The US stock market entered 2018 looking a lot like 2017: low volatility, a broad advance led by large technology stocks and investors optimistic – if not complacent. This all changed around mid-January, as volatility resurfaced with a vengeance. 
The approximate cause of the early downdraft in stocks was growing concerns about inflation and interest rates.
However, as the first quarter unfolded, volatility continued, and new concerns arose surrounding a trade war with China. We also saw some questions raised around the business models of certain large-cap tech companies. Consequently, the US market recorded its first quarterly decline since 2015.
The volatility and concerns are continuing. However, stepping back from the day-to-day ups and downs of the market, we continue to believe the underlying fundamentals are sound. None of the normal, historical precursors of recession and bear markets are present. Economic growth is solid across the world. In the US, we expect GDP growth to improve from the approximately 2 per cent annual rate it has been stuck at since the financial crisis.
After years of underinvestment, domestic capital spending is poised for acceleration. Led by surging employment growth and, abetted by somewhat better wages and lower taxes, household incomes are growing again. Housing construction activity, which historically has been a key driver of US economic growth, is set to accelerate based on demographics and underinvestment since the crisis in 2007-2008. Earnings growth this year should approach 20 per cent, boosted by the recently enacted tax bill and faster GDP growth.
The Federal Reserve is likely to continue normalising rates this year, but there is a debate about how many times the central bank will hike. Gradually rising interest rates – from a low level, impelled by stronger economic growth – have not historically been an impediment to higher stock prices. We believe there is still enough slack in global markets for goods, commodities and labour to keep inflation at or below most central bank targets of 2 per cent.
A change in market leadership is likely
It is possible to paint a dire picture, based on a spreading trade war with China. This possibility cannot be ruled out completely. However, in our experience, it is wiser to position portfolios for the most likely outcome and not for a high-risk, but-low-odds, result. We believe, in spite of some real economic concerns and grievances, the impending ‘trade war’ is mostly political posturing and neither side would benefit from a significant escalation.
Despite this, we must acknowledge leaders make irrational mistakes. Until the air clears, this concern likely will weigh on stocks. Further, it may prevent stronger earnings growth from being fully translated into higher stock prices.
Market corrections such as the ongoing one often have ushered in a change in market leadership. We believe it is quite likely the technology sector – particularly social-media companies – may struggle for a while. Business models are being questioned, if not attacked outright, valuations seem extreme and the sector is approaching the same share of the market’s capitalisation it held during the ‘internet bubble’, which disastrously ended in 2000.
The FANGs sell at 133x current earnings and 73x 2018 estimates. That compares to about 17x earnings for the S&P 500. These four stocks also comprise nearly 8 per cent of the S&P 500’s market capitalisation.
On the other side of this correction, we expect a much more ‘democratic’ market – with many more stocks and sectors showing good performance on the basis of earnings and attractive valuations. We believe a reversal of the dominance of growth stocks, compared to value, may well be under way. Also, we would expect attraction to companies displaying growing dividend streams to re-emerge in the still-low interest rate environment.
Ed Cowart is manager of the Nordea 1 – North American All Cap fund. The views expressed above are his own and should not be taken as investment advice.