- With valuations stretched and earnings growth past its peak, we believe U.S. equities are priced for perfection.
- Geopolitical and trade issues may need to be resolved before the market can continue higher.
- Against this backdrop, we maintain a positive yet cautious outlook for equities.
Kevin Preloger: We think that valuations are very stretched at this point because we think that earnings growth probably peaked late last year, and now you’re seeing earnings expectations being ratcheted down. And so the rally we’ve seen year to date has been all multiple expansion. So we were cautious last year. We’re even more cautious this year, given the run that markets had, and it seems to be priced for perfection.
Valuations is the key concern, and I think the risk to the market at this point is: Does the Fed reverse course? Do they start to raise interest rates because inflation spiked? If you look at commodity prices, for example, oil prices have gone up and the price of the dollar, if oil goes up, the dollar goes up, you’re somewhat exporting inflation to other countries, so does that lead to economic weakness elsewhere? And I think there’s a whole host of geopolitical events that could occur at any time that the market might not be prepared for. In addition, nothing’s been settled with China. It seems to be an extend-and-pretend situation. So, tread those headlines at your own risk, but I think we also feel that for values, we would really focus on value equities. And we think that the small- and mid-cap space provide decent opportunities, as they’re much more attractively priced than, say, small- and mid-cap growth equities.
For instance, in the first quarter, for small- and mid-cap growth stocks, they outperformed small- and mid-cap value stocks by over 500 basis points. So if it’s a function of value equities finally catch up or value equities go down less because growth equities went down a lot more – we’re not sure which scenario occurs, but we feel that [with] value, you’ve got some downside protection on valuation but also, if the market continues its march higher, then I think people still participate but to a lesser extent.
I think one of the keys areas of concern is probably just disruption and the likes of Amazon and other interrupters of the traditional ways of doing business. So I think what we need to focus in on is the competitive advantage in companies that are durable, that can withstand that sort of threat.
We feel the valuations are priced for perfection, but the market could probably continue to grind higher because equities are still the better place to be versus fixed income and some other asset opportunities. So we like the outlook for equities. Although they’re not at the Fantasyland-type valuations that you saw in 2000, but they are rich. So the companies need to deliver on earnings, and we need, I think, a relatively quiet geopolitical environment and perhaps some of the trade issues to be resolved before the market can continue higher.