Underneath the Headlines, the Market has gotten Cheap

Investors kicked off Q2/2018 by tripping on the curb: on the first day of April trading the S&P plunged by 2.2 per cent and the Dow Industrials gave up 758 points before regaining some ground to end the day down 459 points.  It takes two to tango and engage in a trade war, and investors reacted to heightened tensions between the United States and China as Beijing slapped retaliatory tariffs of 15-25 per cent on a variety of US farm products, including pork, cherries and nuts, in response to President Trump’s steel tariff announcement. This morning, we learned that China announced new tariffs on our nation’s largest exports, including autos and aircraft, in response to the escalating trade tiff.  The S&P 500 slipped below its technically important 200-day moving average for the first time since June 2016.

Buried beneath this daunting market performance are improving fundamentals. First quarter earnings season is about to kick off, and in a welcome change, analysts have been upgrading their forecasts and penciling in nearly 20 per cent profit growth for the S&P 500. Revenue growth expectations are accelerating as well. The bottom line: when you strip away the headlines, equities are now cheap.

Owning equities entitles investors to a stream of dividends based on earnings. Over time, the cumulative market return is constrained by the cumulative growth in earnings and dividends. For the first time since 2016, the S&P 500 is cheap relative to cumulative earnings and dividend growth thanks to lower equity market values and an improving earnings outlook.  As of now, the market is 7.5 per cent undervalued relative to cumulative earnings and dividends through Q1/2018.  While an unlikely trade war has the potential to push consumer prices up and productivity down, investors should take comfort in knowing that equity markets are now inexpensive relative to what really matters: earnings and dividends.