Volatility is back!

2017 was an exceptionally strong year for global stock markets. In the United States the S&P 500 was up 21.8%, many overseas markets fared even better. The momentum continued into January 2018 with the S&P 500 adding an additional 5.7% for the month.

The S&P 500 peaked on January 26th and then things turned rather ugly with the index shedding 10% of its value in just the next 9 trading days. This was the fastest correction of 10% in market history excluding market crashes. After being up in January, the S&P 500 dropped 3.7% in February, and another 2.5% in March.

2017 was a year of record low for market volatility registering no days with closing prices up or down by 2% or more and only 8 trading sessions with gains or losses of 1% or more. In contrast, 2018 has already had 2 sessions with losses of over 3%, 6 additional sessions with closing moves of between 2%-3%, and 19 further trading session with changes of 1%-2%.

Declines of 10% are referred to as corrections and are considered to be bear markets once declines reach 20%. Since the Great Depression, corrections occur on average about once every year and have been common during bull markets.

Is this correction just the necessary purge of speculation and market excesses allowing for the continuation of a healthy bull market or is it a warning that there is something fundamentally wrong with the economy or the financial system? The later would ultimately lead to a bear market. At this point, it is believed to be the former, but we are watching closely.

The economy seems healthy. Gross domestic product grew by 2.3% in 2017, growth is currently expected to be 3% in both 2018 and 2019. The unemployment rate is down to 4.1% and is expected to decline further this year. The Conference Board Leading Economic Index climbed in March. Inflation is low. Energy prices are higher than last year, but still low relative to peaks of the last decade. Interest rates are increasing, but are still low by historical standards.

With a healthy economy, corporate profit growth is expected to be very strong and stock prices ultimately follow corporate profits. The companies that comprise the S&P 500 are expected to have earnings this year of $158 up nearly 20% over last year, led by the energy sector. In 2019, S&P 500 consensus estimates have profits growing an additional 10% to $174.

The S&P 500 closed the day at 2,604. As stated, 2018 earnings are expected to be $158, so this means that the index is currently trading at 16.5x earnings and roughly 15.5x earnings if you remove corporate cash from valuations. Over the last 10 years the average forward P/E multiple has been 14.3x as stocks were very cheap coming out of the financial crisis. Over the last 20 years the average forward P/E was 17.2x – this multiple reflects the dot.com bubble and the financial crisis. In this context, stocks are very reasonably valued.

Stock valuations are not stretched, the economy still looks sound and corporate profits should be strong. Barring a further escalation of trade rhetoric with China, stock markets should stabilize and resume their move higher.

-Michael Kane

Michael Kane