November 2018 - Over the past few months, equity markets have been experiencing an increase in volatility. While the daily ups and down can be unsettling, it’s appropriate to step back, assess the situation and gain some perspective in order to avoid panic. For much of the past few years we have become accustomed to the lack of volatility and so it is easy to forget that volatility is a normal part of market behavior. Since the 2008 market bottom, we’ve had 23 corrections where the market fell at least 5% and seven times where the market fell more than 10%. Many of these declines may have felt like “the top” but, in each of those prior instances, the market subsequently rebounded. That said, at AMI we continuously analyze the data to see if this might be the start of a prolonged downturn or if there is potentially light at the end of the tunnel. Here are a few things we are monitoring which would influence our view:
1) Valuations of companies have come down, especially within technology where things appeared to be overheated. Prior to October, the S&P Tech Index was up approximately 500% over the past 10 years and grew to become a large percentage of the S&P 500 relative to history. We believe some of what we are seeing now is the market normalizing this imbalance. Much of the recent sell-off has been led by tech stocks and fortunately, AMI strategies have generally been conservative within this sector. Though we like many of these companies, AMI has always been focused on those with recurring revenue business models with reasonable valuations which we believe can better withstand downturns.
2) We often get asked if a recession is imminent and at this point we do not see significant recessionary signals. This is an important point as corporate earnings, for the most part, have been positive in our view. It is true that some companies are feeling the impact of tariffs and rising wage. This is something we track closely and any negative change in the earnings outlook would be the main reason why we would alter our views. Specifically, we would look for signs of slowing demand or lack of an ability to pass on some of these higher costs which would suggest that earnings may have peaked.
3) Many investors still recall the impact of the 2008 downturn and are thus understandably skittish when volatility arises. However, the issues in 2008 with respect to banks and housing do not appear to exist today. Banks have healthier balance sheets and are willing to lend to people who are eligible.
4) The Federal Reserve is raising interest rates which always causes concern for the equity markets. However, rates are still very low relative to history and we do not think the Fed will raise rates dramatically if they see signs of a weakening economy. Recently, the Fed made it clear that they are aware of the risks in the market and this might lead them to slow down or even stop the rate hikes sooner than anticipated, which should help support stock prices.
5) AMI believes that much of the uncertainty in the market has to do with the ongoing trade skirmish with China. With President Trump, it is hard to predict how it will turn out or when we will see some resolution. What makes our outlook slightly more positive is that this President seems to care about the movement of the stock market, and so we do not think the trade issue will persist if markets continue to struggle. China’s stock market has been much worse off than the U.S., so we believe that both countries see the need to come to an agreement on trade. We believe that a positive outcome on trade should boost stock prices.
6) After the recent decline, the S&P 500 now trades at a reasonable valuation to earnings in our view (~15x P/E, down from almost 19x in early October). A 15x P/E is near the low end of the S&P 500’s historical range. The market is essentially already pricing in sluggish 2019 earnings growth, and any improvement or clarity on the prior points could lead to multiple expansion. While market volatility is never a pleasant experience, we believe that much of the correction is behind us and the above points suggest that there are opportunities for sentiment to improve. That said, we rigorously track corporate earnings, economic data, and management commentary for all the companies in the AMI strategies and are monitoring for any significant changes in the outlook.