Since last week was a time to remember past presidents, my thoughts strayed to FDR and his insightful warning. The “Fear Index,” officially known as the CBO’s Volatility Index, moved sharply higher in October and remains elevated. Equity prices pulled back as jittery investors demanded lower prices to hold onto risky equity. At the same time, however, companies have been reporting strong earnings for the quarter just past and are guiding to near double-digit growth in 2019. Yet investor attention has turned more toward the risks from rising interest rates, an ongoing trade war, inverted yield curve, weakening economies abroad, and a possible recession. Should investors be that concerned?
Investors know at some level that market corrections, like the two in the S&P 500 this year, are a normal part of market behavior. They happen. They are temporary. Move on. But investors may not realize just how quickly the market fully recovers. Even protracted corrections, absent a recession, tend to be short lived, as the following table shows.
Investors fully recoup paper losses from a market correction in a little over four months, on average. So why not get out of the market for three, you might ask? Because the recovery is generally happening in fits and starts during those few months and if you’re out of the market, you’ve turned paper losses into real losses and are missing out on that recovery. Also, once the correction has occurred you’ve already missed the opportunity to sell before a lot of the decline.
But what if the correction signals a coming bear market and recession? A look at the recent economic data suggests the chances of a recession in the next year are remote. Job creation remains solid, unemployment low, GDP growth moderate, and inflation tempered. Interest rates are rising, but that merely reflects the normalization of interest rates after policy pushed them to zero to promote the fastest possible recovery. Higher interest rates reflect, on the negative side, the need to keep inflation in check, and on the positive side, the need to keep up with ongoing real growth in the U.S. economy. Although the trade war remains a threat to the health of the U.S. economy, the reaction to that threat among investors appears overly cautious when it comes to valuing companies, and that is readily seen when so many wildly different stocks—some having no exposure to the trade war—traded down as much as they did last week. Others worry that the yield inversion, which has preceded recessions in the past, may be signaling a coming downturn, but the time until recession follows an inversion has been anywhere from two to three years historically.
Stock prices reflect investors’ assessments of the long-term value of the underlying companies, and so they incorporate three key components. First up is the company’s earnings outlook. Earnings growth remains better than just good—the companies in the S&P 500 are expected to deliver earnings growth of roughly 9% in 2019. Beyond that, we would expect growth to slow somewhat, if only because labor scarcity will prevent firms from hiring. And given that the current S&P 500 multiple at about 15 times forward earnings is below the 50-year average (of 16.2x), stocks look particularly cheap. So we can’t attribute the sell off to a weak earnings outlook.
Next up is the interest rate at which we should discount those future earnings. Expectations of rising rates had already caused some multiple compression, but last week did not raise those rate expectations. Indeed, rate forecasts declined. So rising rates don’t help explain the selloff.
The final component of valuations (and P/E multiples) is investor perceptions of risk. Note I said “perceptions.” While some risks can be quantified objectively, such as when we can look to the laws of physics, other risks cannot. Future earnings depend on economic, political, and human variables that require investors to make subjective assessments of all three factors. When investors, for whatever reason, come to the conclusion that negative developments—in economic, political, or human behavior—are more likely, company valuations fall. This is so even if no change has actually occurred in the economic data, in politics, or in the ability of executives to manage their companies. Since early October we have seen these risk assessments rise. We are seeing that materialize in the elevated “Fear Index,” and we saw it in last week’s market selloff.
When we step back and look more objectively at the outlook for U.S. and global economic growth, we find little reason to expect a recession anytime soon. The key fiscal and monetary policies which shape company earnings’ prospects remain supportive—these being low corporate tax rates, fewer regulatory headwinds, and well-paced inflation and interest rate paths. While, some data—slower employment growth, a rise in the broader (U6) unemployment measure, slower home sales, and weaker growth abroad—remind us that expansions follow uneven paths, we are not seeing a source for the sort of crisis that typical tips an economy into recession. Tariffs are our main concern, but even there, the burden is concentrated on identifiable companies in select industries. We are unlikely to see a broader economy-wide impact. The 24-hour news cycle, however, focuses on the possibilities for disaster and this skews investor perceptions toward the negative (as has been documented in numerous studies). Beware of becoming part of the herd and heed FDR’s warning if you plan to realize the long-term benefits of a sound and balanced investment strategy.