Navigating the New Environment

Key Points

U.S. stock indexes have rebounded from their correction lows, although remain short of new highs; but risks remain elevated that additional bouts of volatility will likely erupt.
First quarter earnings season has exceeded elevated expectations allowing valuations to improve alongside the recent consolidation in prices; but geopolitical concerns persist and uncertainty about the midterm elections could keep investor sentiment from becoming frothy again, and keep the Federal Reserve from tightening policy more swiftly.
European and Japanese earnings seasons have resulted in better stock market performance in those regions than in the United States, despite a lower “beat” rate—a further illustration that diversification is essential at this stage in the market cycle.

We’re not in Kansas anymore

Investors may be feeling a bit like Dorothy from the Wizard of Oz who was dropped into a world that was nothing like she had known. In 2017, all news seemed to be good news and stocks moved consistently higher, while volatility stayed remarkably low. Now well into 2018 and it’s a completely different world—most news is seen through more negative lenses, volatility has returned and although stock indexes have rebounded off their lows, they continue to struggle a bit to find direction.

A different world

S&P

VIX

There’s no yellow-brick road to follow, so how should investors deal with this new world? In a word—patience. We don’t believe we’re on the precipice of a prolonged downturn in stocks, but an uptrend may be difficult to sustain in the coming months. We’re entering a traditionally weak seasonal time of the year and midterm election years have not been kind to the bulls in the past. Even though past performance does not guarantee future results, the S&P 500’s average loss (or “maximum drawdown”) during midterm years has been 17%, largely concentrated in the first three quarters; with subsequent one-year rallies of an average 32% from our analysis. Before trying to time that “trade,” however, remember that successful market timing requires two correct decisions—you have to get both the sell and the buy decisions right. History often rhymes but rarely repeats exactly, and given more rapid movements related to algorithmic trading, that timing could be compressed, thrown off, or entirely different this time.

Conditions improved, but more work may need to be done

Earning season has bested elevated expectations, with the S&P 500 posting earnings growth to-date of 26%, above the roughly 16% expected coming into the season, according to Thomson Reuters (for more on earnings season read Liz Ann’s Beast of Burden of a High Earnings Bar). Some companies have been rewarded, but the indexes struggled in the first month of the quarter, before rebounding more sharply in May. Courtesy of a stock market that hasn’t yet taken out its January highs, and the surge in forward earnings expectations, valuations have improved. The S&P 500’s forward P/E dropped from 18.6 in late January, to 16.5 currently—only slightly above the 20-year average according to Thomson Reuters.

Investor sentiment also corrected along with the market’s correction, with the Ned Davis Research (NDR) Crowd Sentiment Poll now in neutral territory. It’s the extreme pessimism zone which has historically been associated with the most robust stock gains, in keeping with the contrarian nature of sentiment. In addition, consumer confidence has remained elevated and in a zone which NDR has shown to be associated with the weakest returns in stocks.

Consumer confidence may need to fade

Bear not in sight

While a sustained upward move has some formidable constraints, a prolonged bear market seems unlikely given the limited risk of an economic recession in the near-to-medium terms. Economic data has been modestly softer recently, as seen in the Citi Economic Surprise Index below, but that’s helped to lower the expectations bar, which could set up the opportunity for the surprise factor to improve. Remember, when it comes to the connection between economic fundamentals and stock market performance, “better or worse (relative to expectations) tends to matter more than good or bad.”

Surprise index decline stalled

Additionally, both Institute of Supply Management (ISM) surveys—manufacturing and services—remain comfortably in expansion territory (above 50), despite easing a bit recently; while the forward-looking new orders component for both indexes remain above 60.

ISMs continue to indicate growth

The labor market also looks healthy, with the forward-looking jobless claims number remaining near historic lows, 164,000 jobs added in April, and an unemployment rate which fell to 3.9%--the lowest level since 2000. However, wage gains remain modest, with average hourly earnings (AHE) rising 2.6% year-over-year, in line with last month’s downwardly-revised level.

