US Equities – Hurricane Edition
“It’s difficult to make predictions, especially about the future.”
Yogi Berra – Philosopher
Looking beyond the short-term considerations for US equities has become lost in geopolitical problems (North Korea) and Washington dysfunction, however, peeking into 2018 the outlook for stocks decidedly outweighs the alternatives, i.e. fixed income and cash. The most recent economic data, published prior to hurricanes Harvey and Irma, put the economy closer to “normal” growth than any period since the financial crisis. Equities have reacted positively to these improvements. Stocks, measured by the major averages, are all within striking distance of new highs. The short-term consequences of the two major hurricanes will no doubt have mixed effects on the data through year-end empowering the permabears to once again yell “impending recession.” The economy will eventually fall into recession, but with current underlying strength accompanied by low interest rates and minimal inflation, it will not be for a while. Additionally, the economic world is experiencing synchronous global growth.
Before moving beyond 2017, investors should carefully assess the impact of the short-term effect of the recent hurricanes. With such external events, overall economic growth initially may show a slight decline as the non-productive aspects of the hurricanes (business closures, cleanup, hours worked and aggregate weekly earnings) moves through the recovery process. The total costs from the two hurricanes vary, but well-over $120 billion is reasonable. Most of the funds will go to the recovery. There will be a positive boost in GDP beginning some time in 4Q2017 extending into 2018. This lagged stimulus will come from restocking, rebuilding, and replacement (homes and autos). After Katrina (2005), there was about nine months of recovery in replacement and overbuild of housing before a return to trend. Following Sandy (2012) auto sales reached new highs and used car prices rose. Non-residential construction, home improvement and building material companies should benefit. Residential flood losses, mostly uninsured, will far outdistance wind losses, putting more costs to the consumers and government.
The economy entering 2018 will benefit from the tailwinds of the hurricanes, craftsmen along with anyone who can handle a hammer, will earn excess income, boosting consumer spending as part of the tailwind. No doubt 3Q2017 and 4Q2017 earnings will be affected for many of the S&P 500 companies. The impact will vary in magnitude and duration. The oil sector, already lowering estimates prior to hurricane Harvey, will show the most earnings volatility. Quantifying lost sales is subjective in the refinery business but precise in the damage and totaled autos. Companies have perennially used weather as an excuse for lower earnings. Over the past few years it has been with winter storms. Expect more confusion during 3Q2017 earnings season centered among retailers, restaurant chains, and travel and leisure. According to FactSet, the estimated S&P 500 earnings growth rate for 3Q2017 is now 4.9%, below the 7.5% at the end of June. Many of the negative adjustments to earnings will improve demand beyond the near-term. Company specific fundamental analysis will provide more focused estimates of storm-affected earnings than ETF sectors.
Stock Market Estimates
The stock market is a discounting mechanism. The Table below illustrates the potential S&P 500 Index with an expanding domestic economy, low interest rates, increasing corporate earnings, and moderately rising P/E rates. Also, the current consensus earnings estimates do not reflect tax reform.
According to the Ogden September 2017 Monthly Strategy, relative to the past decade’s normal relationship, stocks are fairly valued, versus 10-year US Treasury Bonds. At this time there is no reason for a reallocation to bonds. Only at yields above 3.5% for the10-year Treasury would bonds be more attractive than stocks.
Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.