Valuations, Recessions and Bears, Oh My!

| December 21, 2018
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Stock Valuations Have Come Down Significantly

The benefit of market declines is of course that stocks get cheaper. How much cheaper have they gotten? After trading at a price-to-earnings ratio (PE) just under 19 only 11 months ago (based on next 12 month's consensus earnings estimates from FactSet), the S&P 500 PE has fallen to 15, slightly below the long-term average. Given low inflation and still-low interest rates, and our still positive earnings growth outlook, we believe stocks are below fair value.

Economic Recession Unlikely in 2019

The average annual peak-to-trough decline since 1980 has been 14%, very close to what investors have had to stomach in 2018. Average volatility feels worse than average, but putting market swings in context can be reassuring. In a midterm election year the average decline is slightly larger (16%), while even in up years, the average peak-to-trough decline has been 11%. Keep in mind that since WWII, the S&P 500 has never declined in the 12 months following a midterm election (18 for 18), and no recession has occurred when earnings rise, as we expect in 2019-our forecast calls for a 6-7% increase in S&P 500 earnings next year.

Bear Markets Unaccompanied by Recessions Are Rare and Not Worse Than This 4th Quarter

Over the past 40 years, the S&P 500 has experienced only one decline >20% that was not accompanied by a recession based on closing prices and that was 1987. It did come very close three times, falling 19% peak-to-trough in 1978, 1998, and 2011. No one can predict with certainty how far this latest selloff will go but fundamentals, including a low probability of recession in 2019, and historical perspective suggest much of this selloff may be behind us.

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