U.S. equities elect to end a strong week on a down note

Brian Nick

The last week’s market highlights:

Quote of the week:

“Oh, East is East, and West is West, and never the twain shall meet,
Till Earth and Sky stand presently at God's great Judgment seat;
But there is neither East nor West, Border, nor Breed, nor Birth,
When two strong men stand face to face, though they come from the ends of the earth!”

— Rudyard Kipling
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q4 Outlook:
  • U.S. economy: Still running ahead of its peers.
  • Global economy: Trade a bigger concern outside the U.S.
  • Policy watch: Trade risks haven’t bitten the U.S. yet, but that may change.
  • Fixed income: Continue to position for rising rates.
  • Equities: The price is right outside the U.S.
  • Asset allocation: Finding pockets of opportunity.

U.S. economy/Equities: Markets certainly hate uncertainty         

If uncertainty is the bane of the stock market, there are few better sources of it than an election.  Indeed, heightened volatility and market declines often precede elections. We discovered this the hard way in October, when the S&P 500 Index plunged by nearly 7%. 
While past performance is no guarantee of future results, the good news for investors is that since 1950, the S&P 500 has advanced in every 12-month period following the mid-term elections, averaging a healthy 15.3%. Although there’s no clear-cut explanation for these rallies, one possibility is that presidents approaching reelection or starting to consider their legacy may focus on the economy by promoting growth-oriented, market-friendly policies. Another theory is that the economic policy uncertainty that often accompanies a president’s second year is largely resolved during the third year. Regardless of the reason, if U.S. stocks continue to benefit from this multi-decade trend, the current bull market, which began in March 2009, could celebrate a 10th birthday and then some.
Even if stocks do manage to carve out further gains, we’ll be looking for signs of the next recession. While we don’t believe an economic downturn will occur in 2019, one might in 2020. In our view, the next recession will be more “conventional” and less damaging than the prior two, which were triggered by the bursting of the dot-com bubble in 2000 and the collapse of the housing market in 2008, respectively.
This time, we expect job creation and credit to eventually dry up amid tighter financial conditions. And despite facing what might be a comparatively less daunting challenge than the last two recessions, Congress may be hamstrung in its response. That’s because the measures that lawmakers favor to rejuvenate the economy—specifically, tax cuts and increased government spending—were the key components of last year’s stimulus package. As we see it, the size of the federal deficit will likely limit the scope of any new stimulative legislation that the next Congress may wish to pass.
But for now, the U.S. economy keeps rolling along. Last week, we received additional evidence of its resilience:
  • The U.S. service sector, which accounts for about 80% of the U.S. economy, continued to sizzle, as measured by the non-manufacturing index published by the Institute for Supply Management. Although this index dipped to 60.3 in October from September’s 21-year peak of 61.6, it remained at its highest level since August 2005. (Readings above 50 indicate expansion.) Employers in service industries expressed confidence in the economy and current business conditions while noting concerns over tariffs and capacity constraints.

  • Similarly, U.S. consumers remain bullish on the U.S. economy, according to November’s preliminary reading of the University of Michigan Index. For 2018 to date, the monthly average for the index is at an 18-year best.   

  • On the heels of October’s strong jobs report, continuing unemployment claims fell to their lowest level since 1973. These claims measure the number of people who have lost their jobs and are receiving unemployment benefits.

  • Same-store retail sales continue to hover near multi-year highs, as measured by the United States Redbook Index. And in a sign that retailers may be in for a merry Christmas, U.S. holiday sales are forecast to top $1 trillion, up nearly 6% compared to 2017. Brick-and-mortar stores could see sales rise by about 4%, despite facing increasing pressure from on-line e-tailers.
For our complete 2018 midterm elections recap and what the results mean for investors, click here.

Equities: Investors yearned for earnings—and for positive guidance

Amid a bruising October and the frenzy surrounding the midterm elections, corporate America has delivered heady top- and bottom-line results. In fact, company scorecards look about as good as they did during this year’s stellar first-and second-quarter earnings seasons. Through November 9, more than 90% of S&P 500 Index companies have reported third-quarter earnings. Among the highlights:
  • Year-over-year earnings and sales jumped a robust 27% and 9%, respectively, in line with the 25% and 9.5% recorded last period.

  • 82% of companies have registered earnings surprises, topping the second quarter’s 80% total.

  • Earnings and sales have beaten forecasts by 6.7% and 0.8%, respectively, close to the previous quarter’s tallies.
In a number of cases, though, earnings “beats” weren’t enough to satisfy investors. Last week, shares of Internet dating service operator Match Group, fast-food chain Wendy’s, and Delphi Technologies all slumped after posting better-than-anticipated results. Why did investors accentuate the negative? They were spooked by shaky guidance from management teams that referenced a strong dollar, rising wages in a tight labor market, and concerns over China, respectively. Admittedly, this is a tiny sample size of just three companies. But these worries have punctuated earnings calls throughout this earnings season, hurting stock prices.
We believe U.S. earnings growth will slow substantially in 2019 as the effects of corporate tax cuts wear off and revenues decline on more moderate consumer spending. A pickup in wage pressures and increasing input costs due to tariffs may also play a part.
With this volatile fourth quarter almost half over, investors may be wondering if valuations will bounce back to January’s “pricier” levels. We don’t think so. Higher interest-rate assumptions are being used to discount future cash flows, and markets are growing more wary of downside risks to the U.S. economy that could spur a recession.
That being said, the overall environment for stocks (and profits) is still good: demand is robust, inflation remains low, and growth overseas is likely to improve next year. Excellent earnings results and, perhaps, a smaller rebound in P/E ratios are forming the foundation of a durable recovery from October’s equity downdraft, in our view.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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