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This stock market is so strong investors hardly notice the corrections

What seems counterintuitive was made possible by a historically good quarter of corporate earnings.

As published in the Minneapolis Star Tribune 6/14/2018.

In financial terms, most investors define a correction as a drop in price of 10 percent or more. We thought a reminder might be helpful given that the current bull market, now in its 10th year, has delivered only four such corrections while the S&P 500 has more than quadrupled in that time. This bull has been so durable and so strong that it now appears capable of hiding corrections in plain sight.

You may already know that several U.S. stock indexes, the NASDAQ and Russell 2000 among them, are (again) trading near all-time highs. You might be surprised to learn that this latest run-up has coincided with a notable correction in valuations.

What seems counterintuitive was made possible by a historically good quarter of corporate earnings. Powered by corporate tax cuts, companies in the S&P 500 reported average earnings growth year-over-year of nearly 25 percent. That’s the largest annual increase in more than seven years.

Common sense suggests stock prices would bolt higher after exceptionally strong earnings, but skepticism about higher inflation, global trade and geopolitical events restricted the S&P 500 to only meager gains in April and May. The result: A stock market trading at a significantly lower valuation.

By the end of May, the S&P 500’s price-to-earnings (P/E) ratio had dropped to 16, the lowest it’s been in two years. The major indexes have climbed off their lows in the first half of June, but the S&P’s valuation remains far below the 18.5 P/E we saw in January. Percentage-wise, the S&P 500 fell by double-digits, but hardly anyone noticed because the change occurred in valuation, not share price.

In other words, many stocks remain attractively priced. It’s true that current valuations remain higher than their long-term averages, but that premium is justified given the reality of lower corporate taxes and a robust domestic economy.

That’s not to say the current environment is devoid of risk. Inflationary pressures continue to build, driving Fed policy and interest rates higher. Political uncertainty in Italy has renewed fears of a destabilized Europe. President Donald Trump has made waves in the global trading waters with ongoing tariff threats. And midterm elections this fall could alter the U.S. political landscape.

Investors can always find reasons to be pessimistic about equities. At this point, however, neither valuation nor the longevity of this bull market should be among them.

 

View the article on Startribune.com

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