in 2019, the “normal” P/E for the S&P 500 would be about 15x. Based on estimates of earnings for that index for 2019 of about $170 per share, the implied value would be 2550. But, if bond yields remain where they are, the S&P could support a P/E of say 18x. That implies an expected value of 3060. Today, the index closed at 2711.
There is still money to be made. But, profit margins are peaking. Labor resources are getting scarce. Higher interest rates and the very strong dollar are making it harder for companies to grow their earnings. As my old colleague, Howard Marks of Oak Tree Capital has said in his recent book, “Mastering the Market Cycle,” there is a time for offense and a time for defense. A bit more defense is in order.
Over the last several years it has been right to add money on dips in the US stock market. That is still the case. However, at least for the foreseeable future, it might pay to take money out on rallies.
A note from WSC and WAMI . . .
Robert C. Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant. Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Chappell Hill, Texas. He now lends his expertise and knowledge of the markets to our company and customers. We hope you find it interesting and insightful.
CANEY CREEK REPORT - The Market Cycle
November 04, 2018|