Highlights

• Market conditions have become more complicated in recent months, and sentiment has been deteriorating.

• While we recognize the risks, we think markets are oversold and that fundamentals remain strong.

• The environment over the next year may not be great for equities, but we do not think this bull market is over yet.

Stocks once again experienced a strong selloff last week as investor concerns over a number of issues grew. It seems that strong earnings results have not offset fears of a future slowdown in earnings growth, the stronger dollar, rising input costs, a weak housing market, uncertain trade policy, slowing growth in China and rising interest rates. The S&P 500 Index lost 3.9 percent for the week, and notched a peak-to-trough 10 percent correction.¹ We recognize the downside risks and expect volatility to continue, but also think sentiment is worse than reality.

Ten Themes In The Midst Of Volatility

1) U.S. economic growth remains solid. Third quarter gross domestic product advanced 3.5 percent, putting the year-over-year gain at 3.0 percent.² Consumer spending was strong, although capital expenditures showed some weakness.

2) Manufacturing levels may come under pressure. The closely watched Richmond Fed Manufacturing Index fell to a six-month low in October.³ Although other regional reports showed more strength, the decline could be a cause for concern.³

3) The outlook for global growth may have weakened recently, but we see no near-term signs of significant financial pressures. We do not see undue pressure in the credit markets. High yield credit spreads have widened slightly, but still remain relatively tight.¹ And while stock prices have declined sharply, valuations have become more attractive.¹

4) Global fiscal policy is likely to be simulative next year. Countries around the world are worried about keeping pace with U.S. growth. We expect a number of countries to adopt stimulative measures as a result, and think corporate tax cuts could be cut across jurisdictions.

5) Corporate earnings remain strong, but growth is set to slow. Third quarter earnings are on trend to show slower growth than the first half of the year, but we expect they will still be up more than 20 percent.¹ Forward guidance from companies suggest management teams are growing more concerned about trade issues, as well as factors associated with the aging economic cycle: rising interest rates, higher wage costs, transportation cost pressures and the stronger dollar.

6) Earnings growth may disappoint in 2019. Consensus expectations call for double-digit growth levels next year, but we expect approximately 6 percent due to the issues we just cited.¹

7) Downward pressure in the financial sector could persist. Since the start of earnings season, this area of the market has declined significantly.¹ Higher rates are causing tighter lending conditions, while a flatter yield curve has put pressure on margins.

8) We believe the U.S. stock market is approaching a bottom. We don’t think we have yet seen the sort of investor capitulation usually associated with the end of corrections, but we may be getting close. Rallies have been short-lived and narrow in scope, but we believe that may start to change if sentiment bottoms.

9) We may have seen the market highs for the year, but we also expect the bull market to continue. Our best guess is that the record highs established in early October will have marked the high point for 2018. But we also believe there is a more than 50 percent probability that markets will reach new records before the bull market is over.

10) History suggests the post-midterm-elections period could be good. Since 1950, U.S. stocks have never experienced a price decline in the 12 months following a midterm election.⁴ And the average price gain for the S&P 500 Index has been 15.3 percent.⁴

Market Conditions Have Become More Complicated In Recent Months

Around Labor Day, investors were generally sanguine, and volatility was low. Now, stock markets are in correction territory. What changed? A long list: a worsening U.S. political backdrop; slowing global growth; rising inflation; higher interest rates; peaking corporate earnings and, of course, a potential trade war.

These issues are real, but we also think equity market action is typical of an aging economic cycle. We believe sentiment is worse than reality. An escalating trade war could significantly slow global growth. A related risk is the degree to which corporate earnings growth slows, both as a result of these fears and fundamental declines associated with the aging economic cycle. But we do not see imminent risks of a recession or an end to the equity bull market—at least not over the next 12 months.

Volatility May Remain Elevated, But Stock Prices Should Rise Over The Next Year

In any case, approximately half of the companies in the S&P 500 have experienced drops of 20 percent or more from their 52-week highs, and the list of worries we cited above could mean markets will remain messy and uneven.¹ The initial catalyst for the current correction (a spike in bond yields) has faded, yet markets have been unable to find a floor.

At this point, we encourage investors to be patient and await improvements in sentiment. Markets may need to see firmer U.S. economic indicators or evidence of less political volatility in order to stabilize, but we believe we are near the end of the current corrective action.

The bottom line: economic and corporate fundamentals remain solid and earnings growth has been particularly strong in 2018 while prices have fallen. That means valuations are more attractive now than in January.

Over the next year, we expect a modest cooling in economic growth and a moderate upturn in inflation. We also think earnings are likely to come under more pressure than the consensus expects. That’s not a great recipe for equity market performance. But it also does not suggest the end of the bull market. We believe volatility will remain relatively elevated, while evidence points to higher equity prices over the coming year.

Robert C. Doll is senior portfolio manager and chief equity strategist at Nuveen Asset Management.

 

1 Source: FactSet, Bloomberg and Morningstar Direct
2 Source: Bureau of Economic Analysis
3 Source: Federal Reserve
4 Source: Strategas Research