Equity Market: A Hot Summer Before The Uptrend Resumes
Equity markets reached an extremely overbought condition in January.
“Equity markets reached an extremely overbought condition in January. They have since entered a volatile period, fluctuating within a lateral range. Although this volatility is set to continue during the summer months, the primary uptrend should return at a later stage, thanks to positive fundamentals.”
Roger Keller
Chief Investment Advisor
The medium-term outlook is positive
Our base-case scenario remains that the global economic expansion will continue. That said, its pace will be more modest, closer to its long-term sustainable growth rate, which will lead to a slower progression of earnings. Consensus expectations are that earnings growth will decelerate from 15.5% this year to 9.4% next year; our scenario is based on slightly lower numbers, particularly in 2019. Historical data show that as long as earnings remain on an upward trend, the bull market stays alive. The main risk is linked to international trade tensions. We will closely watch the publication of business confidence indicators to gauge whether earnings expectations need to be revised down significantly.
Valuations at around long-term averages
Valuations will not stand in the way of markets reaching higher levels over the next 12 months. Indeed, the 12-month forward PE has fallen from 16 times to 14 times over the last few months due to a combination of upward earnings revisions and market weakness. The current prospective PE is marginally below its long-term average (14.6x). The price-to-book of approximately 2 is in line with its long-term standards, while the dividend yield (2.4%) is attractive, particularly compared with bond yields outside the US. More importantly, bull markets do not end with valuations around their long-term averages; they usually reach high or extreme levels due to investor euphoria.
A new regime for volatility
With growth peaking, inflation strengthening, monetary conditions normalising slowly and central bank liquidity being withdrawn gradually, we observe that backwinds are fading. In addition, rising bond yields will prevent valuations from expanding. All these developments augur in favour of a regime change versus 2017: a regime of higher volatility. Obviously global trade tensions will contribute to this rise in volatility. Intensifying volatility coupled with an expected widening of the return dispersion are supporting active asset management.
Seasonal factors point to lacklustre returns over the summer
Looking at market behaviour since 1950, there have been repeated patterns. June, August and September are months that deliver the worst returns on average. Hence the famous saying “Sell in May and go away”, which reflects the fact that the six-month period between May and October historically produces the worst returns on average: 1.9% versus 7.1% for the best six-month period (November-April). Another seasonal factor worth mentioning is the US Presidential cycle: since 1928, the second year of a president’s mandate has traditionally been the worst (the best year is the third). These statistics comfort our current recommendation to leverage on volatility to buy, assuming that markets will move higher in 6-12 months.
The bottom line
Equity markets will probably lack positive catalysts during the summer months. They are likely to behave in a volatile way, especially as political uncertainties (particularly trade tensions), are likely to remain high. The upward trend should resume at a later stage.