February 2018 put the battle between bulls and bears on the big screen. Rising concern over inflationary pressures sent bond yields higher, igniting fear that the Federal Reserve would be forced to become more aggressive in raising interest rates. The scare triggered a sell-off across the major indices and at the close of trading on February 8th, year-to- date gains for the Dow Jones Industrial Average, S&P 500 and NASDAQ had been erased. Yet, markets quickly regained their footing as investors, emboldened by improving U.S. economic growth and strong earnings fundamentals, jumped into the fray propelling a dramatic rebound, as all three major indices exited February in positive territory. And with the month of March marking the 9th anniversary of the bull run, why are we, the contrarian investor, still bullish?
We believe the market is underestimating the health of America’s businesses. Although the birth of the current bull cycle was driven by a liquidity influx from central banks, relatively stable global growth and steady corporate earnings growth have supported the run.
In fact, S&P 500 corporate revenue and profits are on track to deliver the best earnings season in six years, up an estimated 8% and 15%, respectively. Earnings expectations for 2018 have surged by 19%, bolstered by the improving economy and U.S. tax reform. Additionally, we anticipate the second order effects from tax reform will be an added kicker, as new incentives encourage capital investment and the repatriation of cash from overseas. The windfall will likely deliver further stimulus at a more moderate pace, by way of employment, new plants, equipment purchases, the expansion of drug-research, mergers and acquisitions, as well as returning capital to shareholders through share buybacks or dividends.
In the meantime there is no question cyclical pressures on inflation are building, but in our opinion, technological innovation presents a considerable headwind. We wonder if productivity increases are fully being captured in the official inflation data as society continuously embraces transformative technology in the era of digitization – cell phones, computers, The Cloud, 3-D printing, artificial intelligence, etc. In our view, inflation may be overstated, while productivity may be understated. Official figures suggest productivity has been lower in the 21st Century relative to the 1990’s, and substantially lower if we look at the data over the last ten years. This is difficult to reconcile, particularly during a time of record profits.
E-Commerce is another technology-enabled disruptor to consider. The transparency that allows consumers to search and compare prices for goods and services, ultimately keeps prices low. Additionally, we have seen disruption to business models that have historically over earned or taken a markup on price through inefficiency. Obvious examples are Amazon vs. Retail, AirBnB vs. hotels and Uber vs. taxis.
Furthermore, wage growth is experiencing similar resistance due to advances in technology, automation and globalization. Falling trade union membership and fragmented labor markets due to more part time, freelance and temporary work are also negative influences. We agree with Federal Reserve Chairman Jerome Powell’s recent remarks, “some continued strengthening in the labor market can take place without causing inflation.”
While we acknowledge interest rates will likely rise further, history has shown that stocks can still do well against this backdrop. The chart below depicts the business cycles of the last 50 years. The arrows mark the periods during which rising interest rates coincided with rising or flat stock prices. So while the month of February was a reminder that markets do not go up forever – we think the bull market still has room to run.
The opinions expressed are current as of the date of this commentary but are subject to change. Earnings expectations for 2018 represent analysts’ consensus of the earnings forecast for the companies in the S&P 500 Index and do not represent a forecast of those companies’ performance in the stock market or of the performance of the companies held in Ariel’s portfolios.
