Current Market Environment by George Tkaczuk, MD, MPH
As 2016 comes to an end with a yearend rally, investors are wondering what to expect going forward into 2017. For now, the market is in a confirmed uptrend. Nothing goes up forever and corrections will come and go. But generally speaking, the outlook going forward remains strong. Below we will offer some thoughts on what we see in the market and the economy and what we can expect.
Technically speaking, as we have highlighted in previous letters, the market has recently emerged into a new bull market from a previous 16-month long stealth bear market. This breakout occurred in early July after the “Brexit” event. In November, the market retested this level during the US election and has rebounded sharply confirming a new bull market.
The equity market caught a tailwind after the election, as investors cheered through the process. Voters made a decision favoring policies of growth over redistribution. We do not take political sides; we just follow the policies and the money. Regardless of one’s political orientation, people should be aware of the fact that voters made their choice clear in a landslide decision favoring Trump’s pro-growth policy over Hillary’s anti-growth agenda. Republicans retained control of the Senate and the House. The importance here is that the stage is set for Trump and Congress to deliver pro-growth tax, regulatory and monetary policies. This should translate into a bull market in equities which may rival the 1980s/90s prosperity.
At this point, investors may be concerned about the current valuations; however, one has to consider the possible increase in corporate profits from the currently proposed corporate tax cuts. President Elect Trump’s administration is targeting a reduction in the corporate tax rate from 35 percent to 15 percent. According to Michael Thompson president and chairman of Standard & Poors Investment Advisory Services, for every 1 percentage point cut in corporate taxes could “hypothetically” add $1.31 to 2017 earnings. Thus, if there is a full 20 percentage point reduction in the tax rate, that may add $26.20 ($1.31. x 20) to the current estimate for the S&P 500 companies of $131 per share to $157 per share for 2017 a 20% increase. The reason this is called “hypothetical” is that it is unlikely that dollar for dollar tax savings goes directly into the bottom line. But the point being that if we do get a cut in corporate tax, the effects could be very significant and we will most likely get some sort of earnings boost. Applying the current price to earnings ratio (PE) of 17 to the possible “hypothetical” earnings estimates puts the S&P 500 price at 2669 for 2017.
The above price target on the S&P 500 might seem extreme but it is not that far out of line. Brian Wesbury, Chief Economist at First Trust uses the Capitalized Profits Model (the government’s measure of profits from the GDP reports divided by interest rates) to measure fair value of stocks. Using the current yield on the 10-year treasury tells us that the S&P 500 is extremely undervalued. Even using a 10-year yield of 3.5% suggests a fair value of the S&P 500 of about 2757 (22%) higher than today (based on current corporate profits). Thus, any improvement from profits either through tax cuts or growth and better investment can truly propel the market higher.
One has to also keep in mind that profits were kept artificially low due to the energy sector, from the steep drop in oil prices. Given that the energy prices have stabilized and companies have absorbed lower oil prices, the energy sector should now act as a tailwind for the economy and profits. Outside of corporate tax cuts, further proposed cuts in regulation and government subsidies will direct resources to more business investment, growing the economy further; translating to higher stock prices.
Other interesting events since the election are the selection of President Elect Trump’s cabinet members. So far, his choices for his team are individuals who are coming from all walks of life. These are not your typical Washington bureaucrats. President Trump is selecting captains of industry with real world experience in decision making and leadership. These individuals come from business, medical and military backgrounds not the typical professional officials or academics.
So, will everything go smooth? We will soon find out, as famed investor Ray Dalio puts it: will Trump’s policy changes be “aggressive and thoughtful” or “aggressive and reckless”?. Most likely, we would expect to see a bit of both; however, anytime the policy is perceived reckless, we may see a market sell-off which should provide a nice buying opportunity.
The next four years will be very interesting as the deal-maker businessmen with this team of pragmatists lead us over the next four years. As it stands now we can look forward to tax cuts, a freer market, less regulation and greater energy production than ever before.
While we caution investors from fixating too much on party or politics but more on policies, economics and sentiment remain true drivers of stock prices. History teaches us that often presidents may not deliver what they promise or may not be able to push their ideas through congress. But keep in mind, beside the election, we still have low interest rates, low oil prices, a new president, renewed hope and optimism, great entrepreneurs, and investors are still underexposed to stocks. Corrections will happen, come and go, so therefore, ignore the scare mongering media headlines, stay optimistic and stay invested. Remember, bull markets do not die of age; they die of either a recession or extreme investor euphoria. Right now, we believe we have no signs of a recession; the Leading Economic Index LEI suggests the economy will continue to expand into the first half of 2017, and investor sentiment is tepid. If we see a negative change in the economy or a euphoric sentiment, then our opinion on the market will change. For now, a slight pick-up in optimism is not viewed as euphoric and could still be supported by a strong economy.
