Monday, May 7, 2018

Research Director Monthly Commentary: May 2018


More On Volatility
 
As we mentioned in our March comment, we expected stock market volatility to increase this year and it  has. The low volatility experienced in 2016 and 2017 lulled many investors into believing low vol was here to stay. This was not to be the case, nor could it be. Market “corrections” (downward moves of 10%-20%) have historically occurred on average about once a year, while market “adjustments” (downward moves of 5-10%), have historically occurred about 3 times a year. To not have not a downward move of even 5% for a period of about 21 months (March 2016 to December  2017) was not only a record, but entirely unsustainable. 

What has contributed to the increased volatility this year? Several factors: concerns over Federal Reserve policy, concerns over rising inflation, concerns over the potential for a trade war with China, and more recently, increased legal troubles for President Trump. We believe the concerns over Fed policy and inflation have been overblown. The Fed continues to maintain a steady and well telegraphed interest rate policy and, absent a dramatic acceleration in inflation (which we do not expect), we believe Fed policy should not lead to damagingly high interest rates. With regard to inflation, we had some good news in the April payroll report in which the pace of both job creation and wage growth cooled off from previous readings. Wage growth of 2.6% is in line with the long-term pace during this recovery and we believe does not have inflationary implications, at least as of now.

With respect to the potential of a trade war with China, we believe investor concerns over this issue are justified; however, we believe a more probable outcome is that China and U.S. will ultimately reach some reasonable and mutually accommodative position. We believe China understands there has to be more of a balance in trade with the U.S. to sustain a positive long-term relationship and access to vital U.S. markets. With respect to Donald Trump’s legal problems, it is difficult if not impossible now to predict an outcome or ending for this. Uncertainty around any country’s executive leader is problematic for the market and we expect this issue could continue to contribute to market volatility in the near term.

What’ the point? So the point about this rather dry analysis is to put recent stock market volatility into context. We have heard some concerns from clients about the recent volatility. We want to assure clients that a) volatility is normal, b) we understand what is causing it, and c) we believe underlying economic fundamentals remain favorable for stocks. We often get the question “should I pull my money out til this is over?”….. in other words, try to time the market? We have long understood, and studies show, that market timing is difficult if not impossible. One interesting statistic on this: according to BTN Research, the total return for the S&P500 over the past 10 years has been 8.5% per year. If you missed the 10 best percentage gain days over this period, the return drops to an annual gain of 1.3%. There will be periods of variability, some more violent than others. Trying to time the ups and downs of the market will almost always lead to disappointment and lower long-term returns. With regard to investing, it is important to keep volatility in context, maintain a long-term view, and adhere to a disciplined investment process.

Despite the recent volatility, we remain constructive on stocks. Valuations based on forward price/earnings for stocks remain reasonable and about in line with the long-term average (about 16x), so stocks are not overvalued. Valuation is the single most important factor in determining long-term stock returns. While there is some concern about a peaking in earnings growth in 2018 (also contributing to recent volatility), we believe it is likely that even if earnings growth slows, which it will, corporate cash flows should increase significantly in 2018 and 2019 as a result of the tax bill. As corporations return this cash to shareholders, we expect a lot of it will get “recycled” into the stock market, thereby providing fuel for higher valuations and stock prices over time. Another way of looking at it is we expect investors most likely would pay up for stronger and perceived sustainable cash flow.

Robert Toomey, CFA/CFP
Vice President, Research