Seeing the Forest through the Trees
The most challenging aspect of being a good investor is removing emotion from the decision-making process, and recent “breaking headlines” have thoroughly tested that resolve. The old adage about a bull market climbing a wall of worry has rarely been truer than it is currently. The S&P 500 is up 9.0% year to date through the end of the third quarter, and justifiably so. Our economy is strong, continues to strengthen and shows no signs of abating. While there have been some headwinds worth monitoring, stocks have been driven higher by very healthy economic conditions that should continue to provide further gains in the foreseeable future.
In the second quarter, GDP rose at a 4.2% annual rate. This was the strongest pace of growth in nearly four years and was powered by robust consumer spending, solid export activity and increasing business investment. These trends bode well for continued economic growth, with the Federal Reserve’s GDPNow model currently predicting 3.6% growth in the third quarter.
Consumers account for roughly 70% of the economy and their outlook remains strong. The U.S. Consumer Sentiment Index remains near all-time highs. Consumer spending continues to expand at a healthy pace. Not surprisingly, a lot of this strength is being driven by the low unemployment rate, which at 3.9% is near an 18-year low. Wages are rising and filings for unemployment benefits are now at a 48-year low.
Exceptionally strong business optimism is manifested in rising sales, hiring and investment activity. A leading indicator of economic activity, the NFIB Small Business Optimism Index is at its highest level in the survey’s 45-year history. Manufacturing activity is also expanding at a solid pace amid steady demand, with the Institute for Supply Management (ISM) Index near a 14-year high.
The current economic expansion is now in its 112th month, nearly twice the average length of post WWII expansions. Growth during this expansion has been slow and uneven, averaging a lackluster 2.2%, a full percentage point below the long-term average. The very strong second quarter results were boosted by one-time factors including trade and tax reform. However, even without those two tailwinds, upcoming quarters should continue to see above-average growth and a continuation of this lengthy expansion.
Our robust economy has produced strong growth for U.S. corporations. In the second quarter, S&P 500 companies saw revenues grow 9.5%, the fastest pace since 2011. That translated into an impressive 24.9% earnings growth rate in the second quarter, with 22.3% growth expected for the third quarter. Despite above average stock price gains year to date, strong earnings growth has resulted in lower valuations and a market now selling at a reasonable 16.8 times forward twelve-month projected earnings.
Stronger economic growth has given the Fed cover to continue to rachet up short-term interest rates from historic lows. Having begun to raise rates in December 2015, the Fed is attempting to bring them to a neutral level that neither stimulates nor slows the economy. The Fed has been very transparent about its intentions, increasing rates three times this year to a range between 2% and 2.25%. One more increase is expected in December and three in 2019. Despite the increasing cost of money, consumers remain resilient and the impact on the broader economy has been minimal so far.
Tariffs and trade wars linger as a potential impediment to further stock price gains. So far, the impact has manifested as increased volatility rather than lower returns. In fact, the S&P 500 added 7.2% in the third quarter even as tariffs began to go into effect. With the newly reached agreement between the U.S., Canada and Mexico, trade with two of our top three trading partners should normalize. For the U.S., exports account for only 8% of GDP versus 19% for China and 16% for Europe. Clearly these other regions’ economies are much more at risk and highly incentivized to break this logjam and reach agreement with the Trump administration.
One area that we are excited about and watching closely is the next generation of ultra-fast cellular networks. This fifth-generation technology, 5G, will open up an entirely new range of applications. Cellular carriers are currently in the process of launching 5G in major cities around the country. The U.S. dominance of the last generation of cellular technology enabled us to lead the way with new services and platforms such as Facebook, Uber, Instagram, Airbnb, Netflix and many others. Using the full potential of 5G, new applications such as self-driving cars and virtual reality may become commonplace. Phones compatible with 5G won’t become widely available until next year and when the technology is fully functioning, full-length movies will be able to be downloaded in a few seconds, for example.
In the 5G era, exponentially more machines and everyday objects will be connected to the internet. Not only are the data transmission speeds stunningly faster, but capacity also expands dramatically as the number of connected devices supported by the network increases by a factor of 500 times. This will enable the long-promised Internet of Things where everything from home appliances to implanted medical devices are connected to the network. Importantly, 5G technology also requires significantly less power than before, providing for much longer battery life.
There are still good gains to be had in the stock market. Our economy is strong, innovation continues and opportunities significantly outweigh risks. Reasonable valuations paired with strong earnings growth will lead to additional appreciation in stock prices. Those with the ability and patience to stay focused on facts and data will be well positioned to reap the coming rewards.
Holger Berndt, CFA Director of Research
