Despite continued strength in broad measures of the U.S. economy, markets took a pretty sharp tumble starting in the second week of October, culminating last week with a drop in the S&P 500 of 4%. Even Friday’s better-than-expected GDP report failed to stem the bleeding. You can find many plausible explanations, and some of them are even pretty good stories. Little has changed in the broader economy, and yet the S&P is down nearly 9% this month. It’s important for investors to remember how normal it is for markets to undergo sporadic corrections, but also to remember that mostly the market goes up. And for good reasons.
The largest concerns among investors are rising interest rates—just how high will they go and what will this do to the economic expansion—and tariffs—will the trade war with China worsen, slow growth, and eat into corporate profits? We are already seeing higher interest rates bring down bond prices—especially longer dated bonds—and we are seeing higher rates reduce multiples for companies whose valuations are mostly based on earnings far into the future. While those two effects are to be expected, the broader selloff is not and likely stems from concerns about the strength of the U.S. economy, Friday’s 3.5% 3Q GDP growth report notwithstanding. Investors are looking deep into economic reports and listening to company quarterly reports to uncover hints about future prospects.
A roundup of earnings reports over the last couple of weeks confirms mostly positive news. Third quarter earnings are running ahead of analyst estimates and are on pace to be 22.5% higher than 2017’s third quarter profits. And that is being driven not only by the tax reform (which accounts for roughly half the growth), but also by virtue of firms selling more stuff this year – nearly 8% more stuff as compared to last year’s 3Q. Company valuations, however, are more about future prospects than past achievements. And outlooks are coming in a bit weaker than expected. Nearly two-thirds of companies that have provided future guidance have announced revenue and profit targets below analyst expectations. This, though, is not unusual. Indeed, the percentage of companies with negative guidance is running below the five-year average. It is often the case that analysts create forecasts which are too high in support of “Buy” recommendations. Over the past year, those forecasts were sustainable as the tax cut’s benefit was conservatively forecast by companies. The tax cut’s effects are now better understood, however, so companies have fewer avenues by which to boost outlooks above the analyst estimates. Add to this that investors are nervous, after such a long bull run, and the slightest sign of weakness is exacerbating those fears and encouraging the risk-off trade which started earlier in the month. The FOMO (fear of missing out) trade has now settled more firmly into the fear trade.
The timing of the risk-off trade, however, remains a bit startling. Last week saw no sudden jump in global risks, no sudden decline in company earnings’ outlooks, and no sudden change in the outlook for the midterm elections. Europe remains intact, despite continuing troubles regarding Brexit and Italy. U.S.-China trade negotiations remain stalled. The data on housing has weakened slightly, but that could be driven by hurricanes and the ongoing shortage in supply. Perhaps the biggest concern came from the semiconductor industry. Investors heard last week about a slowdown in demand for a broad range of semiconductor chips based on cautious remarks from (among others) Texas Instruments, a chip supplier with 100,000 customers across end markets from autos to industrials to consumer electronics. Intel’s outlook was much stronger, but it is benefiting from high demand for servers needed to power the cloud following a security breach which has necessitated an increase in chip hardware to offset the software fix which reduced performance by up to 50%.
While chip suppliers are warning of weakening demand—and they do tend to be the canaries in the coal mine—long-term investors must remember that cycles are part of the normal course of business. If you have near-term needs for your principal, you are likely already heavily tilted towards a fixed income portfolio. If not, just remember that a diversified equity portfolio likely includes companies which produce more stuff over time, deliver higher profits and cash flow, and generally become more valuable. A look at the rise in the S&P 500 over the last 50 years confirms this reality. And remember also, the S&P 500 has seen a 10% decline roughly every other year since 1950, and has typically seen several declines per year of 5% or more. Downturns in the market—and even recessions—are fundamentally transitory events. They are hard to predict—both the beginnings and the endings—but history has shown that staying invested in the stock market over the long term delivers an average annual return of roughly 8%. That’s a return worthy of a little patience.