The third quarter saw a continuance of choppy stock market conditions.Oct 2019
Short-term movements in equity prices were driven by a number of factors. These include investors’ expectations for Fed rate cuts oscillating between fewer cuts and more cuts, and trade war expectations alternating (often on a headline by headline basis) between near-term progress and a long-term, protracted battle.
There are numerous other factors at play as well, but these have been the biggest in terms of their impact on future expectations for corporate earnings and valuation multiples. As interest rates fall, stocks are more attractive, driven by higher returns expectations compared to bonds. On top of the relative attraction compared to bonds, stocks tend to rise with hopes that rate cuts will stimulate accelerating corporate profit growth. It is a similar case with tariffs: as expectations for a trade deal rise, so do expectations for corporate profit growth, which makes stocks more attractive. A similar argument can be made for volatility: higher volatility means greater uncertainty, which is negative for valuation multiples and stock prices.
With these dynamics in mind, the short-term gyrations of the stock market make sense as they are driven by on-again/off-again expectations surrounding the Fed’s actions and global trade resolution. When will all of this stop, you ask? It is difficult (if not impossible) to predict what is going to happen over a short period of time; everything is so intertwined that it is challenging to isolate the effects and determine what the outcome might be.
Thankfully, we are focused on the longterm outlook for companies and stocks as we believe that is a much greater determinant of the financial well-being of our clients. Barring a confluence of significant, negative events or shocks, we continue to believe the long-term outlook for stock prices remains favorable as numerous macroeconomic tailwinds remain in place. Low inflation, low interest rates, job creation and healthy consumer balance sheets are all favorable for continued stock price appreciation.
One important development in the third quarter became evident when looking at stock price movements at a more micro level. Since early September, certain stocks that have performed exceptionally well over the last year or so have started to underperform others that have significantly lagged the broader market. Said another way, valuations in certain areas of the market have increased to the point where investors are selling shares to realize capital gains and redeploying the proceeds into areas of the market where stock valuations are lower.
We are staying the course on our overall allocation to equities, as we believe it is the most attractive asset class to deliver investment returns over a long timeframe. Our positioning within equities has always emphasized stocks in high-quality companies with durable earnings and cash flow that we believe will compound over a long period of time. These stocks have attracted much attention and interest from investors, which has pushed their valuations to historically high levels in some cases. We are using recent market strength to trim a number of core positions where valuations leave little room for error. In a world of slowing growth and record low interest rates, equities still offer the most attractive risk/reward in our view. However, we expect their returns are likely to come down more in line with long-term historical averages.