Market Update: Thurs, Dec 20, 2018 | LPL Financial Research

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Fed hikes again, but lowers projections. The Federal Reserve (Fed) hiked interest rates yesterday, but lowered its projections for future rate increases in a nod to both the hawks and the doves. Still, the S&P 500 Index slid 1.5% for the day after being up about 1% pre-announcement (more below), closing down for a seventh straight Fed day. In today’s LPL Research blog, we highlight stocks’ adverse reaction to the rate hike and Fed Chair Jerome Powell’s press conference comments, and outline our reasoning for why investors should still have faith in the Fed’s gradual approach and data-based pragmatism.

Oversold conditions may support a bounce. Higher selling volume, credit spread widening, falling Treasury yields, and weakness in transports and semiconductors presented strong evidence of investor disappointment with the Fed announcement yesterday. Many price-based metrics suggest we may get a bounce, including just 22% of S&P 500 stocks sitting above their 200-day moving average, advancing volume drying up, more extreme put/call readings, and increasing use of cash as a safe haven. With the S&P 500 near 2500, the next support level is 2450, followed by 2375; resistance on the upside is 2650/2700. Clearly the bond market is screaming “stop” to the Fed with the 10-year Treasury yield down to 2.75% and some additional yield curve narrowing.

Volatility perspective. The average annual peak-to-trough decline since 1980 has been 14%, very close to what investors have had to stomach in 2018. Average volatility feels worse than average, but putting market swings in context can be reassuring. In a midterm election year the average decline is slightly larger (16%), while even in up years, the average peak-to-trough decline has been 11%. Keep in mind that since WWII, the S&P 500 has never declined in the 12 months following a midterm election (18 for 18), and no recession has occurred when earnings rise, as we expect in 2019-our forecast calls for a 6-7% increase in S&P 500 earnings next year.*

Non-recessionary bears are rare and not much worse than this. Over the past 40 years, the S&P 500 has experienced only one decline >20% that was not accompanied by a recession based on closing prices and that was 1987. It did come very close three times, falling 19% peak-to-trough in 1978, 1998, and 2011. No one can predict with certainty how far this latest selloff will go but fundamentals, including a low probability of recession in 2019, and historical perspective suggest much of this selloff may be behind us.

Valuations have come down significantly. The benefit of market declines is of course that stocks get cheaper. How much cheaper have they gotten? After trading at a price-to-earnings ratio (PE) just under 19 only 11 months ago (based on next 12 month’s consensus earnings estimates from FactSet), the S&P 500 PE has fallen to 15, slightly below the long-term average. Given low inflation and still-low interest rates, and our still positive earnings growth outlook, we believe stocks are below fair value.

We continue to under-emphasize developed international stocks in our 2019 Outlook. Growth in Europe has been slowing and may struggle to reach even 2% in 2019, while political risk is rising. Meanwhile, growth in Japan is also lagging, despite stimulus and corporate reform efforts.

Favor emerging market equities for 2019. We favor emerging markets (EM) over developed international equities for their solid economic growth trajectory, favorable demographics, attractive valuations, and prospects for a U.S. trade agreement with China, with a bias toward emerging Asia. GDP growth in China, as well as broader EM, is likely to more than double the pace of developed international economies in 2019, and we believe political uncertainty is actually higher in Europe than in EM.

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IMPORTANT DISCLOSURES

*Please see the Outlook 2019: FUNDAMENTAL: How to Focus on What Really Matters in the Markets for additional description and disclosure.

Investing in foreign and emerging markets securities involves special additional risks. These risks include but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

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.

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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.

All company names noted herein are for educational purposes only and not an indication of trading intent or a solitication of their products or services. LPL Financial doesn’t provide research on individual equities.

All performance referenced is historical and is no guarantee of future results.

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Index data obtained via FactSet

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