North American stock markets are at or close to all-time highs, and have gone pretty much straight up since the great financial crisis ended in 2009. Not surprisingly, many investors are asking: Where do we go from here?  We’ve had a terrific rally so far in 2019, but no one should be shocked. After all, the S&P 500 had one of its worst Decembers ever in 2018, falling a shocking 9.2% in one month. Since 1928, the S&P 500 has returned approximately 9.5% a year to investors. Since 2015 the S&P 500 is up somewhat less than that at about 9% a year—a good result, but below the long-term average. Even with the great results in the first half of 2018, markets are still only up about 1% from the highest levels reached in 2018.  This is hardly a raging bull market.

As always, the answer to where stock markets go from here will depend ultimately on what happens with the economy, the valuations investors are prepared to put on stocks, inflation and interest rates, and most importantly, the trend of corporate earnings.

We are in the midst of second quarter earnings releases, and this is what we are learning from our investee companies that have reported so far:

  • Many companies are still seeing growth in revenues and profits, but this growth is less robust than what was seen in 2018;
  • Many employers are finding it hard to fill jobs with qualified applicants;
  • There is a slowdown in manufacturing output in North America as a result of uncertainties with global trade, particularly with China;
  • The U.S. consumer is in great shape, and there is good demand from businesses for loans.

The statistics we follow are also giving us a mixed picture about the U.S. economy. One could make either a logical Bull or Bear case, based on enough positive and negative data points. Bulls will argue that jobs are plentiful, people are spending money as evidenced by retail sales growth hitting an all-time high, and business conditions are still positive. Bears will counter by saying rail and trucking traffic is in contraction, industrial output has flat-lined, new job creation is slowing and the demand for new homes is lackluster.

Numerous uncertainties have made central banks around the globe nervous enough that we have seen many countries lower interest rates. Some countries in Europe are even selling bonds with negative interest rates to stimulate economic growth. Many commentators and analysts are expecting the U.S. to follow suit and cut interest rates this month. Given the weaker economic growth around the globe as well as low inflation, most pundits believe that interest rates will be very low for years to come.

Valuations on stocks are above their long-term averages based on traditional measures such as the ratio of price to earnings, but this is not surprising.  We have never had interest rates so low and since money is fungible, it will eventually go to the asset that offers it an acceptable return. Supposedly safe fixed income investments, such as government and corporate bonds, offer unacceptable, generally negative returns after paying fees, taxes and accounting for inflation. We believe that the main reason stock markets are so high is that investors don’t have many choices for acceptable returns.

As long-term investors, we aim to build portfolios of high quality companies, each with a strong competitive advantage. More often that not, these companies deliver above-average revenue and earnings growth. If the economy does in fact weaken moving forward, the ability for these firms to deliver growth will likely be stunted. Of course, in any given year returns from stocks will drop below the long-term average of 9.5% a year, however, volatility and short-term uncertainty are the price we pay for superior returns over time and, with such low interest rates, we believe that with patience, our portfolio companies will deliver better than acceptable returns to our clients.