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The same set of factors that have driven economic growth have been broadly positive for stocks.

Jul 2018

The same set of factors that have driven economic growth have been broadly positive for stocks.  After a volatile start to the year, the broad S&P 500 index of US stocks advanced 2.9% for the quarter. The variance in returns across sectors persists, however. During the first half of the year, Energy, Consumer Discretionary, and Technology led the way while Industrials and Financial stocks lagged. This disparity is evident in the Dow Jones Industrial Index performance, which eked out a 0.7% gain for the quarter, while the perennially technology-driven NASDAQ increased 6.3%. The same variance is notable across style, with Growth stocks up 7.8% for the year while Value stocks have actually declined about 1.7%. This lack of market breadth is typical of a later stage bull market, and one reason we are carefully focused on stock selection. We have tended to focus our investment efforts on quality growth stocks that trade at reasonable valuations relative to their future earnings growth rate.

Just as we see economic growth persisting, we remain generally optimistic about the potential for moderate growth in equity prices and dividends during the second half of the year. While many high-growth stocks trade at lofty valuations, the broad market valuation of 16.1x is right in line with the twenty-five year historical average. Valuations do not reflect the same “irrational exuberance” that led to a 25x price to earnings multiple at the height of the 2000 technology bubble. The technology sector may be below its all-time maximum weighting of 33.6% reached during the peak of the market in 2000, but the narrowing leadership in the market to only a handful of stocks is reminiscent of that time. As we look at stocks in 2018, expectations are high though not unrealistic; earnings are projected to continue to grow at a double-digit rate for the remainder of the year, following 26% year-over-year growth in the first quarter. It is rare for earnings to grow at such a high level eight years into an expansion; earnings typically only grow this fast following a recession as they are recovering off a low base. While revenue growth and corporate tax cuts have played a big part, recent earnings growth has also come from continued margin expansion as companies use technology, human capital, and low-cost financial leverage to drive efficiencies and profitability. As always, the focus of our research efforts is identifying and selecting companies with sustainable and reasonably valued earnings.

Finally, we would note the continued relative under-performance of equity markets outside the U.S. While the S&P 500 has advanced over 300% since the bull market began, the MSCI All Country World Index excluding the U.S. has increased by about 115% over the same horizon. With a more diversified underlying economy, a highly innovative technology sector, and more dynamic labor market, the U.S. has led the global recovery. By contrast, structural challenges persist in both advanced and emerging economies in Europe, Asia, and Latin America. These include currency fluctuations, slow-moving political reform, and tighter controls on the movement of capital in places like China, Brazil, and India. While these factors make us cautious over the near term, we still have a long-term positive view of emerging markets, and are watching for opportunities as volatility in these markets persists.

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