As noted in client conversations last Fall, the Federal Reserve’s decision to reduce and ultimately remove quantitative easing (QE) from its playbook would put this market into a grind, one characterized by short term price fluctuations but lacking sincere upward traction. It’s taken awhile – so much so that I had practically given up on the premise. But stock indexes are now roughly where they were a year ago. It appears that a lag impact of QE tapering by the Fed is indeed now being squarely shouldered by equity markets. In hindsight, it’s almost impossible to envision a scenario where the removal of QE by the Fed wouldn’t invoke some sort of upward halt to the market’s trajectory – whatever form and tenure that may be. That is, unless a QE handoff to a sounder, more sustainable corporate earnings growth model was executed literally to perfection. That premise is now being tested.
For equity investors, the S&P 500 has long been viewed as one of the better gauges for U.S. stock performance, with the price-to-earnings (P/E) ratio accepted as a popular valuation metric. This month, as markets have pulled back, the S&P500 traded at roughly 15x forward earnings, comfortably within historic norms. This fact isn’t lost on perma-bulls – those who enthusiastically embrace the notion of a long term positive trend in market prices and expect this market sell-off to be extremely short-lived.
While corporate earnings do trend up over time, investors need not lose sight of their inherent cyclicality. Commodity prices remain a mess. Even gold, on a 4-year display as to what happens when investment hyperbole overrides common sense, has yet to act as a serious buffer for investors. In August, DeBeers, the world’s largest diamond miner, announced additional price cuts of 9%. Oil is skirting $45/barrel. Copper and iron ore prices remain historically depressed. Disinflation in many if not most commodity sectors is in full swing. And with visibly shaken emerging markets including most of South America, the Middle East and China standing as a backdrop, properly framing short-to-mid term investment return expectations will be critical to maintaining one’s sanity.
The punch line here? If we’re looking at a sustained global economic slowdown; one that evolves from its origins in a combination of slowing growth in China, commodity disinflation and the ending of QE here in the U.S., corporations will undoubtably experience slower earnings growth. And depending on the length of time experienced before expected earnings growth reaccelerates, stocks prices should adjust lower from highs experienced early this Summer. How much of an adjustment, as always, remains the wild card. Volatility is unfortunately back. As are lower stock prices. Welcome to the grind.
Burton Baker, CIPM
The BAM Rising Dividends Portfolio