Market Perspective Bull Market Intact as Healthy Reset Continues May 9, 2018 Investment and Insurance Products: Are not FDIC or any other Government Agency Insured Are not Bank Guaranteed May Lose Value Keith Lerner, CFA, CMT Managing Director, Chief Market Strategist 2018 SunTrust Banks, Inc. SunTrust is a federally registered service mark of SunTrust Banks, Inc. 1
Bull Market Intact as Healthy Reset Continues Key Takeaways Our work continues to suggest the consolidation phase that has been underway since January is within the context of an ongoing bull market. bulls and the bears alike, the price pattern we are seeing is very consistent with recent history. Indeed, when looking at the sharp Following other recent sharp corrections, it took an average of 10 months for stocks to reclaim the high set prior to the pullback. This transition period has provided a healthy reset of price, sentiment and valuation. Nevertheless, a strong corporate profits season has been offset by concerns that we are past the peak of economic momentum and earnings growth, while the Fed is gradually removing accommodation. Our view is these concerns appear overdone. The weight of the evidence suggests moderating stock returns with higher volatility, not the end of the bull market. Our work continues to suggest the tug-of-war that has been unfolding since January is within the context of an ongoing bull market. The action over the past few months has served to provide a healthy reset of price, sentiment, and valuation. Although this process continues to frustrate the corrections in 2010, 2011, and 2015/2016, it took an average of about 10 months (range of 6 to 14 months) for stocks to reclaim the high set prior to the pullback (slide 4). In the interim, a battle between fear and greed has been normal and punctuated by several sharp price moves back and forth before eventually climbing higher. Moreover, stocks have tended to trade in a choppy fashion during mid-term election years, with most of the market s gains typically occurring in the fourth quarter (slide 5). From a fundamental perspective, it may be disappointing to see the market not react better to what has been a very strong corporate earnings season, but context is important. The S&P 500 entered this year with a record-tying, nine-straight calendar years of positive total returns. Further, after a robust 2017, stocks started off 2018 with strong gains in January, and the market simply became overextended on a short-term basis. This sideways period is allowing fundamentals to catch up with prices. Nevertheless, the positive corporate earnings season has been overshadowed as some investors are concerned that we are past the peak of economic momentum and earnings growth, while the Fed is gradually removing accommodation. Although this is leading to greater volatility, it does not necessarily imply an end to the bull market though moderating gains are more likely (consistent with our view coming into 2018). Indeed, the Purchasing Managers Index (PMI), a survey of US manufacturing activity, reached a cycle high in February. 2
Bull Market Intact as Healthy Reset Continues Importantly, following past peaks in PMI levels, the economy and stock market have expanded for almost three years on average (slide 6). Moreover, more than 90% of the countries we track are currently showing expanding manufacturing trends, which indicates firm and broad-based growth. said, with stocks trading near a 16x forward multiple, down from 18.5x in MASTER January, TITLE we think most of STYLE the valuation compression is now behind us. We also expect global growth to firm over the coming months. The first quarter was weighed down by one-off factors, such as labor strikes in France, extreme weather in the UK, and a flu outbreak in Germany. The US should also bounce back from a softer first quarter, which has been a recurring pattern over recent years. That said, the fundamental battle between the prospects