Dear Clients and Friends of Insight,
Our meetings with clients last year were very well received due in part to the stock market’s persistent positive performance. Portfolio values climbed steadily, even for many clients who withdrew substantial funds. Though we believe the backdrop for stocks should continue to be supportive, we must always be vigilant regarding potential risks, and be prepared for a market downdraft.
Our counsel to you in our October 2017 letter warrants repeating:
- “Though we do not think the next bear market is around the corner, risk is elevated and some meaningful corrections should be expected.”
- “Corrections can be sparked by any number of unanticipated reasons and can cause considerable short-term pain.”
- “We are reminded of October 19, 1987, when major market indexes declined more than 23% in one day.”
Well sure enough, along came February, and with it, investor sentiment that was very different than last year – fear. Driven by heated reactions to a daily variety of news, stock prices started the month by gyrating severely, and mostly downward. The S&P 500 Index, which peaked in late January, lost more than 10% of its value in a mere nine trading days. This resulted in the first “official market correction” in nearly two years and sparked a debate about whether this could be the beginning-of-the-end to our nine-year bull market. Let’s take a closer look to better understand how this bull market achieved its gains, and to assess the potential downside that might result from continued fearful sentiment.
From its lows in March 2009, the S&P 500 Index advanced some 250% through earlier this year. Recall that stock prices advance, over time, generally in line with the growth in underlying earnings. However, during a period when stock prices are advancing less than earnings, the market’s valuation falls, and is reflected in a declining P/E ratio. Likewise, if stock prices are advancing more than earnings, then the market’s valuation rises, as the P/E ratio increases. A recent article in the Wall Street Journal dissected this 250% price advance to identify which portion was credited to earnings growth, and which was attributable to an expanding valuation and P/E ratio. What they reported was that earnings growth accounted for about three-quarters of the S&P 500’s gain (a price increase of 185%), and an expanding P/E ratio contributed about one-fourth of the gain (a price increase of 62%). Consequently, earnings growth was the solid underpinning for this bull market’s success!
Although this is a very simple analysis, it provides a useful model for us to assess future market levels, and a clue to how severe another pullback might be. Applying a combination of future earnings expectations to P/E ratios can provide us with a range of likely market levels to expect over the course of the next year or so. The current consensus is for earnings to grow 20% this
year, and another 10% in 2019. The S&P 500’s forward P/E ratio now stands at about 16x, having fallen from about 18x in the recent sell-off. This is a reasonable level. As we move through the year, and the 20% improvement in earnings begins to materialize, investors will re-calibrate their views of an appropriate market level.
Let’s focus on two scenarios for the S&P 500. First, the negative one where the S&P 500’s valuation contracts from 16x to 14x due to continuing negative sentiment. Given the level of expected earnings, we believe the market could trade down as much as another 10%. Anything more than that we would consider extreme because the earnings outlook is so strong. It would mean that investors have given up nearly all of the P/E expansion that they were rewarded with during this bull market. Conversely to this, and a scenario we consider ultimately likely, the market’s valuation improves along with investor sentiment. The P/E of the S&P 500 revisits its pre-correction level of 18x, and the market advances by 20% or so.
As an interesting demonstration of how puzzling it can be to follow the market’s daily moves, we looked at the daily price changes in the S&P 500 for the last several years. We separated the negative days from the positive days and compiled the following table to show the importance of not letting the short-term noise of the markets deter you from achieving the long-term rewards of stock ownership. Notice that the average ‘reward’ from positive days was more than double the average ‘pain’ from negative days. Yet so far, in 2018, it is pain that has been most evident.
| Period | Days with Negative Price Change | Cumulative Return from Negative Days | Days with Positive Price Change | Cumulative Return from Positive Days |
| 2015 | 53% | Loss of 29% | 47% | Gain of 46% |
| 2016 | 48% | Loss of 49% | 52% | Gain of 116% |
| 2017 | 43% | Loss of 25% | 57% | Gain of 59% |
| AVERAGE | 48% | LOSS OF 34% | 52% | GAIN OF 74% |
| 3/31/2018 | 44% | Loss of 24% | 56% | Gain of 29% |
Obviously, it is early in the year, and there are more than these two simple scenarios to consider, especially when managing portfolios during uncertain market conditions. Our investment horizon is long-term, and our strategies are employed in accordance with our intermediate-term assessments. We are very particular to not adjust our equity allocations in response to short-term market moves. Rather, we continually rebalance client portfolios to their long-term equity targets, consistent with their investment objectives and tax situations.
INSIGHT INVESTMENT COUNSEL