During the first quarter of 2018, stocks finally behaved like stocks. The return of volatility served as a jolt that awakens investors from the complacency of the steadily rising market of past few years. For the quarter, S&P 500 fell 0.76% on a total return basis. The index started the year at 2674. It soared to a height of 2873 on January 28, but promptly plunged to a depth of 2581 less than two weeks later. For the rest of the quarter, it gyrated back and forth in an uncomfortably wide trading range.
The fall of S&P 500 was initially promptly by January Employment report showing much higher than expected wage growth and other signs of rising inflation. The 10-year Treasury had been rising all year and climbed above 2.9% shortly afterwards. The rising yield heightened the valuation problems for stocks. The January estimated 2018 earnings for S&P stood at $148. At the index’s highest point during the past quarter, stocks were trading at 19.4 times earnings.
The February Employment report that came out in early March brought the inflation fear to at least a temporary halt. The higher wage growth of January had been reversed. It was conjectured that the unusually cold January weather in Northeast which shut down many roads caused hourly workers to be furloughed. With a greater proportion of management type in the work force, the reported data thus exaggerated wage growth. Long dated Treasury securities rallied and the yield on 10-year is now below 2.8%.
For stocks, the respite was ephemeral. With tax legislature in the rear view, the current US administration has moved on to another of its major campaign promises, namely trade. The opening volley was an announcement of higher steel and aluminum tariff. With 160 existing trading restrictions on importation of Chinese steel, the People’s Republic was a rather minor player. The splash of the discharge seems to hit many US allies except its intended target. The second volley was aimed at China squarely with a package of yet to be announced specific measures on at least $50 billion of Chinese imports. Trade has now replaced inflation as the greatest threat to the long running equity bull market.
Reduction in corporate tax rate and strengthening economic outlook have brightened the corporate earnings picture considerably over the past couple of months. In fact, the fallen equity price and stronger upward earnings revision have made stocks much more attractive. The 2018 earnings estimate for S&P 500 now stands at $158. With March’s closing price, the index’s PE ratio stands at 16.7. This is only slightly higher than the 5-year average of 16.1. On the current 2019 estimate, the S&P 500 PE ratio is at 15 which is only slightly higher than the 10-year average of 14.3.
Going forward, valuation will no longer serve as a detriment to stock price. We continue to favor energy, materials, and financials as attractive late cycle opportunities.
Dong Hao Zhang
President & Chief Investment Officer