Schwab Market Perspective: Navigating the New Environment

Key Points

  • U.S. stock indexes have rebounded from their correction lows, although remain short of new highs; but risks remain elevated that additional bouts of volatility will likely erupt.

  • First quarter earnings season has exceeded elevated expectations allowing valuations to improve alongside the recent consolidation in prices; but geopolitical concerns persist and uncertainty about the midterm elections could keep investor sentiment from becoming frothy again, and keep the Federal Reserve from tightening policy more swiftly.

  • European and Japanese earnings seasons have resulted in better stock market performance in those regions than in the United States, despite a lower “beat” rate—a further illustration that diversification is essential at this stage in the market cycle.

We’re not in Kansas anymore

Investors may be feeling a bit like Dorothy from the Wizard of Oz who was dropped into a world that was nothing like she had known. In 2017, all news seemed to be good news and stocks moved consistently higher, while volatility stayed remarkably low. Now well into 2018 and it’s a completely different world—most news is seen through more negative lenses, volatility has returned and although stock indexes have rebounded off their lows, they continue to struggle a bit to find direction.

A different world


S&P 500 Composite Index



There’s no yellow-brick road to follow, so how should investors deal with this new world? In a word—patience. We don’t believe we’re on the precipice of a prolonged downturn in stocks, but an uptrend may be difficult to sustain in the coming months. We’re entering a traditionally weak seasonal time of the year and midterm election years have not been kind to the bulls in the past. Even though past performance does not guarantee future results, the S&P 500’s average loss (or “maximum drawdown”) during midterm years has been 17%, largely concentrated in the first three quarters; with subsequent one-year rallies of an average 32% from our analysis. Before trying to time that “trade,” however, remember that successful market timing requires two correct decisions—you have to get both the sell and the buy decisions right. History often rhymes but rarely repeats exactly, and given more rapid movements related to algorithmic trading, that timing could be compressed, thrown off, or entirely different this time.

Conditions improved, but more work may need to be done

Earning season has bested elevated expectations, with the S&P 500 posting earnings growth to-date of 26%, above the roughly 16% expected coming into the season, according to Thomson Reuters (for more on earnings season read Liz Ann’s Beast of Burden of a High Earnings Bar). Some companies have been rewarded, but the indexes struggled in the first month of the quarter, before rebounding more sharply in May. Courtesy of a stock market that hasn’t yet taken out its January highs, and the surge in forward earnings expectations, valuations have improved. The S&P 500’s forward P/E dropped from 18.6 in late January, to 16.5 currently—only slightly above the 20-year average according to Thomson Reuters.

Investor sentiment also corrected along with the market’s correction, with the Ned Davis Research (NDR) Crowd Sentiment Poll now in neutral territory. It’s the extreme pessimism zone which has historically been associated with the most robust stock gains, in keeping with the contrarian nature of sentiment. In addition, consumer confidence has remained elevated and in a zone which NDR has shown to be associated with the weakest returns in stocks.

Consumer confidence may need to fade

Consumer confidence

Bear not in sight

While a sustained upward move has some formidable constraints, a prolonged bear market seems unlikely given the limited risk of an economic recession in the near-to-medium terms.  Economic data has been modestly softer recently, as seen in the Citi Economic Surprise Index below, but that’s helped to lower the expectations bar, which could set up the opportunity for the surprise factor to improve. Remember, when it comes to the connection between economic fundamentals and stock market performance, “better or worse (relative to expectations) tends to matter more than good or bad.”

Surprise index decline stalled

Citigroup Economic Surprise Index - US

Additionally, both Institute of Supply Management (ISM) surveys—manufacturing and services—remain comfortably in expansion territory (above 50), despite easing a bit recently; while the forward-looking new orders component for both indexes remain above 60.

ISMs continue to indicate growth

ISM manufacturing vs non-manufacturing

The labor market also looks healthy, with the forward-looking jobless claims number remaining near historic lows, 164,000 jobs added in April, and an unemployment rate which fell to 3.9%--the lowest level since 2000. However, wage gains remain modest, with average hourly earnings (AHE) rising 2.6% year-over-year, in line with last month’s downwardly-revised level.

Claims indicate continued growth

Weekly initial jobless claims - 4-week MAV

In the midst of this relatively good earnings and economic news, there are continuing trade and geopolitical concerns weighing on the market and sentiment.. Trade rhetoric has been harsh at times from both sides, but negotiations are ongoing and to date, no substantial trade actions have yet been taken, which is good news. At this point, we view the risks as asymmetric—with investor sentiment suggesting a worse-case scenario is expected, meaning market’s would likely take kindly to a more benign or positive outcome.

