After a 10% correction, where are the markets heading?

In his weekly commentary, Bob Doll, senior portfolio manager and chief equity strategist at Nuveen Asset Management, offered his thoughts on where he thinks the markets are going.

“For much of the past year, we have been cautioning that market volatility was too low and a consolidation or correction could come at any time,” Doll writes. “It appears it finally happened with a bang, driven primarily by inflationary pressures and a spike in bond yields.”

Last week, the Dow Jones Industrial Average experienced two separate 1,000 point declines, while the S&P 500 500 Index lost 5.1% for the week and has now declined 12% from peak to trough.

“While we think the worst of the correction may be behind us, messy market conditions may continue,” Doll writes. “And the long-term outlook is growing more complicated.”

Here are Doll’s 10 predictions for where the markets go next, after a 10% correction.

1. The recent spikes in volatility have been due in part to technical market factors. 

As markets started to fall, bid/ask spreads widened and highly leveraged low-volatility strategies were forced to unwind. In Doll’s view, this accelerated selling contributed to the panic-like conditions early in the week.

2. Rising inflation pressures could act as an ongoing headwind for stocks. 

According to Doll, improving wage growth was one catalyst that sparked the current correction. Doll expects this trend will continue putting upward pressure on inflation and bond yields.

“A combination of tax cuts and significant federal spending increases may accelerate these developments,” he adds.

3. Last week’s budget deal removes short-term uncertainty from the markets, but could cause longer-term issues. 

Doll says the spending package will add significant additional short-term stimulus and boost defense spending, which could cause an increase in both economic growth and inflation.

“It also makes the nation’s troublesome fiscal problems even worse,” he adds.

According to Doll, the spending package greatly reduces the risk of another budget fight. However, he adds, it also probably eliminates any chance of an infrastructure deal.

4. Despite the market turmoil, economic fundamentals remain sound. 

According to Doll, leading indicators and corporate earnings trends point to a continuation of the economic expansion and bull market.

“Warning signs to the contrary would include widening credit spreads and/or tightening financial conditions, but those have not materialized,” Doll says.

5. Corporate earnings continue to improve. 

With more than 80% of S&P 500 companies reporting results, earnings-per-share are up about 15% and sales are up in the high single-digits, according to Doll. Doll says that at this point 81% of companies are beating earnings expectations, which he adds is “the highest level in eight years.”

6. The selloff has modestly reduced equity valuations. 

Doll looks at the S&P 500 forward price-to-earnings ratio, which had climbed as a high as 18.4 when the market peaked in mid-January. But, as of Friday’s close, it had fallen to 16.3, near where it was two years ago when markets experienced the early-2016 correction, according to Doll.

7. Despite additional declines late last week, market technicals improved. 

After last week’s Monday/Tuesday selloff, markets retraced before plunging again on Thursday into Friday morning. 

Doll points out that while price levels fell further late in the week than they did earlier, technical conditions were stronger. According to Doll, volume was lower, there were fewer 52-week lows and a fewer number of stocks declined.

“We think these are positive signs,” Doll says.

NYSE traders. (Photo: AP)

8. Double-digit market corrections are a normal part of bull markets. 

Doll points out that the S&P 500 has more than quadrupled in price since it bottomed at 666 in March 2009. 

“During that same time, we have seen five different double-digit corrections: 17% in 2010, 22% in 2011, 10% in 2014, 16% in 2016 and (as of now) 12% in 2018,” he adds.

9. This correction is close to its low in price terms, but markets probably need time to digest and repair. 

Doll thinks investors should “respect this correction, but not fear it.”

“The economy is solid, earnings are improving, financial conditions are sound, and corporate balance sheets look healthy,” he says.

And, Doll believes these fundamental factors should eventually drive stock prices higher.

10. Doll still believe stock prices will rise for all of 2018. 

Doll says that Nuveen’s fair-value target for the S&P 500 this year has been and remains around 2,800, which would imply around a 7% total return for the year.

“We also believe that valuation levels will be lower by the end of the year compared to the beginning due to higher interest rates and inflation,” he adds.

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