Gloomy clouds rolled in late last year in the form of a government shutdown; U.S.-China trade-war tensions; hawkish Federal Reserve interest rate policies; a continued special counsel investigation by Robert Mueller into potential Russian election interference; a change in the congressional balance of power; Brexit deal uncertainty; and U.S. recession concerns, among other worries. These fear factors contributed to a thundering collapse in S&P 500 stock prices during the September-to-December time frame of approximately -20% (from the Sept. 21 peak until the Dec. 24 trough).
However, the dark storm clouds quickly lifted once Santa Claus delivered post-Christmas stock price gains that have continued through February. More specifically, since Christmas Eve, U.S. stocks have rebounded a whopping 18%. On a shorter-term basis, the S&P 500 index and the Dow Jones Industrial Average have both jumped 11.1% in 2019. January showed spectacular gains, but last month was impressive as well, with the Dow climbing 3.7% and the S&P 500 index 3.0%.
The rapid rise and reversal in negative sentiment over the last few months have been aided by a few positive developments.
- Strong Earnings Growth: For starters, 2018 earnings growth finished strong with an increase of roughly 13% in fourth-quarter 2018, thereby bringing the full-year profit surge of roughly 20%. All else equal, over the long run, stock prices generally follow the path of earnings growth (more on that later).
- Solid Economic Growth: If you shift the analysis from the operations of companies to the overall performance of the economy, the results in fourth-quarter 2018 also came in better than anticipated (see chart below). For the last three months of the year, the U.S. economy grew at a pace of 2.6% (higher than the 2.2% Gross Domestic Product growth forecast), despite headwinds introduced by the temporary U.S. federal government shutdown and the lingering Chinese trade spat. For the full year, GDP growth came in very respectably at 2.9%, but critics are dissecting this rate because it was a hair below the coveted 3% or higher target of the White House.
Source: The Wall Street Journal
- A More Accommodative Federal Reserve: As mentioned, a major contributing factor to the late-2018 declines was a stubborn Federal Reserve that was consistently raising the interest rate target (an economic-slowing program that is generally bad for stocks and bonds), which started back in late 2015 when the Federal Funds interest rate target was effectively 0%. Over the last three years, the Fed has raised its target rate range from 0% to 2.50% (see chart below), while also bleeding off assets from its multi-trillion dollar balance sheet (primarily U.S. Treasury and mortgage-backed securities). The combination of these anti-stimulative policies, coupled with slowing growth in major economic regions like China and Europe, stoked fears of an impending recession here in the U.S. Fortunately for investors, however, the Federal Reserve Chairman Jerome Powell came to the rescue by essentially implementing a more “patient” approach with interest rate increases (i.e., no rate increases expected in the foreseeable future), while simultaneously signaling a more flexible approach to ending the balance sheet runoff (take the program off “autopilot").
Source: Dr. Ed’s Blog
The stock market tailwinds
For those of you loyal followers of my newsletter articles and blog articles over the last 10 or more years, you understand that my generally positive stance on stocks has been driven in large part by a couple of large tailwinds (see also Don’t Be a Fool, Follow the Stool):
1) Low Interest Rates – Yes, it’s true that interest rates have inched higher from “massively low” levels to “really low” levels, but nevertheless interest rates act as the cost of holding money. Therefore, when inflation is this low, and interest rates are this low, stocks look very attractive. If you don’t believe me, then perhaps you should just listen to the smartest investor of all time, Warren Buffett (Trades, Portfolio). Just this week the sage billionaire reiterated his positive views regarding the stock market during a two-hour television interview, when he once again echoed his bullish stance on stocks. Buffett noted, “If you tell me that 3% long bonds will prevail over the next 30 years, stocks are incredibly cheap … if I had a choice today for a 10-year purchase of a 10-year bond at whatever it is or 10 years, or buying the S&P 500 and holding it for 10 years, I’d buy the S&P in a second.”
2) Rising Profits – In the short run, the direction of profits (orange line) and stock prices (blue line) may not be correlated (see chart below), but over the long run, the correlation is amazingly high. For example, you can see this as the S&P 500 has risen from 666 in 2009 to 2,784 today (up 318%). More recently, profits rose about 20% during 2018, yet stock prices declined. Moreover, profits at the beginning of 2019 (the first quarter) are forecasted to be flat or down, yet stock prices are up 11% in the first two months of the year. In other words, the short-term stock market is schizophrenic, so focus on the key long-term trends when planning for your investments.
Source: Macrotrends
Although 2018 ended with a gloomy storm, history tells us that sunny conditions have a way of eventually returning unexpectedly with a boom. Rather than knee-jerk reacting to volatile financial market conditions after the fact, do yourself a favor and create a more versatile plan that deals with many different weather conditions.
