A few weeks ago I advised readers to hang onto their hats because earnings season was likely to lead to puzzling drops in stock prices despite companies delivering strong earnings growth and “beating” expectations. The vast majority of companies which have reported thus far have indeed beaten consensus forecasts handily (78%), yet the S&P 500 has gone nowhere since first quarter reporting began in mid-April. Investors don’t know whether to blame noisy domestic politics, the threat of trade wars, or rising interest rates. Or it could simply be that much of the rise in earnings was already priced into the market. While S&P 500 share appreciation has stalled and volatility remains elevated, placing our current investing environment in the context of history reminds investors to stay focused on value and ride out the market’s gyrations.
The facts of today’s investment environment are encouraging. Companies have indeed been delivering strong results: first quarter earnings came in 8% above expectations, which exceeds the 5-year average. Sales are also coming in above the 5-year average. We expect earnings growth to slow down, but in the meantime companies are creating more value by turning in profits that are higher than at any time in history. The U.S. economy is growing at a solid pace, job creation remains strong, unemployment low, and wage and price inflation remains moderate. As my colleague David Lieberman recently wrote, the international outlook is similarly encouraging. U.S. firms are enjoying rising demand from South America to Europe and to Asia. Rarely has economic expansion occurred simultaneously in so many countries. The threats to international trade are real, but the main target, China, needs some attention as it attempts to further exploit U.S. technological advances. We remain hopeful that those negotiations lead to a more equitable arrangement.
Amidst these positive economic conditions, we are seeing greater value creep into company shares. The current price of S&P 500 stocks, relative to 12-month forward earnings, has fallen to 16.0 times, down from the 18.6 peak earlier this year and below its 5-year average. Valuations of some companies with above-average earnings growth potential have fallen so low as to put price-to-earnings ratios below expected growth rates—reducing so-called PEG ratios below one—and by a substantial margin. This makes value investing particularly appealing. Rather than investing in the broader market, today’s environment makes taking advantage of such value investments more appealing. Many dividend-paying stocks have also become more attractive, enabling investors to capture higher yield while waiting for the stock market to resume an upward trajectory. But in a rising rate environment, it is important to select companies with the potential to raise those dividends over time. Here, too, we are finding value opportunities to be among the most attractive.
Investors can also find reassurance in the pattern of stock market returns over history, as described in the chart below. Notice that 10% or larger peak-to-trough corrections in the S&P 500 occur in more than half the years since 1978 (20 out of 38 years). Yet in the majority of those years (13 out of 20), the market ended the year with a gain. In most of those years when the market did finish down, the next year saw double-digit appreciation (5 out of 7 years). While it is tempting to exit the market when volatility spikes and appreciation seems to have taken a holiday, the long-term investor knows to ride it out and the find the value lurking in the shadows.
Source: Factset Research Systems.