Be Prepared for Reality
“Reality is that stuff which, no matter what you believe, just won’t go away.”
Markets rose every day last week and the Dow ended within 1% of the media-hyped 20,000 level. All major broad-based averages set record highs last week. A Trump rally, based on expectations of more favorable growth policies from Washington, is the widely circulated catalyst. But the forecast of low taxes, less regulation, and stimulative infrastructure spending comes on the heels of realistic improvement in economic fundamentals and a trough in quarterly earnings. The more favorable economic data guarantees a Fed rate hike next week, removing this perceived negative from the equities markets. Stocks, measured by the S&P 500, are up near 6% since the Trump upset and 10.6% thus far in 2017. The small-cap Russell 2000 has risen 22.2% in 2017 with more than 13% coming in the month since the election.
Our optimism with stocks is based on the economic outlook prior to the election and the potential of realistic improvement from a more pro-free market Trump Administration. Getting beyond the hyperbole may disappoint many current supporters as expectations are translated into reality. President-elect Trump has 100-day agenda, but aside from Obama’s executive orders there will be many bureaucratic hurdles requiring multiple steps. Repealing Obamacare, renegotiation of trade treaties, and the enforcing of immigration laws will take well-beyond the 100 days. Further on will be immigration, abolishing the Iranian Treaty, ISIS, and the building of the wall. Frustration will surface both from the new Administration and Trump followers. Already Trump has backed off some of his populace rhetoric. Stocks will need an economy growing above the current 2% level to satisfy the basic revenue needs to pay for the paired down programs coming out of Congress. Many of the programs will never be implemented.
The sector rotation since the election is clearly more bullish for the economic outlook. As pointed out in the last Compass (11/28/16), the move into Financials was immediate and now has broadened into the other economic sensitive areas. This has resulted in year-to-date gains for Financials (22.2%), Industrials (18.7%), Materials (17.7%) and Technology (12.9%). Energy, which had risen 11.4% with the 70% rise in oil prices, increased 24.6%. The rotation to these economic sensitive sectors is typical of the early stages of a business recovery rather than a signal of an impending slowdown, as expounded by those who believe bull markets are determined by the calendar.
The move toward interest rate normalization will get a boost when the Fed raises rates. While there are some comparisons to the rate increase of last December, circumstances are much more accommodative than last year. The manufacturing ISM is above 53 and was below the 50 expansion level and falling in November and December 2015. Both employment and wages are much different. The unemployment rate at 4.8% is nearing historical lows and job claims are at the lowest level since the series began. Wage increases are trending up giving a lift to 2% inflation compared to a declining 1.5% inflation level in 2015.
Rising inflation expectations and higher bond yields from current rates are not disruptive to equity markets. Since 1950, stocks have risen every year the annual growth rate and the S&P 500 earnings exceeded the 10-Year Treasury bond yield. With the 10-Year Treasury yield currently at 2.48% and the earnings recession ending, there is scant chance that yields will rise above earnings growth in the foreseeable future. The current yield has risen from 1.80% to the current level in one month, an 85% increase. Prior to this rise the S&P 500 was up 2.0% and as of last Friday’s close it had climbed an additional eight percentage points. Examples of sharp spikes in the 10-Year Treasury are in 2003 when the yield rose from 3.07% to 4.67% in two months. In 2003 the S&P 500 was up 26.4%. The same pattern occurred in 2010 when the 10-Year yield rose 2.33% to 3.74% in four months, the S&P 500 rose 12.8% for the full year. As recently as 2013 the 10-Year Treasury yield jumped from 1.61% to 3.04% in seven months and for the year the S&P 500 stocks rose 29.8%.
Going forward into 2017, earnings should provide a firm base for rising stock prices despite the recent strength of the US dollar. The US Dollar Index (FX) has risen 10.9% since May 3rd until the recent high on November 25th, with most of the strength following the election. Unless there is a reversal, this dollar appreciation will limit earnings expectations for companies with a high percentage of revenues overseas. There will be indications of the extent of the decline when Fourth Quarter earnings are reported beginning in January. For the average S&P Large Cap 100 company this is 39% of total revenues and for the Small Cap 600 company foreign revenues are only 18%. This explains in part the recent outperformance of the Russell 2000.
The Table above is a comparison of the earnings and stock prices over the past five years incorporating optimistic, but achievable, earnings for 2017. The estimates for 2017 reflect a $132.00 a share consensus a share for next year plus a $13.00 average for analysts’ potential benefits of implementation of lower regulation, tax reform, and a stimulative spending program. The data assumes a steady P/E ratio at the current level but no multiple expansion or contraction. To fully realize these estimates the economy must move beyond the 2% real growth to a base of 3% or higher real GDP.
Our investment policy remains optimistic. Transitioning to a new Administration may increase volatility short term, but should not interfere with long-term investment strategy. Realistically the positives from expansionary policies will take more time than generally expected. A more dominant consumer-oriented economy is evolving, but not fully reflected in corporate aggregate earnings. 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, financial, industrial and technology companies. To mitigate the potential of higher-than- expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.