MG100 Suffers 10% Correction In October … Bottom Doesn’t Fall Out

The MarketGrader 100 Index suffered a 10% correction in October, falling hard along with U.S. equities in general, though by a greater amount than the overall market. MG100 fell 10%, trailing the Russell 3000 Index’s 7.5% decline. It was little consolation that small caps, as measured by the Russell 2000 Index fell even harder, down 11% for the month. Within MG100 there were few places to hide, as only seven stocks ducked the trend and saw some kind of monthly gain. The remaining 93 stocks fell by an average of 10% apiece.

With little to ‘sugar coat’ what was a truly awful October, our best advice for nervous investors waiting for the other shoe to drop is to look ahead, particularly at company fundamentals, in order to make an informed decision about 2019 allocations. For our money, things aren’t as bad as many think. In fact, the relatively high dose of pessimism provided by the recent correction turned market sentiment to the healthiest level we have seen in a while; especially as a parade of investment strategists continue to predict an imminent recession with their strongest argument being that we’re overdue for one simply because the current expansion is long in the tooth. Company fundamentals, at least among MG100 constituents, suggest otherwise. From a top down perspective, though, the story is a bit muddier.

First, it’s worth noting that some underlying weakness is indeed noticeable in company earnings reports when compared to what had been stellar reports during the year’s earlier quarters. More specifically, of the 92 companies in MG100 that have already reported third quarter earnings, 80 beat their consensus estimate by a median of 4.2%. This is still a healthy figure but nevertheless a couple of percentage points weaker than prior quarters. Furthermore, only 53 companies beat their quarterly sales estimate by a median of less than 1%, also the weakest record so far this year. We believe a large part of October’s correction may be attributed to investors’ expectations that further revenue gains will be harder to come by in the quarters ahead than they have been in the past couple of years. While we don’t entirely disagree, especially in a rising interest rate environment, we also don’t think things will be as bad for equities as many predict, especially at current valuations (within MG100). Here’s why.

Looking at 2019 earnings estimates, of the 99 companies in MG100 that have a FactSet consensus estimate, 81 are expected to see a fiscal year 2019 increase of 10.2% (median) from 2018. Meanwhile, 89 companies are expected to post average full year revenue gains of 10% with a median gain of 7.2%, which are both pretty solid numbers. The bigger question is what investors should be willing to pay for such gains. Here, MarketGrader’s GARP methodology should serve investors well; as we have always argued, what you pay for growth is as important as the rate of growth itself. So, considering that MG100 companies are now trading at a median forward P/E of 14, relative to 2019 EPS estimates, we believe the downside for the index going into 2019 is fairly limited, barring any external shocks to the system.

This view, thus, is consistent with what we wrote at the beginning of October (http://www.marketgrader.com/mg_blog/2018/10/02/the-marketgrader-100-index-journal-october-2018/) when we raised some concerns about investor euphoria among mega caps (tech in particular) and a rising rate environment. In terms of the former, we still think mega cap tech stocks might see a little more air come our of their valuations, which will no doubt put pressure on stocks overall given how widely held these stocks are and the large percentage of widely followed benchmarks they represent, by design. However, our view is that whatever weakness might come from the top down should be short lived among high quality stocks given current valuations. This brings us to rising rates, which are once again our biggest concern for stocks going forward, especially with the 10-Year yield solidly above 3% and a Fed that seems determined to stick to their plan to keep raising short term rates regardless of what financial markets may be saying of late. While we have argued for a couple of years in favor of a policy of rate normalization, and overall we’re glad to finally see some price discovery in the value of money, we think a pause by the Fed wouldn’t be such a bad thing in order to give markets more breathing room to adjust. From a valuation perspective, though, for MG100 companies, we see little reason for concern.