Elementary, My Dear Watson
“The data strongly suggests that very good years in the stock market are followed by more good years.”
Historically, stock prices, measured by the S&P 500 Index and the NASDAQ Composite, show since 1950 and 1971, respectively, these indices have both fallen an average of 0.5% in September. For the S&P 500 it is the only month with an on balance decline (30 up, 36 down). NASDAQ is positive for all 12 months. With only three trading days remaining in August the S&P 500 is off 1.3% and the NASDAQ Composite is down 1.0%. The months of August, September and October are seasonally weak months cited by bearish forecasters. The S&P 500 and the NASDAQ Composite have both fallen about 3% since their record highs in late-July, and given the seasonal history, are expected to fall further. Among the other reasons given to justify a selloff in addition to seasonality are; high valuations, political uncertainty, the upcoming budget battle, the length of the bull market, and the recent breakdown in the technical condition of stocks. Not mentioned is the economy or the upcoming 3Q2017 earnings.
From January 1, 2017 through last Friday, the S&P 500 has risen 9.1% as the NASDAQ Composite climbed 16.4%. Over the same period, the S&P 400 MidCap (+2.9%) and the S&P 600 SmallCap (-1.2%) underperformed. According to many analysts the most recent selloff in the MidCap (-4.8%) and the SmallCap (-5.8%) since late-July are a justification that tax reform will not pass this year. From a valuation standpoint the forward P/E of the MidCap (17.3X) and the SmallCap (18.6X) are reasonable when compared to the S&P 500 (17.4%). The bears response to such comparison is that the S&P 500 at 17.4X forward earnings is overvalued given the historical ten year 14.6X and the five year 15.4X. Additionally, much has been made about the rise in the S&P 500 attributable to FANG + Apple & Microsoft. It is interesting to note the valuations of these companies in terms of their P/E’s; Facebook (36.2X), Amazon (238.6X), Netflix (204.2X), Google (33.0X), Apple (18.3X) and Microsoft (26.8X). Given the 12% weighting of these stocks in the S&P 500 a recalculation of the remaining 492 companies would bring the resulting P/E closer to the five year average of 15.4X. Stocks trade at higher P/E’s when interest rates and inflation are low. Today, stocks are at normal risk premiums to bonds and cash. A downturn for a lengthy period would need a decline in earnings, a further rise in the US dollar, and a more aggressive Fed raising interest rates. None of these conditions are evidenced in the markets today.
Almost daily it seems that the financial media cannot understand how the market continues to rise in spite of all the geopolitical events and the chaos being generated by the White House. Onee would think that the lesson has been learned over decades. For example, President Kennedy’s assassination on November 22, 1963 proved only a short sharp one day drop in the averages and afterward markets climbed through December and stocks were up for the full-year 1964 (+13%). More recently, the Greek bankruptcy, China growth, the oil price crash, Brexit, terrorist attacks, and North Korea, have created a media firestorm without any significant changes in market direction. To conclude, geopolitical events have little meaning for the markets until they become an economic crisis. From a different perspective, in today’s world people who move large sums in the financial markets do not give a damn who is in the White House. Maybe the upcoming budget authorization and the increase in the debt ceiling will be different this time,
but we all know the answer. A budget will pass but may require an interim spending bill. Unfortunately, the downside of a budget delay will push back the tax bill, but tax reform is no longer priced into the market.
A case has been made that this is a mature bull market. It has been a mature bull market according to the permabears for many years, but because valuations are higher than historical norms does not portend lower valuations. Fundamentals, the economy and individual company earnings determine stock prices. GDP growth is only beginning to break above the 2% level and corporate earnings are the strongest since 2014 and forecast to grow through 2018. The mature stage of a bull market is characterized by rising inflation, increasing interest rates, and speculative excesses, none of which are present in the current environment.
Global growth is in sync. Overall global economic growth is expected to be 3.8% led by India at 7.2% and China at 6.8%. Even Japan at 4.0% is once again growing. Industrial metal prices are up an average of 22% in 2017, while consumer sensitive energy, agricultural products, and soft commodities are down. The rise in industrial commodities represent the broad-based growth in developed and developing countries. Stock markets around the world reflect this growth. Data published by Yardeni Research Inc. show the extent of this synchronous bull market. The MSCI All Country Index is up 12.6% thus far in 2017 when measured in US dollars. Below are the highlights for major areas and countries for 2017 through 8/25/17.
A. Emerging Markets are up 25.9%, led by China (38.8%), India (25.9%), Argentina (48.5%) and South Korea (30.2%). B. Developed Markets are Europe (20.1%) led by Greece (33.5%), Spain (26.4%), Italy (24.2%), France (19.4%), Sweden (18.0%) and Germany (16.3%). C. Falling below the average global performance are; Australia (11.0%), Japan (10.5), US (9.3%), UK (7.9%) Canada (5.4%) and Russia (-12.6%).
In total, over 90% of the country stock markets are positive thus far in 2017.
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.