from the February investment comments by Provident Investment Management
We should note that stocks derive their value from corporate earnings, not overall macroeconomic performance. These two things tend to be highly correlated — businesses generally make the most money when the economy is performing at a high level — but it is also possible for the rate of profit growth and economic growth to diverge for periods of time. We may be entering such a period, which in turn may explain why financial markets are flashing warning signals when major economic indicators are not.
The canaries in the stock mine are starting to wheeze. Cyclical industries like homebuilding and semiconductors did poorly in 2018. Homebuilders were very weak in the beginning of the year and, no surprise, the housing market cooled dramatically in the second half of the year. Semiconductor stocks were big laggards in the second half. As if on cue, their largest downstream customer, Apple, shocked the market on January 2 by preannouncing revenue expectations 8 percent below analyst estimates. Competitor Samsung reduced its estimates as well. With cyclical stocks rolling over, some analysts are warning of an impending “earnings recession,” where aggregate corporate profits decline despite generally favorable macroeconomic conditions. Cyclical stocks always tend to extremes, however, and it is easy to get carried away projecting a major downturn when the reality is much more modest slowing.
Valuations remain generally consistent with the low level of long-term interest rates. After a year of negative returns, the S&P’s forward P/E ratio is now 8 percent below its 5-year average according to FactSet’s January 11 Earnings Insights by John Butters. If anything, we would say the market looks a little cheap right now. This could imply that forward earnings estimates are too optimistic, meaning forward valuations are actually higher than they seem, or it could signal that long-term rates will rise. It is possible neither will happen — rates could stay low while corporate profits advance. Both are unlikely to happen together. It is hard to imagine that long-term rates will recover meaningfully without business performance keeping pace.
A balanced investment strategy should reliably participate in periods of economic strength and also weather periods of economic softness. You can’t afford to miss the bull moves, and you can’t let the bear moves knock you out of the game. With financial markets sending out warning signals that aren’t confirmed by the economic data, this seems like a particularly good time for investors to move slowly. Invest in a diversified portfolio of companies that also look good on their individual merits. Stick to a sensible plan over time, and your results will be fine no matter what comes.