2018 2nd Quarter Outlook

Review of 1st Quarter

That was fun, wasn’t it? During the first three months of 2018, the market incurred a level of volatility we haven’t seen in a couple of years. Most investors think the quarter was worse than it actually was. All four sectors we track – U.S. stocks, developed international stocks, emerging market stocks, and U.S. bonds – each fell in value by about 1%. Given the great returns of the past couple of years, a 1% decline doesn’t seem like a huge issue. But as is the case with many trips, we remember the route taken instead of the destination (insert your turbulence reference here). U.S. stocks rose by 7% over the first four weeks, then fell by 10% over the next two weeks, then recovered by 8% over the next two weeks, and finally fell by 5% over the last month. The huge single day drops were startling given the relative calm over the past two years.

Those of you who are regular readers know that we’ve been warning about the potential of increased volatility – simply because unexpected things frequently occur in the stock market. In this case there were two causes for the instability. In late January, many investors expressed fears of inflation caused by the strong job market and potential growth in the economy. Not surprisingly, those fears evaporated, and the market slowly recovered, almost reaching its previous high point. Then on February 27, President Trump announced his plans to impose tariffs on steel and aluminum, triggering concerns about a potential trade war. Regardless of your political perspective, we know the stock market does not like any infringement on free trade, and stock prices reacted accordingly.

State of U.S. Economy Below is a table showing key economic and market indicators (as of March 31)* :

The data continue to show the strength in the economy. One thing to note is the fact that the price-earnings (P/E) ratio fell over the past year. Usually, when the P/E ratio falls, it’s because stock values have declined. However, stock prices over the past year have risen by 12%. The reason for the declining P/E has been the enormous growth in earnings we’ve been describing for the past 18 months.

Stock Market Outlook

Anytime stock market volatility spikes up, it’s difficult to predict how long it will take to settle down. In this case, as long as our trade policy remains unsettled, the sharp daily movements in stock prices are likely to continue. However, the continued growth in earnings expected for the next two years should be a mitigating force, and eventually markets should stabilize. Given the relative cheapness of stocks, our long-term outlook remains positive.

Bond Market

The volatility that impacted the stock market also affected bonds as well, although in a much less severe way. Both a strong job market and a trade war can impact inflation, which in turn will cause higher interest rates. However, because of the higher yields already in place, last quarter’s decline in values won’t impact investors’ long-term returns.

Summary

From our perspective, the only true surprise about the increase in volatility is that many analysts seemed surprised. If we had believed that markets would always be as calm as they were in 2016 and 2017, we would have recommended that every investor have an allocation to 100% stocks. We didn’t make such recommendations, mainly because the types of movements we saw over the past three months are consistent with our forecasts of the capital markets. Hence, we see no reason for long-term investors to revise their allocation.

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