of a better economy/earnings and higher interest rates persists. While there is not a perfect comparison to the current environment, there have been six calendar years since the 1950s where S&P 500 earnings growth was strong (>15% as expected in 2018) and shortterm interest rates and the 10-year US Treasury yield rose from the previous year. The average total return for the S&P 500 during those calendar years was 12% (with wide variations). Notably, in every year, with the exception of 1999, price-to-earnings ratios compressed. This makes sense in that strong earnings are also being discounted back with a higher interest rate. Thus, while robust earnings should support stocks grinding higher this year, the contraction in valuation is consistent with history (slide 7). That Further, when looking at just the relationship between the stock market and a rising 10-year US Treasury yield, stocks have risen in 12 of the 15 periods we studied, or 80% of the time since the 1950s (slide 8). This makes sense so much as higher rates often coincide with an expanding economy and earnings. Finally, our work suggest the concerns related to peak earnings growth is overdone. Naturally, stocks should see a one-time lift in the rate of profit growth following a tax cut. However, forward earnings estimates just reached another record high, and corporate guidance remains strong. Indeed, the percentage of companies exceeding analysts earnings estimates this quarter is the highest in 15 years (slide 9). In addition, 77% of companies have exceeded sales estimates, and sales growth is coming in at 8.4%, which is the best rate since 2011. Moreover, 56% of companies are seeing their earnings estimates revised higher, which is the strongest pace in several years with the exception of the two months following the tax cuts (slide 10). As the economy continues to move forward, earnings should follow suit. Bottom Line So far, what we are seeing following the sharp correction from the January high is very consistent with history and the normal ebb and flow of a bull market. The stock market is going through a digestion period after very strong gains. History suggests this is a process that takes time. The good news is the fundamental drivers of the market including rising profits and solid global growth remain intact. Therefore, we expect the bull market to eventually reassert itself. 3
It Has Taken an Average of 10 Months for Stocks to Reclaim the High Set Prior to Correction Following the sharp corrections in 2010, 2011, and 2015/2016, it took an average of about 10 months (range of 6 to 14 months) for stocks to reclaim the high set prior to the pullback. In the interim, a battle between fear and greed has been normal and punctuated by several sharp price moves back and forth before eventually climbing higher. 3000 2500 S&P 500 14 months to recapture former high 3.5 months since January high 2000 1500 6 months to recapture former high 10 months to recapture former high 1000 500 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Data Source: FactSet, SunTrust IAG 4
Stock Returns Tend to Be Back-End Loaded During Mid-Term Election Years Although we recommend not overemphasizing seasonal tendencies, it is notable that during mid-term election years, stocks have tended to trade in a choppy fashion, with most of the gains occurring in the fourth quarter. 106 105 104 103 102 101 100 99 98 97 S&P 500: Average Path During Mid-Term Election Years 96 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Data Source: Bloomberg, SunTrust IAG 5
Peak Economic Momentum Does Not Imply End of the Cycle The Purchasing Managers Index (PMI), a survey of manufacturing activity, reached a cycle high in February. Following past peaks in PMI levels, the economy and stock market have expanded for almost three years on average. 90 80 70 60 50 Months to Recession After PMI Peak Months to Market Peak After PMI Peak Months to Recession Average 90 80 70 60 50 Months to Market Peak Average 40 Average = 33 Mos 40 Average = 34 Mos 30 30 20 20 10 10 0 0 Data Source: FactSet, SunTrust IAG 6
