on Monday, 08 May 2017. Posted in 2017, May


Earnings Trump Swamp

The major problems of attempting to input politics as a significant variable in determining investment strategy is “politics by definition is irrational.”  Excepting external events such as war or financial crises, markets quickly adjust to changing political conditions.  It is best to ignore the short-term political dysfunction and take a longer term view from the direction of the economy.  This is particularly important today as political chaos reigns in the media, but more importantly, the underlying economy continues to improve.
As of last Friday the S&P 500 was up 7.2% year-to-date, and just about at its record close on March 1, 2017.  The major difference is that the net new highs as a percentage of the S&P 500 is only 10.6% compared with 26.3% at the record high.   Although the S&P 500 breadth shows near-record levels, the net new highs are more concentrated in Technology and Consumer Discretionary, and more specifically the FANG stocks plus Apple and Microsoft.  These six stocks comprise 13% of the S&P 500 weighting and are all near or above 2017 highs.   Money managers, over the past two years, have had a difficult time beating the S&P 500 without being overweight these companies.   Also, the recent selloff in energy stocks has lowered the percentage of net new highs.   
Corporate Earnings
With the contentious Healthcare bill sent over to the Senate, tax reform moves center stage.  Healthcare has no significant financial impact and tax reform will be pushed well into the second half of 2017 or even 2018.  First quarter 2017 earnings have surpassed most estimates in breadth and quality.  FactSet’s Earnings Insight shows that as of March 5th, with 83% of the S&P 500 reporting, 75% have beat the mean EPS estimate and 66% have exceeded on revenues.  Overall, 1Q2017 S&P 500 earnings are up about 15% over 1Q2016.  For 2Q2017 estimates are forecast to rise about 8.0% and revenues 5.0%.  The most recent Forward 4-Quarter Growth rate is 9.8%, higher than all recent estimates creating a floor for S&P 500 prices moving forward.  (These estimates do not assume any tax relief whose primary beneficiaries are Energy, Technology and Healthcare the most.)  
InfoTech is the leading S&P 500 GICS Sector with a 16.5% price increase year-to-date through May 5th.  According to Thompson Reuters, with 85% of market cap of InfoTech reporting, 96% were at/above estimates.  Overall earnings were 6.3% above estimates.  For Consumer Discretionary, the sector average is up 10.8% year-to-date and with 64% of market cap reporting, actual earnings are 11.3% above 1Q2017 estimates.  A GICS sub-industry, Retail Internet leads a troubled Retail sector with actual earnings up 22.4%.  Energy shows a different picture.  Earnings are at/above estimates by 24% in 1Q2017 but prices for the Energy sector is off 10.7%.  This reflects the price decline in WTI which began in early-March and fell from $54 a barrel to below $44 a barrel last week.   
For market bears this recent decline in the price of oil is an indicator of slowing global growth.  However, there is reason to believe the WTI may no longer have any major role as an economic indicator.  Oil prices are now more reflective of technological advances, resulting in greater efficiencies and lower prices.  US Shale is the swing producer, offsetting OPEC reductions.  US Production forecasts have been rising since last year.  In April 2016, production was 8 million barrels per day and has risen to a current level of 9.2 million for April 2017.  Fracking is profitable for most US drillers over $50 barrel.   Production is expected to rise as break-even levels continue even lower.  Lower oil prices will be positive for lower input costs and for consumers, gasoline prices.  We continue to believe oil will track in a $45$50 a barrel range for the foreseeable future, even following the expected OPEC extension of production limits in June.  Also, the high yield market does not reflect any concern similar to 2015-2016.  

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal 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, 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.

David Minor
Rebecca Goyette

William Hutchens