July was a positive month for the S&P 500, rising 1.3% while the core bond ETF (AGG) increased only 0.2%. Looking beyond the United States, stocks and emerging markets (stocks) slumped in the same period. Now, if we focus on the Price/Earnings ratios alone, domestic stocks may appear overvalued. However, relative value must be considered given the landscape around the world.
So, which is better, stocks or bonds? At this stage, we still favor stocks over bonds for our diversified strategies based on our outlook for solid domestic economic growth and valuations that remain attractive as interest rates have declined even as stock prices have risen. Digging a bit deeper, the valuation gap has narrowed between large- and small-caps, based on our review of trends in P/Es, price/sales ratios and dividend yields. In other words, we see potential opportunity in small- and mid-cap stocks as well as those focused on growth, as opposed to value.
Many analysts call for mid- to high-single-digit earnings growth in 2019-20. These conditions would favor growth, particularly in the United States. U.S. stocks have outperformed global stocks over the trailing five years and we are betting this trend will continue amid uneven global economic and currency conditions. In no way are we suggesting that foreign stocks should not be part of a diversified investment strategy. To be more precise, we believe the risks of investing outside the U.S. justifies a lower allocation to foreign equities.
The past 18 months provided a lot of turbulence for investors notwithstanding solid performance from stocks and bonds year-to-date. Looking across the remainder of this year and 2020, it seems that conditions will become tougher stocks will most likely be driven by earnings. Moreover, the Fed’s policy appears to be turning less dovish which we believe will push investors to (again) focus on earnings growth.
Our Assessment: We think stocks and other risk assets are likely to struggle over the coming weeks as investors digest what seems to be a shift in Fed policy and the probability for new tariffs. Beyond those points, markets will probably be driven by the question of whether the global economy is headed towards recession or progressing towards a continuation of expansion. On the whole, our opinion is the latter appears more likely. Resolution of the trade-war has become more protracted than many expected. Realistically, it could take many months to reach a fitting and lasting agreement. In spite of this feud between China and the United States, we still expect a rebound in manufacturing activity which should provide some tailwind to the aging bull market.
Looking ahead, our intermediate outlook is bullish; low interest rates and inflation, confident consumers and continued jobs growth. We are cognizant of the many risks, but our conclusion favors the theory that, while aging and likely tired, the bull market still has a little more left in the tank.