Monetary tightening and fiscal stimulus

The Federal Reserve maintained the current level of short-term interest rates at its most recent meeting but gave no indication that it will deviate from its path of gradual hikes—noting that inflation will “run near” the bank’s 2% target. Fed officials have also expressed a willingness to tolerate inflation moving above that level for some time (a “symmetric” view about inflation) to cement the reflationary theme. The latest inflation data shows still-subdued upside pressure, but leading indicators for inflation—including tax cuts, the closure of the “output gap,” and a tighter labor market—have firmed.  Of all the concerns weighing on the market, inflation and monetary policy are the ones we view as most important—a more aggressive Federal Reserve could quickly change the outlook for both the timing of the next recession and the longevity of the bull market in stocks.

Global earnings also in focus

It’s not just in the United States that investors narrow their focus four times a year  to the most fundamental driver of investment performance: earnings. The first quarter earnings season is drawing to a close in the United States and has now passed the midway point in Europe and Japan, contributing to some interesting—and counter-intuitive—stock market outcomes.

It’s been a strong global earnings season, with first quarter earnings-per-share from companies in Europe and Japan joining the United States in posting double-digit growth relative to a year ago. Yet, stocks have performed differently across regions during the earnings reporting season that kicked off about a month ago, as you can see in the table below. Given how much stronger-than-expected earnings were in the United States (with 80% of companies beating Wall Street analysts’ consensus estimates), it may seem that U.S. stocks should have outperformed their European and Japanese peers (where beat rates were 57% and 40%, respectively). Yet the opposite has occurred.

First quarter earnings season: earnings beats and stock market performance

Earnings surprises vs change in market index

Regions represented by the MSCI USA Index, MSCI Europe ex-UK index and MSCI Japan Index.
Source: Charles Schwab, Factset data as of 5/8/2018.Past performance is no guarantee of future results.

The exceptionally high rate of  positive surprises in U.S. earnings is mostly due to tax (and regulatory) reform; while Europe and Japan saw soft spots in their economies during the first quarter that may have impacted earnings and forecasts thereof. All three regions have seen upward revisions to earnings estimates for the coming 12 months according to Factset.

The widely-watched global Purchasing Managers Index (PMI) has been a good indicator of where overall earnings for global companies may be headed. The global PMI peaked in January then fell in February and March, but showed some stabilization in April. This may help to account for stocks’ lackluster performance this year as market participants factor in a peak in the earnings growth rate (although not a peak in earnings-per-share).

Is the global PMI signaling a peak in earnings growth?

MSCI World EPS vs Global Manufacturing PMI

Source: Charles Schwab, Bloomberg and Factset data as of 5/9/2018. Past performance is no guarantee of future results.

The stabilization in the global PMI in April may be signaling the economic soft spot was over at the start of the second quarter; suggesting the slowdown in the pace of earnings growth may be modest, which may have helped to support global stocks in recent weeks. Global stocks have been tracking the typical pattern for a correction, as you can see in the chart below.

Is the stock market correction over?

Market corrections

Source: Charles Schwab, Bloomberg data as of 5/9/2018.
Past performance is no guarantee of future results.

If this turns out to be a typical correction, as the market behavior so far seems to suggest, then it may be over. But that doesn’t necessarily mean short-term volatility is likely to subside. While earnings may continue to rise, even as the growth rate slows, other factors may return to buffer the market as investors’ focus widens from earnings to politics and central bank actions, among other factors.

So what?

A more challenging investing environment requires a more disciplined and patient investing approach. The next few months could continue to be choppy, but a U.S. and/or global recession still appears a ways off, which should keep the bull market—here and globally—intact.

Important Disclosures

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. This content was created as of the specific date indicated and reflects the author’s views as of that date.

Diversification and rebalancing of a portfolio cannot assure a profit or protect against a loss in any given market environment.

Past performance is no guarantee of future results.  Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Chicago Board of Exchange (CBOE) Volatility Index (VIX) is an index which provides a general indication on the expected level of implied volatility in the US market over the next 30 days

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology. 

The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.

The Citigroup Economic Surprise Index is an objective and quantitative measures, which show how economic data are progressing relative to the consensus forecasts of market economists.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

ISM Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation, by the Institute of Supply Management (ISM). The ISM Non-Manufacturing Index tracks economic data, like the ISM Non-Manufacturing Business Activity Index.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 626 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

The MSCI Europe ex-UK Index is an index that the captures large and mid cap representation across Developed Markets countries in Europe, with the exception of the United Kingdom. With 42 constituents, the index covers approximately 85% of the free float-adjusted market capitalization.

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 321 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan

Purchasing Managers Index – The global PMI is an indicator of the economic health of the global manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries.  With 1,648 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.