- After experiencing strong and unusually steady gains last year, volatility has returned to the stock market. We view this as more of a return to normal market conditions after an anomalous 2017.
- Despite the recent volatility, underlying fundamentals have remained solid. We continue to favor stocks over bonds in this environment, albeit slightly. We continue to see better value in stocks overseas.
- The rising interest rate environment was a headwind for bond prices in Q1. We expect rates to rise only modestly and gradually, particularly towards the longer end of the yield curve. We also believe that a gradually rising rate environment can be good for long-term fixed income investors.
“No pain, no gain” may be most often heard around gyms, but this adage is often true of investing. Equities have historically delivered strong gains to investors over time, but they have not come without the pain of occasional declines. (Figure 1)
After delivering strong and unusually steady gains throughout 2017, volatility has returned to the stock market. In February, the S&P 500® entered its first official correction in two years, falling more than 10% from its previous high. Overall, the index finished the quarter with modest losses, snapping a nine-quarter streak of positive returns.
Despite the recent volatility, underlying fundamentals have remained solid. We continue to favor stocks over bonds in this environment, albeit slightly. While volatility may very well continue for stocks, we believe that investors who can endure the short-term pain will be rewarded with long-term gains1.
Volatility Returns, but Fundamentals Solid
The S&P 500 bounced up and down by at least 1% 23 times in the first quarter compared with a total of just eight times for all of 2017. Despite the increased fluctuations in stock prices, business fundamentals remain strong.
Continued economic growth, both here and abroad, is expected to boost corporate earnings significantly this year. Recently enacted corporate tax cuts provide icing on the cake. Based on proprietary research from Thomson Reuters, 2018 earnings “per share” for the S&P 500 are projected to grow a stellar 19% year-over-year, marking the highest growth rate since 2010. Earnings estimates for 2019 currently call for 10% growth on top of that. (Figure 2) Perhaps more importantly, these growth estimates are higher than they were at the beginning of the year.
Major data points continue to point to an improving economy while recession risks appear low. Recent surveys by the Institute for Supply Management indicate strong expansion throughout the economy. The labor market remains its strongest in years, with the unemployment rate hovering near its lowest levels since 2000. The tax cuts and $1.3 trillion federal spending bill are likely to boost economic growth even further near-term, although we worry about the long-term budgetary implications.
Economic fears seem to have turned from that of sluggish growth/deflationary to potential over-heating/inflationary. The Federal Reserve has increased rates five times since December 2016 and currently projects two to three additional rate hikes this year. Long-term interest rates have also risen this year in response to potentially stronger growth and higher inflation.
While interest rates remain low by historical standards, monetary policy has been tightening, which has likely created a headwind for equity valuations. Recent trade restrictions between the U.S. and China have weighed on stocks too, as investors fear fallout from a potential trade war. The forward price to earnings ratio for the S&P 500 now stands around 16x - near its long-term average - compared to 19x at the beginning of the year. (Figure 3)
We believe that valuations look reasonable for U.S. stocks. However, we currently see better value overseas and remain overweight international equities. The U.S. has enjoyed a long and strong bull market over the last nine years while many international markets have floundered. This has left a wide valuation gap between the two. While we see additional runway for growth in domestic equities, many of the international markets appear to be just leaving the gate.
Bonds Can Go Down Too, But…
The rising interest rate environment was not just a headwind for stock prices in Q1, bond prices were also impacted. The Bloomberg Barclays US Aggregate Bond Index declined 1.5% in the first quarter, providing a reminder that bonds can go down too.
We believe that losses on a high-quality, well-diversified bond portfolio are likely to be relatively minor compared to potential declines in equities. In other words, the pain is usually much more moderate for bond investors. Of course, the gains are usually much more moderate over the long run too. Risk and reward often go hand-in-hand. We also note that a gradually rising rate environment can be good for long-term fixed income investors, as rising rates allow them to reinvest their coupon and principal payments at higher yields over time.
Moreover, we expect rates to rise only modestly and gradually, particularly towards the longer end of the yield curve, given the push and pull between cyclical and secular forces. The current spread between long-term and short-term interest rates is relatively narrow and could contract even further. Thus, we prefer bonds with relatively shorter maturities, as we believe that fixed income investors are currently receiving little additional compensation for taking on additional interest rate risk.
