Earnings, Valuations, and the Role of Active Management

As we work our way into 2019, the U.S. economy appears to be making the transition from the middle stage to the late stage of the economic cycle. With several geo-political issues in the forefront of the news, we expect to see the growth rates of economic activity decelerate both in the U.S. and across the globe. In view of that, now is a good opportunity to review some of the fundamental drivers of investment returns in this environment, and position portfolios for the future. We at Atlas are hard at work on this, and I’d like to share my views on a few of the areas we’re focused on: earnings, valuations, and the role of active management.

Corporate Earnings

As we know, corporate profits (earnings) are the most consistent indicator of stock price performance over the long term. Without higher profits, it’s difficult for the market to support higher stock prices.  

Growing profits at 20% year-over-year is a remarkable achievement

With the help of the tax package that was passed late in 2017, profits grew nicely in 2018 as compared with previous years. In fact, while the final 2018 calculations are still to be determined, it appears that on average, S&P 500 companies will have achieved around 20% growth in earnings over the previous year. As always, certain sectors, industries, and companies did better, and some worse. But for most, growing profits at 20% year-over-year is a remarkable achievement.

So, why didn’t stock prices gain 20% in 2018? Most professional market participants are less concerned with history than they are with the future. That’s why we look at expected future profits, and refer to the stock market as a “leading indicator” of future economic activity.

Going back to the second half of 2017, insightful market participants were anticipating higher profits resulting from the tax cuts that ultimately came in December. In addition, during that time, economic growth indicators were showing strength. By January of 2018, the positive news had already been priced into the stock market. In fact, from April 2017 to January 2018, the S&P 500 gained about 20%. At that point, stocks were actually quite expensive. Of course, when stock prices are high, sellers often take over. Which brings us to the subject of valuations.

Valuations

Along with profits, is the matter of valuations. Are the stocks of companies expensive or cheap relative to their profits? As we seek to understand what stock prices may do in the future, it just makes sense to look at the expectations for future profits and what resulting valuations look like.

We think that we’ll see a flattening of earnings growth early in 2019 as both the U.S. and global economies decelerate

The price to earnings ratio (or P/E, a widely used indicator of valuation) stood at 19 in January of 2018. To put this in context, the 10 year average for the P/E is 14.7¹. The run-up resulted in a market valuation that was higher than normal. Then, in late January and February, we saw a sudden sell-off, leading to a more volatile market for the rest of 2018.     

So, with earnings having shown solid growth in 2018, where might profits be going in 2019?

We think that we’ll see a flattening of earnings growth early in 2019 as both the U.S. and global economies decelerate. I’m not suggesting that an economic recession is likely this year, but rather we expect a slowing of the rate of expansion. As a result, profit growth may be unsustainable for some companies in the first two of quarters of 2019. That said, this would likely be a temporary issue in our opinion.

Active Management

To be sure, there are times when index investing holds an advantage over active management, and vice-versa. In fact, most prudent investment strategists advise using a combination of indexing and active management over the long term. This is commonly referred to as a “core and satellite” investment strategy, which we at Atlas employ as part of the overall strategy for our clients.

That said, we think that at the moment we’re in more of a “stock picker’s environment” than we’ve seen in years. This is where the value of active management shows. While we expect stocks to move forward this year, we expect stock pickers to assume an advantage, with potentially more moderate returns from the major indices.

In this environment, when volatility is increased, fundamental differences in companies become more meaningful to investors. Insightful analysts and portfolio managers look for catalysts for increased profitability or unusually attractive valuations. Competitive issues are heightened, and the management of a company can become more important than simply the industry they’re in.

We’re encouraged by the recent performance of our active manager lineup, and expect the value of their active management to become evident as we move forward in this late stage of the economic cycle.

While the economy and markets are an important focus for us at Atlas, continuing to improve and foster the advisory firm that our valued clients require is of equal importance. We’ve been hard at work, and are excited about the future.

We do hope that when you have any financial decision facing you, you think of Atlas as a trusted and objective voice. As always, feedback is extremely important to us, and we enjoy hearing from our valued clients. If you have any questions about this or any other financial topic, please feel free to contact your Atlas Wealth Management Advisor.

¹ Factset Earnings Insight, February 22, 2019.