Claims indicate continued growth

In the midst of this relatively good earnings and economic news, there are continuing trade and geopolitical concerns weighing on the market and sentiment.. Trade rhetoric has been harsh at times from both sides, but negotiations are ongoing and to date, no substantial trade actions have yet been taken, which is good news. At this point, we view the risks as asymmetric—with investor sentiment suggesting a worse-case scenario is expected, meaning market’s would likely take kindly to a more benign or positive outcome.

Monetary tightening and fiscal stimulus

The Federal Reserve maintained the current level of short-term interest rates at its most recent meeting but gave no indication that it will deviate from its path of gradual hikes—noting that inflation will “run near” the bank’s 2% target. Fed officials have also expressed a willingness to tolerate inflation moving above that level for some time (a “symmetric” view about inflation) to cement the reflationary theme. The latest inflation data shows still-subdued upside pressure, but leading indicators for inflation—including tax cuts, the closure of the “output gap,” and a tighter labor market—have firmed. Of all the concerns weighing on the market, inflation and monetary policy are the ones we view as most important—a more aggressive Federal Reserve could quickly change the outlook for both the timing of the next recession and the longevity of the bull market in stocks.

Global earnings also in focus

It’s not just in the United States that investors narrow their focus four times a year to the most fundamental driver of investment performance: earnings. The first quarter earnings season is drawing to a close in the United States and has now passed the midway point in Europe and Japan, contributing to some interesting—and counter-intuitive—stock market outcomes.

It’s been a strong global earnings season, with first quarter earnings-per-share from companies in Europe and Japan joining the United States in posting double-digit growth relative to a year ago. Yet, stocks have performed differently across regions during the earnings reporting season that kicked off about a month ago, as you can see in the table below. Given how much stronger-than-expected earnings were in the United States (with 80% of companies beating Wall Street analysts’ consensus estimates), it may seem that U.S. stocks should have outperformed their European and Japanese peers (where beat rates were 57% and 40%, respectively). Yet the opposite has occurred.

First quarter earnings season: earnings beats and stock market performance

Regions represented by the MSCI USA Index, MSCI Europe ex-UK index and MSCI Japan Index.
Source: Charles Schwab, Factset data as of 5/8/2018.Past performance is no guarantee of future results.

The exceptionally high rate of positive surprises in U.S. earnings is mostly due to tax (and regulatory) reform; while Europe and Japan saw soft spots in their economies during the first quarter that may have impacted earnings and forecasts thereof. All three regions have seen upward revisions to earnings estimates for the coming 12 months according to Factset.

The widely-watched global Purchasing Managers Index (PMI) has been a good indicator of where overall earnings for global companies may be headed. The global PMI peaked in January then fell in February and March, but showed some stabilization in April. This may help to account for stocks’ lackluster performance this year as market participants factor in a peak in the earnings growth rate (although not a peak in earnings-per-share).

Is the global PMI signaling a peak in earnings growth?

Source: Charles Schwab, Bloomberg and Factset data as of 5/9/2018. Past performance is no guarantee of future results.

The stabilization in the global PMI in April may be signaling the economic soft spot was over at the start of the second quarter; suggesting the slowdown in the pace of earnings growth may be modest, which may have helped to support global stocks in recent weeks. Global stocks have been tracking the typical pattern for a correction, as you can see in the chart below.

Is the stock market correction over?

Source: Charles Schwab, Bloomberg data as of 5/9/2018.
Past performance is no guarantee of future results.

If this turns out to be a typical correction, as the market behavior so far seems to suggest, then it may be over. But that doesn’t necessarily mean short-term volatility is likely to subside. While earnings may continue to rise, even as the growth rate slows, other factors may return to buffer the market as investors’ focus widens from earnings to politics and central bank actions, among other factors.

So what?

A more challenging investing environment requires a more disciplined and patient investing approach. The next few months could continue to be choppy, but a U.S. and/or global recession still appears a ways off, which should keep the bull market—here and globally—intact.

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