Credit spreads remain narrow too, providing investors with little additional compensation for taking on additional credit risk. As a result, we continue to prefer high quality, investment grade bonds. (Figure 4)
The Bottom Line
Volatility has returned to the stock market. We view this as more of a return to normal market conditions after an anomalous 2017. Superior gains from equities do not come without the pain of substantial declines from time to time. However, fundamentals remain solid, and we continue to slightly favor stocks over bonds in this environment.
Our outlook for both stocks and bonds over the next five to ten years remains unchanged, as we continue to expect returns from both asset classes to be below their long-term historical averages. (Figure 5)
COUNTRY Trust Bank Wealth Management Team
- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Officer
- Jonathan Strok, CFA - Investment Analyst
- Austin Burant - Investment Associate
1. Past performance does not guarantee future results.
The S&P 500® Index is an unmanaged index consisting of 500 large-cap stocks. Since it includes a significant portion of the total value of the market, it also considered representative of the market. The index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The Institute for Supply Management’s non-manufacturing index is based on data compiled from purchasing and supply executives nationwide. Survey responses reflect the change, if any, in the current month compared to the previous month. The NMI® (Non-Manufacturing Index) is a composite index based on the diffusion indexes for four of the indicators with equal weights: Business Activity (seasonally adjusted), New Orders (seasonally adjusted), Employment (seasonally adjusted) and Supplier Deliveries. An NMI® above 48.9 percent, over a period of time, indicates that the overall economy, or gross domestic product (GDP), is generally expanding; below 48.9 percent, it is generally declining. The distance from 50 percent or 48.9 percent is indicative of the strength of the expansion or decline.
The Institute for Supply Management’s manufacturing index is based on data compiled from purchasing and supply executives nationwide. Survey responses reflect the change, if any, in the current month compared to the previous month. The PMI® is a composite index based on the diffusion indexes of five of the indexes with equal weights: New Orders (seasonally adjusted), Production (seasonally adjusted), Employment (seasonally adjusted), Supplier Deliveries (seasonally adjusted), and Inventories. A PMI® reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally declining. A PMI® above 43.3 percent, over a period of time, indicates that the overall economy, or gross domestic product (GDP), is generally expanding; below 43.3 percent, it is generally declining. The distance from 50 percent or 43.3 percent is indicative of the strength of the expansion or decline.
The U-3 unemployment rate is the nation’s official unemployment rate, as measured by the Bureau of Labor Statistics. It defines people as unemployed if they do not have a job, have actively looked for work in the last four weeks, and are currently available to work. The U-3 rate is calculated by dividing the number of unemployed by the labor force (the sum of the employed and unemployed).
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.
The price-to-earnings ratio is a valuation ratio which compares a company's current share price with its earnings per share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be derived from the estimates of earnings expected in the next four quarters (projected or forward P/E). The ratio is also sometimes known as "price multiple" or "earnings multiple."
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the USD-denominated, investment-grade, fixed rate, taxable bond market of securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS sectors. It is not possible to invest directly in an index.
The yield curve plots the interest rates of similar-quality bonds against their maturities. The most common yield curve plots the yields of U.S. Treasury securities for various maturities.
Duration is a measure of a security’s interest rate risk. It is based on the timing of cash flows received by an investor and expressed in years. Longer duration securities typically have higher price sensitivity to interest rate changes than shorter duration securities.
Credit spreads measure the difference in yields between bonds with the same maturity but different credit quality.
Moody’s Investors Service provides ratings to securities in order to provide investors with a simple system of gradation by which future relative creditworthiness may be gauged. Moody’s Aaa-rated obligations are judged to be of the highest quality, subject to the lowest level of credit risk. Its Baa-rated obligations are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.
The long-term average return data in Figure 5 comes from Morningstar. The long-term annual return for each asset class is the compound average annual return from the period from 1926 through 2016. Stocks are represented by the Ibbotson® Large Company Stock Index. Bonds are represented by the five-year U.S. government bond. Cash is represented by the 30-day U.S. Treasury bill. Balanced Portfolio is representative of an investment of 50% Stocks and 50% bonds rebalanced annually from 1926 through 2016. These returns are for illustrative purposes and not indicative of actual portfolio performance. It is not possible to invest directly in an index.
Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
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All information is as of the report date unless otherwise noted.
Past performance does not guarantee future results. All investing involves risk, including risk of loss.
This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.
Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.
Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.
International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.
Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.
Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.
All indexes are unmanaged and returns do not include fees and expenses associated with investing in securities. It is not possible to invest directly in an index.