Historical Market Performance During Strong Earnings Years and Rising Short- and Long-Term Rates Markets are undergoing a tug-of-war between strong earnings and rising rates. While robust earnings growth should allow stocks to grind higher this year, one should not expect valuations to expand; since the 1950s, the price-to-earnings (P/E) ratio compressed in every period, except 1999, in years that saw strong earnings growth coupled with rising interest rates. Year S&P 500 Total Return (Calendar Year) S&P 500 Earnings Growth (Calendar Year Change) Change in Trailing P/E (Calendar Year Change) Change in Federal Funds Rate Change in 10-Year US Treasury Yield 1955 32% 31% (0.4) 1.2 0.5 1959 12% 17% (1.5) 1.6 0.8 1973-15% 27% (6.6) 4.6 0.4 1979 18% 21% (0.5) 3.8 1.4 1994 1% 18% (2.9) 2.5 2.0 1999 21% 17% 0.7 0.6 1.6 Average 12% 22% (1.9) 2.4 1.1 Screen criteria: S&P Earnings growth >15% and Federal Funds rate and 10-year US Treasury yield rising >25 basis points from end of previous year to end of current year. Data Source: FactSet, St. Louis Fed, SunTrust IAG 7
Stocks During Rising 10-Year US Treasury Rate Periods When looking at just the relationship between the stock market and a rising 10-year US Treasury yield, stocks have risen in 12 of the 15 periods we studied, or 80% of the time since the 1950s. This makes sense so much as higher rates tend to coincide with an expanding economy. Starting 10-Yr Treasury Yield (%) Ending 10-Yr Treasury Yield (%) Change in 10-Yr Treasury Yield (%) S&P 500 Annualized Total Return (%) Rising Rate Periods 4/30/1954 10/31/1957 2.3 4.0 1.7 16 4/30/1958 1/31/1960 2.9 4.7 1.8 19 5/31/1961 8/31/1966 3.7 5.4 1.7 6 3/31/1967 5/31/1970 4.5 8.0 3.5-2 3/31/1971 9/30/1975 5.5 8.5 3.0-0.4 12/31/1976 2/29/1980 6.8 12.7 5.9 7 6/30/1980 9/30/1981 10.1 15.8 5.8 7 4/30/1983 5/31/1984 10.3 13.9 3.6-4 8/31/1986 9/30/1987 7.0 9.6 2.7 29 9/30/1993 11/30/1994 5.4 7.9 2.5 2 9/30/1998 1/31/2000 4.4 6.7 2.2 28 5/31/2003 6/30/2006 3.4 5.2 1.8 11 12/31/2008 12/31/2009 2.3 3.9 1.6 26 7/31/2012 12/31/2013 1.5 3.0 1.5 26 7/31/2016 4/30/2018 1.5 3.0 1.5 14 Average 4.8 7.5 2.7 12 Screen criteria: Periods where the 10-year US Treasury yield rose at least 150 basis points based on monthly data Data Source: Morningstar Direct, SunTrust IAG 8
As Stocks Consolidate, Earnings Estimates Continue to Rise Naturally, stocks should see a onetime lift in the rate of profit growth following a tax cut. However, forward earnings estimates have recently made a new record high. 3000 2500 S&P 500 (L) S&P 500 vs. Earnings Forward Earnings Estimates $180 $160 2000 $140 1500 $120 1000 '13 '14 '15 '16 '17 $100 Data Source: FactSet, SunTrust IAG 9
1Q-03 4Q-03 3Q-04 2Q-05 1Q-06 4Q-06 3Q-07 2Q-08 1Q-09 4Q-09 3Q-10 2Q-11 1Q-12 4Q-12 3Q-13 2Q-14 1Q-15 4Q-15 3Q-16 2Q-17 1Q-18 1Q-03 4Q-03 3Q-04 2Q-05 1Q-06 4Q-06 3Q-07 2Q-08 1Q-09 4Q-09 3Q-10 2Q-11 1Q-12 4Q-12 3Q-13 2Q-14 1Q-15 4Q-15 3Q-16 2Q-17 1Q-18 The Percentage of Companies Exceeding Sales & Earnings Estimates Is the Strongest in 15 Years 90% 80% 70% 60% 50% 40% 30% 20% 10% S&P 500: Quarterly Sales Beat Rates (%) S&P 500: Quarterly Earnings Beat Rates (%) Average 77% 90% 80% 70% 60% 50% 40% 30% 20% 10% Average 78% 0% 0% Data Source: FactSet, SunTrust IAG 10
Corporate Earnings Estimates Head Upward More than half of the companies in the S&P 500 have seen their earnings estimates rise recently, which is the strongest pace in several years with the exception of the two months following the tax cuts. As the economy continues to move forward, earnings should follow suit 90% 80% 70% 60% % of S&P Companies That Are Seeing Earnings Estimates Revised Higher 56% 50% Average 40% 30% 20% 10% 0% Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Apr-17 Jul-17 Oct-17 Jan-18 May-18 Data Source: FactSet, SunTrust IAG 11
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