John Lynch Chief Investment Strategist, LPL Financial
The current environment looks favorable for strong earnings and stock gains. We do expect volatility, but steady economic growth provides a strong backdrop and the potential for opportunity.
The first half of 2018 saw the return of equity volatility after the docile trading patterns of 2017. The surge in bond yields after the January jobs report, along with the initial trade concerns in late March, resulted in the first market corrections (a pullback of at least 10.0%) since the Brexit vote in June 2016. Though higher bond yields caused market disruptions, rising market interest rates (especially from relatively low levels) have typically been associated with an improving economy and higher stock prices. As a result, when viewing market volatility in the context of steady economic growth, it is not something to fear, in our opinion, but to embrace, as temporary market selloffs may provide suitable investors with opportunities to rebalance portfolios toward long-term targets.
Given that the Fed is well on its way to unwinding accommodative measures, we encourage investors to focus on the fiscal tailwinds of favorable taxes, regulation, and government spending, while identifying companies that are willing and able to take advantage of these developments.
MIDTERM ELECTIONS: THE NEXT MARKET CHALLENGE?
Throughout the increased volatility in the first half of the year, we’ve emphasized to investors that “bottoming is a process.” In other words, when the market does experience a correction, even as the catalysts for that decline dissipate, the recoveries can still take several months. We saw this in 2011 and 2015, and this year has been no exception. The second half of the year will also likely see the added potential headwind of midterm elections, which have historically provided the most volatility within the four-year presidential election cycle.
Because the president’s party typically loses approximately 25 House seats, investors have historically struggled with the policy uncertainty leading up to midterm elections. The good news is that stocks tend to bounce back strongly after midterm election year corrections, as the average decline (-16.0%) has been followed by a solid recovery from the trough (+32.0%) over the ensuing 12 months
THE STRENGTH TO PERSEVERE
We also believe that during volatile periods, investors should focus on positive fundamentals like the strength in corporate profits. In the first quarter of 2018, S&P 500 Index companies’ earnings per share (EPS) came in well ahead of expectations. Given this development, we have decided to slightly upgrade our operating earnings forecast from $152.50 to $155.00 per share for the S&P 500, which would represent approximately 17.0% year-over-year growth.
Our forecast is still below consensus expectations and may prove conservative given the substantial impact of the transition to fiscal leadership. However, we remain cautious due to several ongoing factors that could affect earnings:
- A stronger U.S. dollar would affect the EPS currency translation for multinational companies.
- Geopolitical risks and trade tensions may hinder capital spending.
- Wage increases could negatively impact companies’ profit margins.
Based on our earnings forecast (of $155 EPS), our fair value projection is for the S&P 500 to trade within the range of 2900–3000 by year-end, which at the midpoint represents an annual increase in excess of 10.0% for the index and a target price-to-earnings (PE) ratio of 19. A PE of 19 is slightly above its historical average; however, when put in the context of still relatively low interest rates and low inflation, we believe a PE at this level is justified.