01 Oct Quarterly Letter to Clients – September 2018
The U.S. economy is now into its tenth year of expansion, just eight months shy of matching the longest period of increase on record and showing few signs of slowdown. Economic strength has been broad-based with no segments showing major weakness. Corporate profits have been expanding nicely in this environment, helped also by lower corporate tax rates.
Overall economic metrics have been impressive. Growth of GNP was a strong 4.2% in the second quarter. While the rate of increase the rest of the year is likely to be less, it should still be at a relatively high level. Employment statistics have also mirrored strength of the economy. Unemployment has been moving down steadily, and at the end of the third quarter was at a 49-year low of 3.7%. Consumer spending, a major component of gross national product, has been increasing at a good clip, reflecting both positive consumer confidence and good availability of funds from savings.
Since 2009, stocks have had a bull market run greater than the growth of corporate earnings, leading some analysts to label the present market fully priced or even overpriced. Price/earnings ratios seem to tell a different story, however. On January 1, 2009, after stocks had suffered large losses in the prior year, Standard & Poor’s 500 Index stood at 866. That was the starting point of the move which carried the Index to 2,914 at the end of September this year. During this period, year-end price/earnings ratios on prior year earnings ranged from a low of 14.9 to a high of 25.3, and averaged 20.1.
This year’s end-of-September Standard & Poor’s 500 close was 18.0 times consensus earnings for the present year. Since the consensus estimate for 2019 projects a 10.3% earnings gain, this would place the Index at a 16.3 multiple of next year’s earnings, well below the average of the past eight bull market years and even below the 16.8 long-term average dating all the way back to the 1870s. On a valuation basis, therefore, stock prices appeared reasonable coming into the fourth quarter.
That being said, there clearly are risks in these assessments, including possible overly optimistic consensus earnings projections, or damaging consequences from the trade wars being waged by the Administration. Current relationships with North Korea, Russia and other countries are not very reassuring either. Nonetheless, the economy is showing excellent momentum and strong corporate earnings growth. With price/earnings ratios at reasonable levels, there even appears to be room for some disappointments. We therefore remain optimistic, but believe as ever that careful selection of individual securities is as important as the overall market outlook.
James M. Connors
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