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Brian Andrew, CFA

Which Glass Is It?

Investor sentiment is a fickle thing. Over longer periods, stock prices reflect the fundamentals of company performance, i.e., revenue and earnings growth, as well as profit margin expansion or contraction. However, on any given day, how investors feel about the prospects for those fundamentals can move stock prices, sometimes significantly. In 2017, all news was seen through a glass‐half‐full lens. As the first quarter of 2018 closes, it seems that the glass‐half‐empty perspective has taken over sentiment. We can use this change in sentiment to our advantage if we understand how this happened and how it might affect what lies ahead for asset prices.

Volatility

Perhaps the easiest way to see this change in sentiment is by looking at stock price volatility. The index we use to understand how investors are viewing price volatility in the next 30 days is the Chicago Board Options Exchange Volatility Index, or “VIX.” As you can see from the chart below, the index was basically stuck near 10 for ten of the last twelve months. Then, in February, the index shot up, and stock prices retreated after being up more than 8% in January of this year.

Since then, we've seen substantially higher price volatility as investors' moods have swung from only seeing that half‐full glass as empty. In fact, the last two days are an excellent example of this change in volatility. The Dow Jones Industrial Index has swung more than 2,000 points up and down.

While media outlets would have everyone believe this is a function of President Trump's tweets regarding Amazon, a trade war and Facebook's data security problems, the reality is probably different.

Glass Half Empty or Half Full?

These issues represent investors' focus on news as being mostly bad. You may recall that nine months ago, everyone was talking about the promise of tax reform and the global synchronization of economic growth accelerating. Bad news was pushed to the side quickly in favor of a more positive outlook about the future.

Keeping in mind that a stock's price is no more than present value of future earnings, investors are always future focused. That bright future everyone saw nine months ago is here. Tax reform passed, the benefits were priced into stock prices and global growth has accelerated.

Stock prices rose dramatically from last August through the end of January – up over 15%. Now investors are looking into the future again and wondering how we can keep up the pace of growth we've priced into these stocks.

Here is an example. The companies in the S&P 500 Index are expected to grow earnings for 2018 by almost 20%. About one quarter of this growth comes from the benefit of corporate tax reform. Stock investors are learning that much of the reform benefit is one‐time, so estimates for growth in 2019 are “only” 10% (still about a third higher than the long‐term average growth rate). This is great news, and as these expectations took hold, investors rallied stocks in January by more than 8%. Because they are future focused, they begin to wonder what can go wrong now that everything is priced for this glass‐half‐full future.

Enter the glass‐half‐empty crowd. In February, stock investors noticed that the Fed was still talking about raising interest rates, and that intermediate and long‐term rates had risen quite a bit, resulting from the better economic growth and inflation story. Employment growth had exceeded everyone's expectations (last year that was viewed as good news), and those worried about rising interest rates only saw the potential for faster wage growth leading to even higher inflation. This group became known as the “four or more interest rate hikes” crowd. This, combined with some problematic volatility in ETFs, led to the volatility spike in the chart above.

Since then, we've had a raft of uncertainty. Congress had to pass a budget bill that stalled twice before being finalized and approved by President Trump to the dismay of the more fiscally conservative in his own party. Some noted the potential for a $1.2 trillion deficit in this fiscal year as problematic.

Then technology stock investors noticed that they had run up prices to the point where there wasn't any room for bad news. Amazon was up 33% from January 1 through the first week of March. Facebook was up another 10% during the first month of this year after rising 40% in the prior eight months.

The glass‐half‐empty crowd decided that when news broke about Facebook's security issues, the price increase was too much. They viewed the president's tweet about Amazon taking advantage of the U.S. Postal Service as bad news. They decided that the fatality in a Tesla crash and the company's inability to deliver on its 2,500 car quota meant that the stock was too expensive.

In 2017, the glass‐half‐full crowd was in charge, and these news events would have been viewed as mere bumps along a rosy path to higher prices. Unfortunately, with the shift in sentiment and the glass‐half‐empty group in charge, they become problems too big to overcome. The reality is likely somewhere in the middle.

We had written about the stock market's valuation last year and noted that it was priced for perfection. That is, good economic news leading to better revenue growth, better employment leading to higher wages and more consumption, higher profit margins and earnings leading to better stock prices.

When valuations get that high (remember the S&P 500 Index traded for more than 18x future earnings, 20% above the long‐term average), everything has to continue to go right and future expectations need to continue to build.

Now with the change in sentiment, investors worry that better economic growth is peaking, higher wages will lead to more inflation and even higher interest rates, profit margins can't get better than they'll be this year, and that 30% earnings growth over the next two years can't get better.

Our view is that it is the same glass. A change in sentiment presents opportunities for acquiring assets at more attractive levels. If we can buy the same half‐full glass at a price that is 10‐15% cheaper, all the better. The good news we saw last year about employment, the economy and earnings growth is still in front of us for 2018. One thing we know for sure is that sentiment will shift again, perhaps even during the second quarter.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.