Dr. Dolittle, central bankers and the stock market

The directionless U.S. stock market in the first few months of 2018 reminds us of a creature from Dr. Dolittle, and we don’t mean “Jip” (his dog). No, we’re thinking of the pushmi-pullyu. Recall this fantastical creature, a cross between a gazelle and a unicorn, had two heads at opposite ends of its body. Most of the time “they” got along fine, but occasionally their wills clashed, and the result was stalemate. For stock investors, the clash of market forces in 2018 involves a far less colorful set of opponents—in this case booming corporate profits and a Federal Reserve determined to “normalize” interest rates. (Wishing we’d stuck with Dr. Dolitte?) The outcome has been the same, however; market stalemate. This essay aims to describe each of these countervailing forces, as well as suggest an eventual winner in the battle for the wills and wallets of investors.

First the boom in corporate earnings. Thanks partly to tax reform, the first quarter of 2018 was good for the economy and stupendous for corporate profits—particularly for large companies that make up the S&P 500 Index. As of May 7, 87 percent of the S&P 500 had reported first quarter results. All 11 sectors within the index reported earnings above expectations, led by Technology, Financials and Industrials. Seventy-two percent of companies beat profit expectations, 73 percent beat sales estimates, and 57 percent beat on both—the highest proportion of beats in the history of data series, going back to 2000. Overall earnings growth in the first quarter is tracking at 23 percent year-over-year, the best rate of increase since 2011. Bank of America, which compiles the numbers, says the gains are broad-based, and result from more than just lower taxes. Pre-tax profits in the quarter are also up 13 percent, and sales are up 8 percent versus 2017, also the best result in 7 years.

So the economy is clipping along fine, with unemployment at multi-decade lows, and corporations flush with newly earned (or repatriated) cash. These amazing stats have not been sufficient to move share prices, however. After soaring 25 percent in the 12 months after Donald Trump was elected, the S&P 500 Index has been stuck in a trading range since early February, and remains flat for 2018. What’s the problem?

The problem is that stock prices are a product of two factors: per-share earnings, and the multiple places on those earnings. The steadily rising earnings detailed above do investors no good if the multiple (P/E) which markets place on those earnings is simultaneously declining, as has been the case in 2018. Price/earnings multiples have fallen from 19 to around 17.5 since December. Essentially the “push me” of higher profits has been offset by the “pull you” of lower P/E multiples, resulting in a flat market.

But why are multiples falling? It turns out that P/E multiples move inversely with interest rates. Investors can therefore thank the Federal Reserve, which has been pushing up interest rates for more than two years, for the static market. Throughout the latter years of the current long economic expansion, and up until this year, higher interest rates seemed not to bother investors. P/E multiples were impervious to rate increases in 2016 and 2017, but now something has changed. Perhaps that “something” is the credibility of the Fed? After more than two years of steady interest rate increases, investors now believe the Fed is serious, and will not be deterred from “normalizing” rates—not even by a potentially punk stock market.

Bottom line: The Fed has signaled quite clearly that it intends to push interest rates back up to a more historically normal level (perhaps 3 percent on the Fed Fund rate), after a decade of suppressing rates with massive Quantitative Easing (QE = money printing). Importantly, they wouldn’t be doing so unless they believed the economy was strong enough to handle more expensive money. An economy strong enough to generate record corporate profits should also be strong enough to withstand higher, yet still historically low, interest rates. The current Fed is not likely to be deterred by the stock market gyrations, even pronounced gyrations to the downside as we saw in early February. They will continue to raise interest rates, and the markets are starting to recognize it.

In some sense, the current environment marks a return to a more “normal” (as in pre-2008/pre QE) stock market, without artificially depressed volatility caused by money printing. Put a little differently, the economy and the markets are healthier, and the “morphine drip” of free money is ending. That’s a good thing. Share prices may do a bit more “pushing and pulling” in the next few years, and many (particularly young and inexperienced) investors may be disturbed by it. So be it. As long-term investors, we’re happy to return our focus to where it belongs—the performance and prospects of the businesses we’ve invested in—rather than the monetary scales in Washington.