After an unusually quiet summer, volatility is back in the market. The Dow lost almost 400 points last Friday, and has moved significantly in both directions all week. The change marks an abrupt end to a long, tranquil summer.
In the equity market, the S&P 500 Index went through 44 consecutive trading sessions without moving more than 1% in either direction leading up to the selloff last Friday. Trading volume spiked in late June following the Brexit vote but then settled down for the rest of the summer.
One of the trends we were following this summer was the continued expansion of P/E multiples, despite the lull in trading activity and the absence of proportionate earnings growth. Multiple expansion is concerning because it is often driven by investor sentiment rather than corporate fundamentals (such as earnings). In other words, we do not believe multiple expansion is a durable source of investment returns over the long term.
It is impossible to know where the ceiling is for P/E multiples in any given sector, but history shows that natural limits do exist. Stock prices do not climb indefinitely and multiples cannot expand forever.
After an unusually quiet summer, volatility is back in the market. The Dow lost almost 400 points last Friday, and has moved significantly in both directions all week. The change marks an abrupt end to a long, tranquil summer.
On the other hand, an encouraging pattern that emerged this summer was the expansion of investor participation in asset classes and market sectors beyond the "safe haven" income-focused trades that performed particularly well in the first half of the year (such as the S&P, fixed income investments or income-oriented equity sectors like Utilities and Telecommunications).
As the summer progressed, investors rotated away from income-oriented sectors and migrated toward growth-oriented sectors—a direction that is generally favorable for our portfolio positioning. Risk assets were also supported by the actions of central banks, including corporate bond purchases by the ECB, negative policy rates around the world and dovish central bank comments in the wake of Brexit.
Risks include uncertainty about the direction of Fed policy, hyperactive global central banks overseas, a growing list of questions about Brexit, the US presidential elections and geopolitical tensions. These risks have resulted in an asymmetrical risk/reward profile in the equity market.
But judging by the valuations we see in various segments of the market, investors have high expectations for earnings in the fourth quarter of 2016. The economy will have to continue improving steadily if corporate America is to meet those expectations.
Portfolio Manager Paul Johnson contributed to this report.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.