Weekly Market Update (August 14 – August 18, 2017)

By Craig Fehr August 18, 2017

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.

A Transition of Power for the Market

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.

Sliding Over

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

  • In the most recent quarter (Q2 2017), S&P 500 earnings rose 10.2% year-over-year. This is the second consecutive quarter of double-digit growth, the first time this has occurred since 2014. 
  • S&P 500 revenue growth was 5.1%, the strongest level in eleven quarters. With many companies leveraging cost cuts/discipline as a way to drive profit growth during this sluggish economic recovery, a much-needed acceleration in revenue growth would offer a healthy boost to bottom lines.
  • For S&P 500 companies that generate more than half of their sales internationally, revenue growth averaged 6% and earnings growth averaged 14%. This is consistent with our view of improving global growth, along with a reduced headwind from a rising U.S. dollar. 
  • 10 of the 11 S&P 500 sectors reported positive earnings growth, the one exception being the consumer discretionary sector.  Energy reported the strongest growth (+332%), primarily reflecting the rebound or return in profitability due to notably higher oil prices compared with a year ago.  Technology and financials were also among the strongest sectors for profit growth, indicating more economically sensitive sectors are benefitting.
  • Aggregate earnings results for the TSX are a bit less informative this quarter due the imbalances in the index's sector weightings and the sizable distortions created by the energy and materials results, given the year-over-year change in commodity prices. Nevertheless, broad takeaways are positive. Ten of the eleven sectors reported positive revenue growth, averaging 11% thanks in large part to sharp increases in the natural resource industries.

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:

  • Rebalancing to the middle of your target for equities and fixed income. We think the transition of power from central bank stimulus to earnings growth could mean higher volatility alongside broader gains over time.
  • Adding to asset class diversification. Recent earnings trends suggest North American growth is still supportive while also confirming that global growth may be firming (international developed-market large-caps, emerging market equities).

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.

The Stock & Bond Market

Index Close Week YTD
TSX 14,952 -0.5% -2.2%
S&P 500 Index 2,426 -0.6% 8.3%
MSCI EAFE* 1,926 -0.1% 14.4%
10-yr GoC Yield

1.87%

0.01% 0.15%
Oil ($/bbl) $48.64 -0.4% -9.5%
Canadian US $0.80 0.8% 6.9%

Source: Bloomberg. *5-day performance ending Thursday; Past performance does not guarantee future results.

The Week Ahead

In a light week of economic reports, retail sales will come on Tuesday.

Important Information

The Weekly Market Update is published every Friday.

Edward Jones does not provide access to past weekly summaries.

The S&P/TSX Composite Index and S&P 500 Index are unmanaged indices and cannot be invested into directly.
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Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

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The content of this report is for informational purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

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Diversification does not guarantee a profit or protect against loss.

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