With The Elevated Valuation Issue Solved, 2019 Earnings Growth Takes Center Stage

With S&P 500 profits set to come in around $157 for 2018, the trailing P/E ratio for the broad market index has fallen from 21.5x on January 1st of this year to 16.5x today. Surging earnings due to lower corporate tax rates have allowed for such a significant drop in valuations despite share prices only falling by single digits this year, which is a great result for investors. Normally, a 5 point drop in multiple requires a far greater price decline.

With sky high valuations now corrected, the intermediate term outlook for stocks generally should fall squarely into the lap of future earnings growth in 2019. On that front, there are plenty of headwinds. With no tariff relief in sight, the steady inching up of interest rates, a surging federal budget deficit, and no incremental tax related tailwinds next year, it is hard to see a predictable path to strong profit growth from here.

Even if 10-year bond rates go back into the 3’s, market valuations should stabilize in the 15-18x range, so stocks today appear to be fully priced for a relatively stable economic environment. Although current profit estimates for 2019 are quite high (double digit growth into the $170+ area), I suspect those figures will come down meaningfully once companies issue 2019 guidance in late January and into February (analysts don’t often go out on a limb so they will wait for companies to tell them what to expect).

Putting all of this together and we are unlikely to make new highs in the market anytime soon, in my view. We probably have 10% downside and 10% upside depending on various economic outcomes over the next few quarters. In the meantime, there are plenty of cheap stocks to accumulate and hold for the long term, until attractive exit points present themselves. Goldman Sachs (GS) is a perfect example, at it inexplicably trades for $176 today, below tangible book value of $186 per share.

Full Disclosure: Long GS at the time of writing, but positions may change at any time.

Momentum Trading Cuts Both Directions

Back on Monday October 19, 1987, the Dow fell 508 points, which was a decline of more than 22% in a single day. Today that same decline equates to roughly 2%. With the Dow trading at such high levels, in absolute point terms, a large decline might seem scary if not presented in percentage terms. The same is true when the financial media likes to focus on every 1,000 Dow points, as if a move from 25,000 to 26,000 is anything more than a simple 4% gain that historically takes less than 6 months, on average.

So rather than care about “a 1,000 point Dow decline!” let’s look at a one-year chart of the S&P 500 for some perspective:

As you can see, all we have done over the last two days, when the Dow has dropped 1,600 points, is give back the gains booked in January! When I look at this chart, I don’t see the mother load of all buying opportunities yet. I probably would not get even a little bit giddy about buying U.S. stocks unless we got back down to 2,400 or 2,500. That does not mean it will get there, or that I think it might (I — like anybody else — have no clue).

Momentum markets work in both directions, and when computerized algorithms conduct much of the daily trading in the stock market, moves like we see today can happen with ease, and most importantly, without tangible “reasons” behind them.

Most of the time I wish we could go back to the days when stocks were less volatile, a 10% correction occurred about once a year, on average, and the media did not over-hype days like today. It will make for good, scary headlines, but that’s about it.