This is a valuation correction, not a response to a weaker than expected economy.

Stocks are now valued below historic norms.  No one knows whether the next 5% is up or down but valuation is now on your side.  Unless there is a pending recession hidden by any data we can find, equities should offer above average returns over the next year plus.

Stocks got slammed once again on Monday is holiday-shortened session dropping close to 3%.  If there was any solace, the stocks that did the worst on Monday were the names that had held up the best in the recent correction, namely consumer staples, drug stocks, REITs and utilities.  An old saw on Wall Street says that the bear ultimately gnaws everyone in the end.  The best performers get beaten up last.  Maybe, therefore, that is a sign that the worst is just about over.

If I had to characterized the almost 20% correction between Labor Day and today, I would say most of it related to valuation.  The economy continues to perform strongly.  And while the market decline is prejudicing opinions to suggest that some economic evil lurks just past the horizon, there is almost nothing in the economic data of the last four months to suggest that growth this year or next year is going to be any different that what was forecasted on Labor Day.  We all know now and knew then that earnings per share growth, which has averaged close to 20% this year, would fall significantly next year once the tax cuts were anniversaried.  

Tariffs?  While President Trump repeatedly threatens to raise tariffs on European cars and Chinese goods, nothing has changed much over the past four months and the odds of a massive increase in tariffs pending is about the same today as it was then. 

The yield curve?  Some feared inversion, a signal of a pending recession.  But while the 2-10-year spread narrowed at one point to just under 10 basis points, it is back up to almost 20 basis points this morning.  It was about 25 basis points in September. Thus, despite all the noise and chatter you hear in the media, the bond market is not signaling recession.  If it is signaling anything, the decline in the yield on 10-year Treasuries of close to 50 basis points to (1) a flight to safety in a sharp market decline, a very natural occurrence and (2) a moderate decline in inflation expectations.  The latter should be good news. 

How about the Fed?   I would contend that the Fed has done exactly what everyone expected four months ago; it increased rates 25 basis points in December and suggested future rate increases would be data dependent.  The December forecasts for 2018 moderated just a bit and so did expectations of future rate increases.  

How about Europe?  Europe is slowing about as expected.  Brexit is proving to be a bit more complicated that one might have hoped four months ago but there are still three months to come to some reasonable conclusion.

How about the mid-term elections?  The general consensus was that Republicans might gain a seat or two in the Senate and lose control of the House.  That is exactly what happened.  While there may be a lot of investigations and noise that which rankle a lot of liberal and conservative feathers in the months ahead, from the stock market’s point of view, little is likely to happen.

Trump?  Some may view him as a bit more volatile and unpredictable.  His rants against the Fed can’t help but the Fed has made it clear that it isn’t allowing political noise to affect its actions.   That may not be 100% true but it seems to be pretty close.   Washington turmoil can’t do much to placate investor fears but no one can argue with any relevant data that what is taking place in the economy is having much economic impact.  According to Mastercard, retail sales from November 1 to December 24 (ex-cars) were up 5.1%, the best performance in six years.  In-store sales were up 3%; a year ago some speculated they would never rise again.  87% of sales were done at retail.  Online sales rose 19%.  Will they slow next year?  I don’t know how anyone can speculate.  What I can suggest is that lower gas prices and expected higher tax refunds should keep sales strong at least through the first several months of 2019.

There must be some negative surprises.  What were they?  I would argue that investment spending is less than what was expected 4-6 months ago.  Tariff fears and Washington uncertainty are probably the culprits. Oil prices have collapsed over the past three months.  That helps energy consumers but it demolishes an industry still reeling from a price collapse a little over two years ago.  Housing had been soft going into the fall but the pace of decline accelerated as mortgage rates rose.  But with rates now declining and input costs, notably lumber, declining, it is possible that the important spring selling season might see some signs of improvement.

GDP rose over 4% in the second quarter and over 3% in the third quarter.  According to surveys, Q4 looks on track to rise about 2.5%.   None of this synchs with a stock market down 19% from its late summer peak.

So, let’s look at where we are today.  As of Monday’s close, stocks were at 14.5x trailing earnings and about 14.0x forward estimates, about one multiple point below historic norms.  Adjusted for the recent inclusion of REITs into the index, maybe the gap today is 1.5 multiple points meaning the S&P 500 at about 2350 should be valued at closer to 2600 based on historic norms.  At its peak it got a bit over 2900.  Should it still fall a bit more, it could get a far below fair value as it got above fair value in February or late summer.

But if one steps back and tries to filter out all the noise, all the insanity of Washington, all the fears you hear 24/7 on CNBC, etc. I come up with the following.   Stocks generally rise about 5-6% plus the rate of inflation, or about 7-9% per year.  For some time, I warned that, because the market had been overvalued, future expected equity returns would be less than historic norms.  Now, with stocks somewhat undervalued, I would argue that forward-looking returns will be greater than historic norms using today as a starting point, perhaps something closer to 9-10% per year.

There are some caveats to this thesis (there are always caveats!).  First, with volatility far above normal levels, I have no idea whether the next 1000 Dow points are up or down.  Heck, the Dow could move 1000 points in a day.   Second, I am presupposing no major economic disruption.  I remind everyone that economic recoveries don’t die of old age; they die of imbalances and bad policy. An escalating trade war would be an example of bad policy but I am not predicting that and I don’t think the market is either.  Some want to point to the recent 25 basis point rate increase by the Fed as bad policy.  Time will tell whether that is true or not.  Certainly, raising rates in such a negative market environment had an undesired short term effect but that could get erased quickly with any change in sentiment.  But if inflation is somewhere a bit under 2%, a Fed funds rate of 2.25-2.50% can hardly be described as a sign of extremely tight policy.   If markets don’t stabilize very soon, the Fed could slow the pace it is shrinking its balance sheet.  If it slowed that from $50 billion per month to a lower number, stocks would rally immediately.  One problem prognosticators have is that they don’t look ahead more than 1 move.  Despite some who say the Fed is blind, it isn’t and, if necessary, it will react. 

All this, says today is a better time to buy than to sell.  Liquidity always dries up at year end and that accentuates market moves.  In a down market, it stokes fear.  Good investors have to control emotions.  We made not get the whole September-December decline back quickly but, if no recession is pending, 12 months from now one should be handsomely rewarded for purchases made today.  To be sure, there are risks; there always are.  Tariffs and Trump-related uncertainties are two.   Analysts still have to adjust 2019 estimates down a bit but not nearly as much as some suggest.  Right now, the mood is to sell the rallies.  That will work until it doesn’t.  My two-day rule comes into play here.  Most rallies recently could be measured in hours.  The first thing one wants to see is a market that finishes a session at a high.  Then next day follow through is needed.  After a 19% decline, missing the first 3-4% isn’t going to be life threatening to your portfolio. But get your shopping list ready.  December 26 offers great bargains in retail stores.  It may offer great bargains in the stock market as well.

Today, Jared Leto is 46.

James M. Meyer, CFA 610-260-2220

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