What happened?

By Guest Blogger Ryan Lewenza

The holidays can’t come soon enough! We need a little holiday cheer in our lives after the early lump of coal we got in October with the steep stock market declines. As we closed out the third quarter the global equity markets were doing ok. Global equities (MSCI World Index) were up 5.9% as of the end of Q3 with the S&P 500 driving most of the gains, up 10.6% including dividends. The TSX continued to lag up 1.4%. Well this all changed at the beginning of Q4 with the S&P 500 declining 9% and the TSX losing 6% as of November 21st. What the heck happened in October that caused this year’s gains to evaporate with many global equity markets now in the red for the year?

Equity Market Performance YTD

Source: Stockcharts.com, Turner Investments. As of November 22, 2018

The October sell-off was triggered by a strong economic report with the release of the September US nonfarm payrolls report. The report showed that the US unemployment rate fell to a 49-year low of 3.7%. This great news story led to market participants pricing in more inflation, and in turn, more Fed rate hikes. Bond yields spiked on the news, which was the spark that led to the first wave of selling in the equity markets.

Then Trump and his crew compounded the sell-off with continued threats and comments regarding their trade dispute with China. For example, Bloomberg published a report that Trump was preparing another round of tariffs and the stock market gains on the day quickly turned to steep losses following the news. And then last week we heard strong comments from VP Pence over China’s trade practices, which also contributed to last week’s declines. The Trump administration can blame the Democrats, the Fed et al. for the recent stock market weakness, but the reality is their tough stance with China is contributing to the negative sentiment on the equity markets and the recent volatility.

So the markets are grappling with concerns of Trump’s trade wars, the threat of higher interest rates, a moderating global economy and one-off issues like UK’s Brexit and Italy’s ongoing budget feud with the EU. The key question is whether the global economy will be dragged down by these headwinds, or does it work through these issues with minimal drag on the economy, thus keeping this bull market intact?

Our call right now is for the latter, and this view is predicated on a few key things.

First, almost all bear markets are caused by the US and global economy falling into a recession, and we just don’t see this in the cards for 2019.

From my investment strategist days I closely studied recessions and bear markets trying to isolate those economic and market indicators that gave us a good early warning of approaching recessions. From this analysis I created a “Recession Monitor”, which is a list of these key leading indicators and can be seen in the table below. This list includes things like US initial jobless claims (they tend to spike ahead of recessions), the ISM manufacturing index (it rolls over and declines below the key 50 expansion level), the yield curve (it inverts) and credit spreads (they blow out). Currently, none of these indicators are signaling a major slowdown in the US economy and imminent bear market.

Our Recession Monitor

Source: Bloomberg, Turner Investments

Second, corporate profits – which are the mother’s milk of stock prices – have been nothing short of spectacular. We just wrapped up the third quarter earnings season and it was another blowout quarter. Sales for all the S&P 500 companies were up an impressive 11% Y/Y while earnings surged 29% Y/Y, marking the third straight quarter of 20%+ earnings growth. And I see another strong quarter coming for Q4.

Some believe we’re at or near peak earnings and therefore this is going to take down the market. I believe earnings growth (i.e. year-over-year change) will peak soon as the benefits of the lower US tax rate rolls off in 2019, however, I don’t see actual earnings peaking, which if correct, should continue to support stock prices. For earnings to drop materially from current levels we would need to experience a US/global recession, and I as covered above, I just don’t see it in the cards for 2019.

S&P 500 Earnings Are on Fire

Source: Stockcharts.com, Turner Investments

The third support for our continued positive view is that the technical trends remain bullish, supporting our fundamental assessment of the markets. Below is a chart of global equities and you can see that they remain in a well-defined upward channel. Yes we’ve broken the 200-day moving average, as we did in 2015 and 2016, but we have not yet broken the lower channel line. This is critically why we’re not freaking out over the recent bout of volatility. As they say, a picture is worth a thousand words.

Global Equities Still In an Uptrend

Source: Stockcharts.com, Turner Investments

Finally, for the first time in a while equity valuations are starting to look attractive. With the big increase in earnings and the lower stock prices, equity valuations (e.g., P/E ratios) have declined pretty significantly. In the US, the forward P/E has dropped from 20x in January to 16.8x currently. International stocks are even more attractive with European and Far East stocks trading at just 13.3x, the lowest level since 2013. Same thing with Canadian stocks now trading at just 13.7x. A lot of bad news is already priced in and, if there is no earnings recession, then the current valuations could be setting us up for a stronger 2019.

Global Equity Valuations

Source: Stockcharts.com, Turner Investments

Ok that’s a lot to take in and hopefully I haven’t bored you to death. I should have tried to mix in a joke about how two real estate agents walk into a bar, but alas, comedy is not my forte. What I am better at is assessing the economy and stock market and currently the weight of the evidence remains positive and supportive of our call for more equity market gains. But there’s no denying the higher risks today so we must remain open to the messages of the market and be prepared to shift our views and portfolio positioning if we start to see danger ahead. Until then, let’s enjoy some rum and egg nog to welcome the holidays and help us forget about the October sell-off.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.