So why are stock prices so volatile if the economy is not heading into a recession?Jan 2019
While the U.S. economy remains on solid footing, the final quarter of the year was an especially volatile one for stocks. The broad S&P 500 index fell 14%, with Energy (-24.4%), Industrials (-17.7%) and Technology (-17.7%) weighing heavily on returns. Only the Utility sector eked out a gain of 0.5% for the quarter. It has been a very long time since stocks have seen drawdowns of this magnitude. So why are stock prices so volatile if the economy is not heading into a recession? There are several reasons, in our view.
Since the beginning of the current bull market run in March 2009, the S&P 500 index has returned 271% through the end of 2018. The number is even higher including dividends as yields have grown from 1.1% per year to 2.3% over the same time horizon. As uncertainty rises about Fed policy, trade wars and corporate earnings potential, some investors have been selling stocks to purchase bonds or other “less risky” options, including cash. This is to be expected after such a long bull market. Yet, it does not fully explain the very high volatility we are seeing. To understand it we also need to consider that the structure of the equity market is now largely driven by Exchange Traded Funds (ETFs), computer-driven “algorithmic” trades and large institutional managers with a very short-term horizon. By comparison, our approach is much steadier, with a long-term focus. We do not attempt to “time the market” by jumping in and out of stocks. Rather, we manage portfolios to have adequate liquidity to meet income and cash needs and include bonds to lower overall portfolio volatility. Doing so allows us to take a longer-term view and in many cases use the elevated volatility in the market to our advantage by adding to positions in high-quality stocks at cheaper prices with the objective of owning them for the long-term. With this longer-term view, and a balanced approach of incorporating cash and income needs, we are well positioned to weather elevated volatility. Finally, some have asked whether it would make sense to be out of the stock market during periods of elevated volatility. Our response is that it does not make sense because when volatility quiets down, markets do not “settle down,” they “settle up.” With clearer skies comes increased optimism and higher prices. The only way to participate in the upside is to go along for the ride, even when it feels bumpy.
Another reason for the volatility in stock prices is the uncertainty of the future path of earnings. Buoyed by strong consumer spending and lower corporate taxes, S&P 500 operating earnings grew 27% in Q1, 27% in Q2, 32% in Q3 and 24% in Q4 (estimated) of 2018 (see the chart below). These figures compare very favorably with the average growth in earnings per share of 6.9% since 2001. Following a period of much higher-than-average growth, we expect slower earnings growth in 2019 and with numerous factors at play the outlook is particularly hazy. Current market consensus is calling for earnings growth of +7.6% in 2019 and +11% in 2020. We believe these numbers are likely too high and will probably be revised downward over time, as often happens. As earnings growth slows it is likely to revert toward the long-run average of 6-7% and potentially even below it given the difficult year-over-year comparison versus 2018.
Another key consideration in the outlook for stock prices is valuation – the multiple that investors pay for estimated future earnings. At the peak of the 2000 NASDAQ market bubble, stocks traded at 27.2x expected earnings. At the 2007 market peak, before the housing market collapse and ensuing financial crisis, stocks traded at 15.7x forward earnings. By comparison, the S&P 500 ended December at 14.4x expected earnings. Compared to a median forward P/E of 15.3x over the past twenty years, stocks appear relatively inexpensive even if we expect earnings estimates (the denominator in the P/E ratio) to come down over time.
Finally, it is important to note that while we look at broad indices such as the S&P 500 to gauge the market, our approach focuses primarily on individual equity selection, not on owning an index. We continue to do as we have always done – identify and own stocks in high-quality businesses with durable competitive advantages, strong management teams and sustainable cash flow to fund growth in earnings and dividends. Through this approach, we seek to deliver a superior return for clients at a lower level of risk over a long time horizon.0