Economic Commentary: The U.S. Equity Market Outlook and Valuations

Investors can best understand the current equity market sell-off by recognizing that cyclical bull markets are routinely punctuated by temporary intra-cycle corrections. The current sell-off is the sixth such episode since the equity bull market began in 2009, and the intra-cycle decline differs from the previous five in that it was not triggered by fears of imminent recession. In addition, the current episode is occurring in an environment of lofty valuations and greater investor optimism, compared with distinct undervaluation and widespread risk aversion prevailing during previous interim market declines.

In this edition of Economic Commentary, Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., shares his perspectives on why the proximate catalyst for the sharp reversal in equity prices in late January was a marked shift in market expectations regarding inflation, and the direction in which he sees monetary policy, long-term interest rates and the U.S. equity market heading.

Q&A With Robert DeLucia

Is there anything happening in the market that suggests a change in direction for U.S. equities?

It is impossible to predict the direction of the equity market in the short term. That said, it appears likely that the next major trendline in stock prices could be up rather than down.

There are several classic variables to monitor as signals that the current consolidation phase is nearing an end and at least a mini-rally in stocks could be imminent:

  • Investor Sentiment: Although the glaring euphoria evident in January has clearly diminished, there still remains excessive optimism and complacency among most classes of investors. Consequently, a resumption of an uptrend in stock prices awaits evidence of further pessimism and risk aversion.
  • Valuation Measures: From extreme levels of overvaluation in January, the equity market can be best described as fully valued. Further market declines to a condition of undervaluation would create a more solid buying opportunity.
  • Economic Data: Incoming economic data in the first quarter were somewhat disappointing and raised concerns about the underlying strength of the economy. A return to more robust data on retail sales, housing, loan demand, export trade and factory orders would restore investor conviction regarding the economic outlook.
  • Quarterly Earnings: Companies will be reporting Q1 earnings over the next four to eight weeks, at the same time providing guidance regarding future business trends. Annual growth in Q1 could reach 20%, which would be the fastest pace in more than seven years. How important are profits for stocks? According to market research by Bloomberg, 80% of stock gains since 2013 have occurred during earnings season.

What is your 12-month outlook for equity market returns?

From current levels, equity market returns of 8% to 10% appear realistic over the next 12 months. This assumption is based upon growth in earnings per share (EPS) of 15% over the next four quarters, partially offset by a moderate contraction in equity market valuations. Beyond the middle of next year, the probability of negative rates of return should increase significantly.

Can equity investors effectively prepare for the next cyclical bear market?

Although economics is an art rather than a science, there are at least a dozen reliable indicators with a decent record in signaling the end of a bull market. These economic and financial market indicators can precede the onset of an equity bear market by as many as 12 to 15 months:

  • A rise in inflation that triggers an aggressive tightening in monetary policy
  • A steep rise in real interest rates on government bonds
  • A significant flattening of the Treasury yield curve
  • Deterioration in credit conditions reflected in rising delinquencies on bank loans
  • A sustained widening in corporate bond risk spreads
  • A peak and sustained downturn in the housing market
  • A contraction in real disposable personal income
  • Fading momentum in corporate earnings growth
  • A peak and steady decline in corporate profit margins
  • Spreading euphoria or even complacency among investors
  • Steady deterioration in market breadth, i.e., narrow market leadership
  • Concentrated market leadership in select large-cap growth stocks

Using these indicators, how would you assess the current market?

Several of these indicators are flashing preliminary warning signs, including an uptrend in consumer inflation; a steadily flattening Treasury yield curve; rising delinquencies in several bank loan categories; lingering complacency among institutional investors; a deterioration in market breadth; and, concentrated stock market leadership. Inflation is by far the most important of these indicators, and it is reassuring that the recent uptick is far from threatening.

The bottom line is that it seems premature to anticipate the onset of an equity bear market within the next year. For the remainder of 2018, the path of least resistance for the equity market appears likely to be upward in an environment of heightened volatility. However, as discussed in my reports in recent months, my expectations for rates of return from domestic equity portfolios are quite modest over both a medium- and longer-term horizon.

As market volatility continues to shape the foreseeable future, you need to help risk averse clients continue to engage in the market. Learn more about the role CUNA Mutual Group Zone and Horizon annuity products play in these efforts with the straightforward overview you’ll find in our guide, Risk Control Accounts: Avoiding the Best & Worst Days to Increase Growth Potential.

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All opinions and commentaries expressed are those of the writer, Robert F. DeLucia, and do not necessarily reflect the opinions of CUNA Mutual Group, CBSI, or its management.
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