The S&P 500 Index jumped in Q3 to provide its best quarter since Q4 2013 and third-best quarter since 2010. However, shortly after the closing of the most recent quarter, selling pressures returned to the stock market, particularly to the more cyclically oriented growth stocks. These types of events are reminders that investors need not be caught up by short-term exuberance nor fear, as neither are components of a well-disciplined long-term investment plan. The Tellone position on this downside volatility is unchanged from our position throughout this year. Volatility is normal and naturally occurring, and we view the current action as a classic symptom of market correction, not the start of a bear market. We urge investors again to remain patient and focus on the economic fundamentals, which remain favorable.
This advice may sound familiar, as it echoes that of earlier this year in February 2018 when the stock market experienced a correction of 10% that lasted about two months. It was an appropriate call to remain patient back in February and we believe the same is true today. While many concerns of the moment are real (i.e., slowing global growth, peaking corporate earnings, and higher interest rates), we also think equity market volatility is typical within an aging economic cycle. Most importantly, we believe sentiment is worse than reality and we do not see imminent risks of recession or an end to the equity bull market – at least not over the next 12 months.
Our viewpoint is based on economic indicators, such as the Ned Davis Research Recession Probability Model, which continues to indicate minimal risk of recession in the near-term. Additionally, the Ned Davis Research composite leading index recently rose 3.4% on a year-over-year trend basis, the fastest pace since March 2011, suggesting a broadly positive outlook for growth over the next six months. To boot, JPMorgan Chase CEO Jamie Dimon recently commented that the expansion is only in the “sixth inning,” which is consistent with ISI Evercore’s recession model that shows the next recession is still years away. Outside of the US, the global economy appears to have downshifted a bit, nevertheless, we think the momentum is bottoming. The eurozone appears to be stabilizing and we think China will experience a soft landing. All of this suggests that the global economic backdrop will continue to support US corporate earnings. Economic and corporate fundamentals remain solid and earnings growth has been particularly strong in 2018, even while prices have fallen. Interestingly, this means valuations are more attractive now than when we began the year.
Recent equity market weakness is not a reflection of current Q3 earnings announcements, which have been largely positive. We attribute it to seasonality and the uncertainty surrounding the sustainability of strong earnings in 2019 and beyond, explicitly amid rising concern about trade conflicts and their impact on global supply chains. The reality is that estimates for third-quarter earnings-per-share and fourth-quarter sales have drifted higher over the quarter, even as headlines have focused on negative surprises. One of those main negative concerns being the impact on global supply chains of a deteriorating US trade relationship with China. While not a long-term worry, increased tariffs could prompt some companies to shift supply chains out of China, thus pushing potentially significant adjustment costs to the forefront and threatening corporate margins in the quarters ahead. As such, any easing of trade tensions would prompt a significant bounce back in the markets. Meanwhile, on average, midterm election years have historically been the weakest of the four for US stocks. Post-midterm election, though, US stocks have not experienced a decline in the 12 months following since 1946, and the average price gain for the S&P 500 Index during this period has been 15.3%. Concurrently, small-cap stock’s most bullish time of the year starts in November and runs through February.
For those asking how long the bull market can continue, we would answer that question by asking another: How long will the economy expand? Our assessment is that the current expansion should proceed well beyond 2019 and continue to impress with its durability and longevity. While rising interest rates will remain a point of conversation, an inverted yield curve has yet to materialize and Federal Reserve Chairman Jerome Powell has made data-dependent monetary policy decisions that make sense at face value. The economy is strong, labor markets are tight, wages are growing, and inflation has firmed. More than any other time in history, the Federal Reserve is telegraphing their monetary policy objectives and making their plans for interest rates quite clear. At no point under current Fed leadership has the market been taken by surprise from Fed actions, and we expect such transparency to continue. For now, interest rate hikes are beneficial to sustainable economic growth at this stage in the expansion.
We concede that early indications suggest 2019 will likely present a more challenging economic and market environment. We believe earnings growth is likely to slow next year, while monetary policy around the world is likely to become less accommodative. Nevertheless, we are maintaining our fully invested models as absolute stock valuations globally are within their historic ranges and US valuations as a whole are only slightly above long-term average. Our active management is dictating that investment selectivity become increasingly important. Within fixed income, we are shortening duration with conservative ultra-short-term bonds and using total return bonds as a ballast to dampen portfolio volatility. For stocks, we are focused on companies with substantial cash earmarked for buybacks and those we feel are well positioned for growth regardless of what happens with broader economic conditions. Additionally, call and put options allow us to capture value during moments of overbought and oversold conditions. Consistent with our investment philosophy and process, we believe volatility often presents compelling investment opportunities in strong companies that are being mispriced by the market over the short-term. It is our conviction that stock markets will reach new records once again before this bull market comes to a close.