Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%. S&P 500 operating earnings per share grew 27% year-over-year in the quarter—compared to their 6% long-term annualized growth rate. A record high 80% of S&P 500 companies reported earnings that beat the consensus expectations. Record levels of share buybacks (estimated by Goldman Sachs to reach $1 trillion for 2018) were another pillar of support for the US market.
Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%. Foreign stock markets were impacted by poor sentiment, and a rising US dollar was a further drag on returns for dollar-based investors.
In fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index had a negative return in September and was flat for the quarter.
Our active bond managers (after a difficult 2nd quarter) performed much better this quarter. We expect these positions to continue to do well, particularly if interest rates continue to rise. The Federal Reserve has raised rates three times so far this year with a fourth teed up for December. Policymaker forecasts call for three more increases in 2019.
Our balanced portfolios also continue to hold liquid alternative strategies funds. This year our positions have not helped our portfolios, but we still believe that these positions will improve our portfolios’ long-term risk-adjusted return potential.
In 2018, US stocks have strongly outperformed EM stocks. Still, given the negative headlines surrounding emerging markets, we highlight several points this quarter that indicate EM stocks remain attractive and their long-term growth outlook is intact. On the other hand, US stocks look expensive, and there are reasons to think the near- and medium-term outlook for them may not be rosy. The valuation of the US stock market represents one of the biggest risks to our portfolios, which is why we maintain a meaningful underweight to US stocks.
Market trends in the third quarter were largely an extension of what we’ve seen so far this year, with a stark divergence in return between US stocks and EM stocks. The US market was propelled by continued strong profit growth, beating emerging markets by roughly 20 percentage points year-to-date through the end of September.
It is common for US stocks or EM stocks to outperform the other over 12-month periods. Just last year, EM stocks gained 31.5% and outperformed the S&P 500 by roughly 10 percentage points. That has sharply reversed this year.
Reiterating Our Outlook for EM and US Stocks
Emerging Market Stocks (EM)
While there are always multiple factors behind short-term market moves, there were two dominant headwinds facing EM stocks in the third quarter: the intensifying trade conflict between the United States and China, and the strength of the US dollar. While neither of these factors presents new or material threats to our analysis of EM stocks, they have impacted our portfolios’ short-term returns by holding EM stocks back relative to the US.
However, there are several points worth highlighting that give us confidence in our assessment that EM stock valuations are cheap and their attractive long-term return potential remains intact:
- Our base-case continues to be that a full-fledged trade war is unlikely as it is in neither country’s best interest, despite the fact that we may be forced to live in a world with an overhang of trade tensions for a while.
- US dollar strength has hurt dollar-based foreign stock returns, but longer term, there are reasons to think this will reverse. Today the US economy is strong, but when it eventually cools, the high debt levels in the US will be a potential headwind for the dollar.
- Economic crises in Argentina and Turkey have made headlines, but these countries’ economies and financial markets are small. We see little risk of contagion to other emerging markets. In contrast to previous EM crises, the fundamentals of most other EM countries are much healthier in terms of debt levels, trade balances, dependence on foreign capital, foreign exchange reserves, etc.
- When we apply the historical discount EM stocks have traded at compared to US stocks, we still find them attractive. EM stocks are even attractive after adjusting for sector differences between US and EM markets.
As for US stocks, no one knows exactly when this record-longest bull market will end. It’s certainly possible US stocks will continue to be favored by investors for some time. However, expectations for S&P earnings growth are now exceedingly high, and the US economy is operating at or near full capacity and full employment. We believe these are unsustainable conditions.
Speaking of corporate earnings, they have been very strong over the past year, supporting the US bull market. But market earnings expectations are now very high—likely too high for the market’s own good. For example, BCA Research calculates that analysts expect the average S&P 500 company to grow earnings at an annual rate of 17% over the next three-to-five years. In BCA’s words, “this is wildly optimistic.” As the chart to the right shows, this forecast is topped only by the 19% growth forecast at the height of the tech bubble in 2000, just before that bear market began.
Ned Davis Research makes a similar point. Their analysis indicates that periods of very strong earnings and forecasted earnings growth are associated with poor subsequent stock market returns. This may seem counterintuitive, but it is how markets operate, particularly at the extremes: when investors are extremely bullish, the market likely already reflects that optimism in current prices and valuations. The potential for actual earnings to disappoint those bullish expectations is high.
By our way of thinking, being an “investor” is synonymous with having a long time horizon. In the financial markets, almost anything can happen in the short run because market prices are driven more by investor sentiment, unpredictable events, and human herd behavior. But as you extend your investment horizon, market returns are determined by economic and business fundamentals (earnings and dividends) and valuations (what you pay for those earnings and dividends).
No matter how we slice it, our analysis suggests the US market, on a relative and absolute basis, is the most expensive major stock market in the world today and, as a result, presents a poor return-versus-risk tradeoff. We also believe skilled, fundamentally-driven active managers can add a lot of value relative to market indexes in this next phase of the cycle.
EM stocks are currently and significantly cheap relative to their US counterparts. Looking at valuations another way, according to Research Affiliates, prior to the 1997–1998 EM Asian crisis, the EM CAPE (cyclically adjusted price-to-earnings ratio) was trading at a premium to the US CAPE. Today, EM stocks trade at a very large discount: an EM CAPE of 13x compared to 30x for US stocks.
EM equity valuations are attractive, and their medium-to-longer-term growth outlook remains intact. But these positions come with additional shorter-term risk. Poor investor sentiment and capital outflows could potentially trigger an adverse feedback loop between emerging markets and economic fundamentals. However, this has always been a risk with emerging markets, and we take it into account in our portfolio construction and risk management. China debt-deleveraging, trade wars, and a resulting growth slowdown are additional nearer-term risks.
But we are longer-term investors. While balancing the short-term risks, we are currently assessing whether the recent EM downturn and divergence with the United States offers an attractive opportunity to increase our allocation to EM stocks. The same holds true for our tactical position in International and European stocks. As always, we continue to analyze new data and information, and if our analysis warrants a change in our views, we will.
Thank you for your continued confidence and trust.
–Jon Houk, CFP®
Third Quarter 2018 Investment Newsletter | Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Jon Houk and Gratus Capital with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.