Dan Chung: The Sky Isn’t Falling
May 30, ​2018​
After a nearly one-and-a-half-year period in which the S&P 500 Index didn’t experience a single monthly decline, market volatility has returned and many pundits are opining that rising interest rates, monetary tightening, and the aging of the bull market could spell doom and gloom for investors. Our in-depth fundamental research of companies and industries, however, provides a more optimistic view. Contrary to many headlines, the sky isn’t falling. Rather, we believe market valuations, high levels of innovation, vibrant economic growth driven in part by tax reform, and most importantly, strong earnings growth are likely to support additional equity gains.

​With 97% of companies having reported their first quarter 2018 results, S&P 500 earnings grew 24.6% year over year, according to FactSet Research. If the 24.6% rate continues as more companies report, it would be the strongest earnings growth since the third quarter of 2010, during which earnings grew 34%. We note that the 34% was based on earnings growing from the depth of the Great Recession. In such instances, strong earnings growth isn’t uncommon because only a small increase from a small number can represent a large percentage.

For the first quarter, earnings growth for all 11 sectors exceeded the estimated growth rate of 17.1%. Among the 97% of companies that have reported, 78% announced positive earnings surprises and 77% announced positive sales surprises. If the 78% rate persists or strengthens as more companies report, it would be the highest percentage of positive earnings surprises since FactSet began tracking the data in the third quarter of 2008.

Earnings growth is benefiting from tax reform’s reduction of corporate taxes, which accounts for about one third of the growth according to Alger estimates. However, we believe a high level of innovation extending across industries is driving the majority of the gains. Leading companies are creating novel products and services that use artificial intelligence, internet-connected devices, cloud computing, ecommerce, genome sequencing and other technologies. In addition to supporting earnings and revenues, these new products are disrupting industries and legacy business models.

Upward revisions to earnings estimates have meanwhile resulted in the S&P 500’s 12-month forward price-to-earnings ratio (P/E) of 16.4. While no method of forecasting market returns is 100% reliable, we believe P/E is one of the best indicators of potential future performance. Based on historical results, an S&P 500 P/E of 16.4 implies a potential 10-year annualized return of 7%-8%.

Current Valuations Suggest Equities Have Potential for Additional Gains

Note: R2 is a statistical measure that indicates the percentage of a security’s or fund’s movements that can be explained by changes in a benchmark index.

We also maintain that the Federal Reserve’s monetary tightening isn’t a harbinger of imminent doom.  Equity markets tend to rise as the Fed increases its Fed Funds rate and recessions typically don’t occur until after the real Fed Funds rate (the amount that the rate exceeds inflation), reaches at least 2%. The current real rate is only 0% and the Federal Reserve anticipates raising rates only 75 basis points a year, which implies that economic growth may continue at least into the near future​.​​

Fred Alger & Company, Incorporated is the parent company of Fred Alger Management, Inc. The views expressed are the views of Fred Alger Management, Inc. as of May 2018. These views are subject to change at any time and should not be interpreted as a guarantee of the future performance of the markets, any security or any strategies managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities.  Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities.

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