Markets around the globe have experienced sharp sell-offs over the past two months, driven in part by geopolitical tensions, uncertainty over trade tariffs, and in the U.S., a continued tightening by the Federal Reserve.
We would like to take this opportunity to share our reflections on the current climate especially as it relates to our expectations for future returns in both stocks and bonds.
One dynamic of this market decline that seems to get lost in financial media is that corporate earnings continue to grow at a consistent, albeit slow pace. The overall strength of the economy is observed in low unemployment, increased wages, and most notably a Federal Reserve that is determined to keep this slow growth in check by raising short term interest rates to fend off the possibility of an overheated economy.
A silver lining in this recent decline is that market valuations are now significantly cheaper than one year ago, as reported by Birinyi Associates in The Wall Street Journal, with the Dow Jones Industrial Average now trading just below its historical Price to Earnings (P/E) multiple of 16, compared to over 21.82 at the same time last year.
This is important to highlight because historically the best predictor of the stock market’s future returns has been its valuations (P/E) of today. This doesn’t mean that the stock market won’t continue its sell-off into 2019, but does indicate that expected returns in common stocks today are much higher than they have been in recent memory, and significantly higher than fixed income (CDs and bonds).
Portfolio declines can cause angst among investors, especially with the S&P 500 index nearing a bear market (down 20% or more from highs). But while this volatility can never be predicted, it certainly is not unexpected, especially coming on the heels of one of the longest bull markets in history. By its very nature, stock market volatility is the one component that allows this asset class the opportunity for higher long term returns.
Over the past few years, we have presented a cautious tone to investors, recognizing that sooner or later a steep stock market sell-off was to be expected. While we never predict short term movements, at current equity valuations, the improved longer term outlook for expected returns from the stock market reminds us of the importance of staying committed to this asset class in our portfolios.