We have good news about broader trends, thought provoking news about the first half of 2018 having been dominated by a handful of expensive companies, and a Rational Investor take about risk management.
The Good News. The economic expansion is intact, earnings are strong, and there are good investment
opportunities at fair prices.
The Thought-provoking News. Year-to-date, a small handful of stocks have contributed to nearly all the market’s positive return.
The Rational Investor Take. It is rarely healthy when the group of market forerunners gets to be both very narrow and very expensive. There are visible signs of a
developing bubble under construction.
What to do?
- Per the Good News: keep your equity allocation intact as is appropriate for your circumstance and focus on the fairly priced investment opportunities.
- Per the Thought–provoking News: be very selective and think critically about valuation.
- Per the Rational Investor Take: Late in this economic cycle, we embrace disciplined risk management over chasing frothy valuations and their potential hazards.
THE GOOD NEWS
Economic Expansion. The primary indicators and data points that we utilize to monitor the strength and direction of this economic expansion and the economic cycle remain constructive. We anticipate this expansion will extend into 2019 to become the longest expansion in the history of the U.S. economy. The Index of Leading Economic Indicators, the yield curve, corporate earnings, and U.S. GDP all continue to post positive readings. The correlation between economic expansion and constructive equity markets is very significant, so the healthy economic news is good news for the marketplace.
Earnings. Consensus earnings estimates for the S&P 500 Index average a gain of over 14% for 2018 and over 9% for next year. Over the last 20 years, there has been a 90% correlation between the direction of earnings and the direction of the market. A little critical thinking around the 2018 estimate is required due to the change in the corporate tax rate in the U.S. On an apples-to-apples basis, profits would have grown approximately 9% without the tax bump. From our perspective, the market is not paying for 14% earnings growth this year. Rather, it has discounted to the tax change and today’s S&P 500 earnings multiple of 18.2X (the 2018 estimate) reflects a discount to the tax rate enhanced growth.
Opportunity. We are pleased to report that despite ubiquitous examples of expensive pricing, we have been able to maintain both our qualitative and our valuation disciplines in our portfolios.
THE THOUGHT-PROVOKING NEWS
While the S&P 500 Index returned a modest 1.7% for the first half of 2018, there have been some immodest, heady returns year-to-date from two sectors and a small group of stocks. Both the Consumer Discretionary and Technology sectors returned over 10% for the first half and each sector had a small subset of companies that were predominate in turning in dazzling numbers. The Index’s other nine sectors combined for a negative return in the first half. In Consumer Discretionary, Amazon and Netflix were the predominates; generating a combined average return for the six months of 74.6%. If you exclude those two stocks, the rest of the S&P 500 Index generated a negative return for the period. Similarly, in the Technology sector, a small amount of companies made up the lion’s share of the sector’s returns. Within the entirety of the S&P 500 Index (as opposed to just the two sectors), a very small group of very expensive companies (with an average PE multiple over 85X the 2018 earnings estimate) turned in out-sized performance for the six months. Without the extravagant results from this handful of companies, the Index posted negative results for the period.
As a point of reference, the long-term average historical PE X for the S&P 500 Index is 16.4X trailing earnings. From that vantage point, 95% of the companies in the S&P 500 Index are on the cusp of expensive and 5% are well into the
speculative zone.
THE RATIONAL INVESTOR TAKE
Market history suggests that when a handful of companies trading at premium valuations dominates market results late in the economic cycle (and we are now 10 years in), one would be well-served to think critically as to whether a bubble is under construction and to focus more on risk management for protection than on risk participation. Because 2008 was our most recent crisis, the perspective about risk management tends to dominate by looking through a 2008 lens (all at once, everything goes bad), but this species of risk more resembles the year 2000, when we went through a harsh valuation correction (NASDAQ -40%) that was more narrow (Tech) than broad.
The point is not about bailing out, it’s not even about attempting to call this a top, which we are not doing. It is about being a historically informed critical thinker and focusing on rational investing. It brings to mind the Buffett quote we shared with you last quarter, “Be fearful when others are greedy, and be greedy when others are fearful.” Over longer periods of time, strategic and rational trumps tactical and emotional.
It may be helpful to remember that we are coming off an overachieving 2017, in which we discounted almost all the good investment news that surrounds us now in 2018, well in advance. When you eat your dessert first, it is not unreasonable that you later forfeit the right to complain that there is no dessert.
We are committed to working as Rational Investors, remaining focused on good news while maintaining investment discipline. We expect continued good results from the exceptional businesses we have invested in together.
