At the midpoint of the year, there continue to be both headwinds and tailwinds for the economy and the market, according to Charles Schwab’s Liz Ann Sonders.
Sonders, who is senior vice president and chief investment strategist at Schwab, recently published a midyear outlook commentary for U.S. equities.
“We are entering the second half of the year in the middle of the S&P 500’s trading range, which has been in place since the correction that began in late January,” she writes. “Until the index takes out its January high, it’s considered to still be in correction mode.”
According to Sonders, if this was a typical correction, it would have been at or near new highs by now. She says that the longer that takes, the higher the likelihood that this correction gets “worse before it gets better.”
While trade uncertainty clearly falls into the headwind category, Sonders addresses three other possible headwinds that the markets may face the rest of the year.
1. Peak Earnings Growth
While Sonders calls earnings the “mother’s milk for stock prices,” she also says to be wary of a very high expectations bar heading into 2019.
“[W]hat is lesser known is that at high earnings growth rates, stocks often have middling returns as they tend to anticipate the inevitable inflection point (when earnings stop getting better, and start getting worse),” she writes.
For an example of this, Sonders breaks historical earnings expectations into three primary zones — more than 14.2% growth, between 3.4% and 14.2% growth and less than 3.4% growth — and looks at the market returns.
Since 1984, during the highest zone for earnings growth, the S&P 500 was actually down a median 2.9%, according to Sonders. Meanwhile, during the middle zone, the S&P was up a median 10.2%; and during the worst zone for earnings, the S&P was actually up nearly 14%.
2. Flattening Yield Curve
The yield curve continues to flatten and cause “consternation,” according to Sonders.
The spread between 10-year and 2-year Treasury yields recently flattened to less than 35 basis points, which Sonders says is getting close to an inversion.
Sonders looked historically at the relationship between the yield curve at similar spreads and the action by the stock market and economy. According to Sonders, there typically remained a decent length of runway between 35 basis points and trouble for either the stock market or the economy.
A flattening yield curve is normal at this stage in the economic cycle, with the Federal Reserve having begun a rate hiking campaign in December 2015, followed by the shift from quantitative easing to quantitative tightening last fall, according to Sonders.
Sonders notes that last year’s lack of volatility was the exception, not the rule. This year’s volatility is more in keeping with the rule, and consistent with late-cycle tendencies, she adds.
Another reason to expect continued bouts of volatility is that the U.S. is in a midterm election year, according to Sonders.
“History has not been kind to midterm election years in terms of stock market weakness,” she writes.
According to Sonders, the average maximum drawdown in midterm years since 1950 has been -17%, with the weakness tending to be concentrated in the pre-Election Day period—specifically in the summer months.
— Check out Bob Doll Checks In on His 10 Predictions for 2018 on ThinkAdvisor.