Last week, markets tumbled across the board, erasing 2018’s gains for most major global equity indices. Sharp downside market moves like last week’s serve as a reminder that the market will do whatever it needs/wants in the short run, oscillating around news du jour, recent news including trade wars, interest rates, Big Tech under the government microscope, government budgets, Trump tweets, etc. However, earnings and interest rates control the market’s long-term direction. We are long-term investors and will benefit from that over time. With that in mind, we are providing the following update, to help filter out some of the short-term noise and provide guidance on where we think the markets are heading.
Market Technicals and Multiples
Last week, the S&P 500 retreated to just above its 200-day moving average of 2585. That 200-day moving average support level held in February, the market is re-testing it again right now. Re-tests of prior pullbacks are a very normal market behavior. The market normally just needs some news to trigger that re-test and the market got all the news it needed to proceed last week. The next level of support below 2585 is the long-term trend line that goes back to the beginning of this bull market in 2009. That support is at 2475, the green line in the below chart, ~4% below where the S&P 500 is now.
At 2475, using projected earnings this year of ~155, the market multiple (P/E) is 16, which is attractive at these level of interest rates. Earnings are projected to increase ~10% in 2019, so more earnings growth to support higher stock prices. If we see $166 earnings in 2019, then the market multiple P/E gets below 15 at that 2475 price. Again, at these interest rates, that is a cheap market!
As already mentioned, one of the news du jour struggles right now for the market is whether the Fed raises rates three or four times in 2018. Yes, the Fed is raising short-term rates (Fed Funds), but the long-term rate in the U.S. fell in the last month, see 30-yr chart below. 30-yr rates hit 3.23% a month ago and now they are down to 3.06%, quite a decrease in a month. That means that the Fed will have trouble raising rates too much in 2018. The 30-year chart says three times, max. High quality bonds (the fixed income portion of portfolios) in the U.S. have rallied in the past month, see the second chart below. In the third chart below, notice how long-term bonds rallied (meaning long-term rates went down and prices of bonds went up) when the Fed made their announcement last Wednesday about the rate increase. Interestingly, when the Fed raises short-term rates, and long-term rates fall, that is what we call on Wall Street “a tell”. It tells the story of the future, that the Fed will have difficulty raising rates too much, because the market disagrees that it is necessary. Remember, the Fed at times has been really wrong about interest rates in its storied history. The market has been a much better predictor of future interest rates than the Fed. A billion human minds (the market) versus a dozen Fed minds and their staff… place my money on the collective intelligence of the billion minds in that competition, always.
On a discounted cash flow present value basis, using 2018 estimated earnings of $150 (we think it will be higher, $155, but let’s use $150 to be conservative) as the starting earnings and growing at 6% per year (we think earnings grow at 7%, as they have for 60 years, but let’s be conservative and use 6%) and a required total rate of return from equities of 10.5% per year, that equates to a present value of $150 / (10.5% – 6%) = 3,333 for the SP500. 30% ABOVE WHERE WE ARE TODAY… yes, we know that 3,333 on $150 earnings is a multiple of 22, but that is what the math says… if interest rates jumped considerably, then the required rate of return will increase from 10.5% to some higher number, and the 3,333 comes down… but interest rates are not going to jump considerably, look again at the U.S. 30-year Treasury Bond chart above, its “a tell”.
Trump was elected due to promises made during the campaign. While most politicians totally forget what they said during their campaign, apparently Trump is not like most politicians. One of the promises was a firmer posture in Chinese relations regarding trade imbalances and the lack of market accessibility to U.S. companies and investors. The voters loved that theme, elected Trump, and then initially the market loved that theme after the election, it rallied. Now the medicine is being administered and the patient does not like it, having difficulty digesting the fight to get “improved trade”. It comes with short-term pain and unknowns… the market hates unknowns.
Cooler heads should prevail this week, a pre-holiday week. Markets, historically, rally into holidays normally and the trade war rhetoric has already softened after weekend talks between the U.S. and China. Countries will act in their best interests and a trade war is in no one’s best interest – ultimately, a resolution will surface, and the market will refocus on earnings, which we believe are still indicating strength and potential for further upside.
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