Both Canadian and U.S. stocks were lower for the second week in a row as Washington-related drama continued and a terrorist attack in Barcelona weighed on investor sentiment. After reaching record-low levels of volatility in late July, the S&P 500 has logged two of its three worst trading days over the past two weeks, dropping the index 2% below its all-time high. With U.S. large-cap stocks near all-time highs, stocks aren’t inexpensive, but price-to-earnings ratios, one way of valuing stocks, have been above average for several years. Above-average valuations have a poor track record of predicting any short-term market moves. However, high valuations have frequently been followed by below-average stock returns. Prepare for a return to higher market volatility and lower long-term returns by keeping your expectations realistic and preparing to buy during short-term market pullbacks.
Canadian and U.S. stocks pulled back last week as political turmoil in Washington heightened concerns that focus will be diverted from President Trump's pro-business agenda. We've seen similar investor reactions this year, including a 1.8% dip in March as the initial Republican health care reform bill failed to find the necessary support in the U.S. House of Representatives. Stocks reacted again in May in response to developing White House investigations, falling 1.9%, followed by a 1.4% decline in June (U.K. election, hearings on U.S. Capitol Hill) and a 1.7% dip earlier this month (escalating North Korea tensions).
The aforementioned catalysts should not be dismissed, but we think expectations for the speed and impact of President Trump's reforms have (appropriately) come down, and geopolitical uncertainties tend to drive markets for short spurts instead of extended periods.
Instead, we think an assessment of the stock market's prospects should center on broader influences. Doing so lends a more positive view of the road ahead than last week's 0.5% drop in the TSX and 0.6% decline in the S&P 500 would suggest. We think we are moving through a gradual transition of power, wherein corporate earnings growth will take the wheel from central bank stimulus.
Make no mistake, the U.S. Fed's unprecedented stimulus is far from gone and the Bank of Canada is still a ways away from normalizing interest rates. The BoC's target rate is currently 0.75% and the fed funds rate is at 1%, compared with 20-year averages of 2.5% and 2.2%, respectively. And the U.S. central bank is still purchasing bonds each month, keeping ample liquidity in the system. Borrowing rates remain at favorable levels - evidenced by the current 10-year government bond rates of 1.9% in Canada and 2.2% in the States.
Since the U.S. Fed first initiated QE1 (its initial bond-buying program) in 2010, the S&P 500 has delivered a total return of 225% (the TSX returned 115% during that period). This gain is not exclusively due to central bank actions, but there's little doubt that the Fed's unprecedented stimulus has provided horsepower to the markets and supported investor confidence/risk taking.
Though not yet hitting the brakes, the Fed will be letting off of the accelerator moving forward by way of gradual rate hikes and a protracted reduction of its balance sheet (bond purchases). While the Bank of Canada did not implement such aggressive monetary policy stimulus over recent years, it too is beginning to pivot toward a less accommodative stance with a July rate hike and the potential for additional hikes if economic conditions warrant. As this occurs, we think the next phase of the bull market will be guided by corporate earnings.
Earnings in the Driver's Seat
While a road paved by profits may not provide quite the "safety net" against volatility that we saw from open-ended Fed stimulus, history shows us that corporate earnings are a powerful driver of longer-term market performance. On this front, a look under the hood at recent earnings trends is encouraging.1
Rising earnings won't prevent higher volatility, but we do think they set a solid foundation for this bull market to put on a few more miles. To position, consider:
Sources: 1. S&P500 earnings data from FactSet, based on 91% of S&P 500 companies that have reported Q2 2017 results. TSX earnings data from Bloomberg.
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In a light week of economic reports, retail sales will come on Tuesday.
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