Stay Focused on Fundamentals

Stay Focused on Fundamentals

  • Strong Earnings Growth
  • Home Sales and Prices Rise
  • The 3% Hurdle
  • Looking Ahead

As most of the U.S. slept, a historic handshake and signed agreement gave hope that, 65 years later, the Korean War would finally come to an end and that peace and denuclearization could become a reality on the divided peninsula.

If North and South Korea can follow through on their pledges, it would cool a notorious geopolitical hotspot. We’re going to save any celebration, however, until we see evidence that the agreement is being enacted in good faith. There is a distinct possibility that this deal in principle (like others in the past) could unravel at a later date. North Korea has a very long way to go on many fronts, but if the nation’s leadership is sincere, this may be a first step toward a better life for the country’s people and a more peaceful planet. Let’s hope.

In the U.S., a trio of tech bellwethers (Amazon, Microsoft and Intel) surpassed Wall Street’s expectations for earnings growth and expressed optimism for the year ahead. Meanwhile, as expected, the initial estimate of U.S. economic growth over the first three months of the year showed a slower pace (2.3% annualized) than we saw in the three prior quarters. If we look at rolling 12-month periods though, the period ending in March represents the best results in almost two years. We remain in a slow growth, not no growth, environment.

For the year through Thursday, the Dow Jones Industrial Average has declined 1.0%, while the broader S&P 500 index has returned 0.3%. The MSCI EAFE index, a measure of developed international stock markets, has matched the S&P 500 index with a 0.3% gain. As of Thursday, the yield on the Bloomberg Barclays U.S. Aggregate Bond index has increased to 3.32% from 2.71% at 2017’s end. On a total return basis, the U.S. bond market has declined 2.5% for the year.

Strong Earnings Growth

With a little less than half of the companies in the S&P 500 index having reported first-quarter earnings, indications are that total profits may have increased more than 20% from a year ago.

Despite growing earnings, the stock market sits about 7% below its January high. Yes, stock prices rose ahead of earnings on expectations of strong results and a boost from lower tax rates, and some of that rise has been taken back as other fears have come to the fore. Plus, stocks may simply have gotten ahead of themselves.

We’ve often spoken about the “ultra-low” volatility environment we’ve been in for years, culminating in 2017’s extraordinarily placid markets. At the same time, though, the S&P 500 index has been in what you might call an “ultra-highs” environment. Since 2013, the Dow has made 204 new all-time highs while the S&P 500 has posted 202. In January alone, the Dow hit 11 highs while the S&P notched 14.

Yes, as we’ve noted in the past, markets don’t go higher in a straight line. Rather, they tend to move in a “stair-step” pattern.

Source: S&P Dow Jones Indices.

Source: S&P Dow Jones Indices.

As you can see in the chart above, it’s completely normal for investors to spend time below a prior peak. Using Vanguard’s 500 Index fund as a proxy for the market, investors have spent 56% of the last 35 years within 5% of an all-time high. And nearly a third of the time, an investor would have found themselves in a correction (down at least 10% from a recent high) or worse.

Yet over this period Vanguard 500 Index compounded at a 10.8% annual pace. That’s the reality of the day-to-day vagaries of the stock market. So the current drop of 7% from the January 2018 apex is perfectly normal. It also doesn’t mean that disciplined investors won’t be able to continue growing their wealth over time.

In fact, if you think stocks will go higher—as we do, given where interest rates, earnings and, as we’ll see below, economic data stand—then buying today provides a 7% discount on what you would’ve paid in January. And who doesn’t love a discount?

Home Sales and Prices Rise

When consumers are confident, they tend to go shopping. That drive is clearly evident in the housing market; sales of existing houses rose 1.1% in March from the previous month and buyers purchased 8.8% more new homes last month than in March 2017.

As we’ve discussed before, there is a lack of supply and a robust level of demand in the housing market. One result is higher home prices—which increased for the 70th straight month in February. Rising home prices are good for consumer confidence if you’re a homeowner, no doubt.

The 3% Hurdle

You hear us talk plenty about how earnings and interest rates drive the stock markets. This week has given us no shortage of fodder on both fronts.

Let’s dive into the financial media’s current obsession: Interest rates. What’s all the fuss? After a slow approach, the yield on 10-year Treasury notes crossed the 3% threshold for the first time since late 2013 on Tuesday. Higher interest rates make bonds more attractive to investors. Quite simply, a yield that starts with a “3” is more appealing than one that begins with “2.”

But is there anything particularly important about a 10-year Treasury yielding 3% aside from the psychological significance of a round number? The media hype would have you believe so. We don’t.

For the most risk-averse investors, sure, 3% might be fine. But in our experience, most investors don’t really want to lock in their money for 10 years in exchange for a taxable 3% per annum return.

That rate of return might be attractive if you are particularly pessimistic about the prospects for stocks. While it is possible that the stock market could return less than 3% year over the next decade, the odds suggest it’ll do better than that.

That Vanguard 500 Index fund mentioned earlier fell short of a 3% annualized rate of return over a 10-year period just 10.5% of the time since its 1976 inception and all of those instances surrounded the 2008 financial crisis. On average the fund returned 11.0% a year over 10-year periods.

And let’s not even begin to think about what happens to that 3% yield if prices for goods and services (inflation) starts running at 2% or higher. Your real return drops to 1%. For investors looking to make money, 1% isn’t going to cut it.

That makes the stock market look relatively attractive, especially when you consider the earnings side of the ledger.

Looking Ahead

Earnings reporting season continues apace next week. We’ll also be poring over a slew of informative economic data, including reads on personal income, spending and savings, inflation, manufacturing, construction spending, vehicle sales, the service sector and the job market.

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Please note: This update was prepared on Friday, April 27, 2018, prior to the market’s close.

This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations or personal investment advice, or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

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