Thoughts on Latest Bout of Market Volatility

The trampoline finally broke on the S&P 500 Index’s 200-day moving average, which had held firm since the Brexit vote in June 2016. Technology and trade were again the culprits, as they have been through this latest bout of volatility over the past couple of weeks. In response to Monday’s market decline, John Lynch noted, “Amid the recent weakness in stocks, manufacturing sector data showed activity levels near decade highs, while expectations for first quarter S&P 500 earnings growth are for an increase of over 17.0%.” Market fundamentals still look pretty good.

As the stock market bottoming process continues, here is what we think investors should focus on:

  • Historically low volatility. Strong market returns coming off the February 2016 lows were characterized by a historically long period without a correction amid historically low volatility, leaving stocks more vulnerable to negative catalysts. Several catalysts emerged in recent weeks, including heightened fears of a trade war with China and potentially onerous technology regulations.
  • Fears of a full-blown trade war have played a lead role in driving this latest bout of volatility. While this situation could linger and weigh on investor sentiment for some time, we are encouraged by the fact that the value of goods under the new tariffs (less than $40 billion) is dwarfed by the amount of additional stimulus being put into the economy this year (estimated at $700–800 billion). Recent signs of compromise have increased our optimism, and we do not expect a full-blown trade war.
  • Fears of increased regulation in the technology sector, the S&P 500’s largest, have weighed on sentiment. After the strong multi-year run for technology, crowded positioning may be exacerbating the sector’s negative reaction to privacy concerns. The sector’s earnings outlook remains strong and we continue to favor it. However, we believe the opportunities in financials, industrials, and emerging markets are more attractive.
  • The U.S. economy remains in excellent shape. Economic data, including the April 2, 2018 release of the U.S. manufacturing survey from the Institute for Supply Management (ISM), is showing preliminary and minimal signs of overconfidence, overborrowing, or overspending that typically precede a recession and bear market. Our favorite leading indicators continue to suggest a low probability of recession in the next year.
  • Valuations have fallen. The recent stock market decline, coupled with the dramatic increase in earnings estimates during the first quarter, have pulled the S&P 500 price-to-earnings ratio on a next 12-month basis down to its lowest level since November 2016 at approximately 16. With inflation and interest rates still low, we believe valuations at current levels are well supported.
  • Key technical level to watch. We believe the 200-day simple moving average for stock indexes is relevant, and history shows that investing in equities, represented by the S&P 500, when the index is below that level has delivered solid gains. Still, after falling below that key technical level yesterday for the first time since the Brexit vote, we would view a close back above this key level as a positive technical sign. (We are back above that level as of 11:30 a.m. ET today.)
  • Inflation remains well contained, in our view. A jump in the prices paid component of the ISM Index for March may have fanned inflation fears yesterday and contributed to the sharp sell-off. But the Federal Reserve’s preferred inflation measure remains well below its 2% target at 1.6% and has a ways to go before it becomes worrisome for the central bank.
  • Earnings outlook remains very strong. We still expect double-digit earnings gains throughout 2018 with an accompanying pickup in economic growth as the full impact of the new tax law kicks in. The manufacturing reading in the ISM Index remains very strong near 60 and is indicative of continued solid earnings growth. We are encouraged that estimates have remained resilient throughout this latest trade spat and expect the upcoming earnings season to be a positive catalyst for stocks to finish building a base and set up for the next move higher. Also note that corporate buybacks will be “unlocked” after earnings reporting season begins and may provide an additional catalyst as repatriated funds from overseas are put to work.
  • Finally, the credit markets have remained generally well behaved and have signaled only a slight increase in financial market stress and only a slight tightening of credit conditions. We continue to watch bond markets closely for signs of additional stress.

 

IMPORTANT DISCLOSURES

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The 200-day moving average (MA) is a popular technical indicator which investors use to analyze price trends. It is the security or index’s average closing price over the last 200 days.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. All performance referenced is historical and is no guarantee of future results.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

This research material has been prepared by LPL Financial LLC.

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