“Buy American” sums up the story of the markets thus far in 2018. Markets around the world were strong last year on the back of a synchronous global economic recovery. It was difficult to find an index that was not up on the year. Emerging market stocks, for example, posted a gain of nearly 40%, and almost every country within the EM index was up. Economic activity has diverged this year, with the United States accelerating (Q2 GDP growth was 4.2%, up from 2.2% in Q1) and other areas having a more challenging time, most notably those very same emerging markets that were so strong last year.
As of September 17, the S&P 500 index returned 10.2%, the Russell 2000 index (a measure of small-cap stocks) rose 13.1%, and the tech-heavy NASDAQ had risen nearly 17%. Meanwhile, developed market stocks outside the U.S. as measured by the MSCI EAFE index were down 3%, and EM stocks had fallen 9.2%. The strong performance by the Russell 2000 is noteworthy because this index is composed of small-cap companies with U.S.-centric businesses, and therefore leveraged to an improving U.S. economy, that also were the primary beneficiaries of a lower corporate tax rate.
From a sector perspective, Technology (up 19.7%), Consumer Discretionary (up 19.4%), and Health Care (up 14.2%) are the only sectors within the S&P 500 to outperform the overall index. Technology is building on its strong gains from last year, but results from the large tech companies remain strong and this continues to attract investor dollars. Recent headlines over the sharing of customer data, the role in potential election meddling, and whether some social media platforms are politically biased put a crimp in the prices of select issues. While the topics are serious, these are the type of headlines that often pressure share prices to levels that create attractive opportunities.
We think the outperformance of the U.S. market, and small-cap stocks in particular, can continue for the balance of the year. First, GDP growth in the U.S. should remain robust. While it may not be above 4%, third-quarter GDP growth is tracking to be above 3%, which Is still well ahead of the somewhat anemic levels of economic growth seen in recent years. Second, as we get closer to the end of the year, it becomes more likely that portfolio managers will ride their winners and cut their losers. Any investor that finds him/herself lagging the averages in what has been a strong year to date has an incentive to try and catch up before the year ends. This phenomenon is often referred to as FOMO, or “fear of missing out.” Third, the valuation on U.S. equities is still reasonable.
With the S&P 500 trading around 2,900, the index is selling for about 17.5x this year’s earnings estimates and 16.2x next year’s projection of $178. Earnings for the S&P 500 are projected to grow 10% in 2019, so if the valuation on the index remains stable then the S&P could rise another 10% next year. The average P/E multiple on the S&P 500 is about 16.0x, but given that interest rates are still low and that earnings are still growing, we believe a valuation on the index modestly above the long-term average would be reasonable.
Speaking of interest rates, the yield on the 10-year Treasury stands at 2.95%. This time last year it was closer to 2.1%. The backup in rates has caused modest declines in fixed-income markets generally, which is also supportive of equities. Given a positive economic outlook, the path of least resistance for interest rates is higher, in our view. As such, fixed income investments are likely to remain under a bit of pressure.
Please contact your Thompson Davis investment advisor with questions on these thoughts or regarding any of our investment services.
- Jack Kasprzak, CIO