Review of 1st Quarter
That was fun! During the first quarter, U.S. stocks rose by 14%, with developed international stocks and emerging stocks close behind, each gaining 10%. Even bonds got into the act, earning a return of 3%.* We’ll offer our relatively simple analysis of what happened, but before doing so, we’ll discuss the current condition of the economy.
State of U.S. Economy
Below is a table showing key economic and market indicators (as of March 31)**:
The economy has been doing well and that has certainly been a factor in the good returns. But the economic data has been good for several years, so there must be other reasons why returns were so high.
It’s all about earnings! Let’s pretend we had a trusted oracle tell us what earnings for each U.S. company would be for the next 10 years. Three things would happen. Stock prices would immediately adjust with that information. Volatility in the stock market would shrink to almost nothing in the next few years. And the unemployment rate among stock analysts and market pundits would skyrocket.
Unfortunately, such an oracle doesn’t exist, so analysts gather various other information such as GNP predictions, productivity forecasts, trade deficits, currency estimates, and dozens of other factors to try to forecast earnings. But what drives changes in market values are NOT the changes in the economic data per se, but solely the changes in that data that will impact a forecast of corporate earnings.
Below is a chart that shows recent average growth rates in profits for companies in the S&P 500, as well as forecasts for the next two years:
Average Growth in Profits for Companies in S&P 500***
Gold bars represent projected earnings
If we want to know why stocks have had returns over the past three years of 14% per year, we can look at earnings growth between 2015 and 2018 (which, not coincidentally, has averaged 14% per year). And if we want to understand why the current level of stock prices are well supported by fundamentals, we can look to the total of 30% growth in projected earnings for 2019 and 2020.
There are of course, risk factors that could cause the level of earnings growth to decline – those include global growth concerns and potential trade wars. Just because stock analysts currently believe that those factors won’t detrimentally impact corporate profitability doesn’t mean the profitability won’t deteriorate. That’s why the market will continue to be volatile for the foreseeable future.
It appears that the Federal Reserve has curtailed its steady policy of increasing interest rates over the past couple of years. This should lead to a steadier bond market going forward than we experienced last year.
The last six months has reminded us that stocks are fickle. We’ve gone from one of the worst performing quarters in this decade to the best performing quarter with not much fundamental change in economic conditions. Stocks are volatile over short-term periods, and the best way to avoid that volatility is to avoid the temptation to make changes as a result of market fluctuations.
* Source of returns is Morningstar, Inc. Past performance is not indicative of future results.
** Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board
*** Source: S&P Dow Jones Indices