Lastly, looking at historic precedent to establish our potential in this environment, we have to ask ourselves have we seen anything like this before. There is a similar period in history from which we emerged from a stagnating market into a new bull market. The chart below shows the S&P 500 from 1968-1987 (blue line), superimposed on it is the S&P 500 from 2000-2016 (red line). So, the question is – just as we seen policy changes in early 1980s, will similar policy changes now give us the same lift we saw in the early 80’s to 1987 and beyond?
(Chart courtesy of Investor’s Business Daily)
Looking Forward to 2017 by Chris Chiu, CFA
In previous letters, we have said that markets go up and down and often not in a meaningful way. However, as a result of an expected sea-change of governmental policies post-election we may finally have a reason to believe the recent market moves are significant.
We believe there are two reasons the recent market gains may also anticipate the possibility of further moves next year.
(1) Anticipated global and domestic growth. On the domestic front, there is the expectation that anticipated deregulation and fiscal spending will be a boost to economic growth next year. Meanwhile, on the global front, the slowing in China has turned out not to be as drastic as anticipated. Both factors have led market strategists recently to revise S&P 500 earnings estimates upward.
Other factors have caused a lift in earnings estimates. Oil prices have climbed above the $50 barrier as OPEC placed limited on output. This has been seen as a slight boost to earnings expectations of the S&P 500 companies, as energy still is a significant part of the index. Nevertheless, we don’t expect oil to reclaim $100 per barrel. It is more likely that we are close to reaching a stable supply-demand equilibrium. Some projects operating below breakeven costs are departing the market, while those that can achieve lower production costs continue to be brought online. Taken in an aggregate, we continue to believe that lower oil is a net positive since it is an input cost.
2) Tax policy. Currently the statutory US corporate tax rate stands at 35%. While some international companies such as Apple may have a lower blended tax rate as a result of different tax rates applied to international sales, companies such as Under Armour, whose sales are primarily in the US, face the burden of a 35% corporate tax.
However, if the republican-controlled congress can pass legislation that lowers the tax rate by even 5%, these companies would immediately realize gains in corporate profit. For example, if the US corporate tax rate went from 35% to 30%, that would be an almost 15 % boost to earnings. The republican proposals are even more ambitious than this with proposals for the corporate tax rate to be in the 20% range. If their ambitions succeed, we would see growth in corporate profits in excess of 30% on domestic sales. These gains would not be one-time events. In the context of these companies’ valuations, these gains would be considered permanent and extrapolated into the foreseeable future.
Gov’t, High Credit Corporates
There has been a change to our view of an extremely slow rate-rising environment. While the US Federal Reserve Bank has raised the Fed rate 25 basis points so that it will sit at .75%, rates have gone up gradually on their own, especially immediately after the election. The market may be anticipating increased inflation with the growth policies advocated by the new administration.
However, as we have said previously, even as the U.S continues to grow steadily, Fed policy is unlikely to diverge significantly from the central banks of other developed economies. On the international front, the ECB has signaled a possible end to their quantitative easing program. Japanese government rates still remain negative as the JCB looks to continue with their program. It will take some time for policy to change globally, as one central bank policy is a consideration for another in a global economy.
High yield experienced a recent rebound through the second quarter for 2016. High yield prices historically have bottomed when defaults have finally exceeded 8% percent.
We are nowhere near those levels currently. With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may be extended for an indefinite period. Investments in the high yield market represent riskier investments among the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility. But it will also be among the fastest to recover in any recovery of credit markets.
Recent developments in Large Caps and the Strategic Knight
Equity markets had a significant gain for the fourth quarter, spurred by the hope of growth with the surprising election results. As stated previously, over the long term, we anticipate that lower oil prices will have a positive effect on stocks.
As there is some expectation that the Fed will raise rates more than once next year, we expect yields to increase, barring some unexpected global catastrophic event (which always remains in the realm of possibility). One could also say that the Fed is anxious to raise rates, partly because they need the ability to lower them as a remedy for the next possible recession.
Accordingly, in the fourth quarter, we bought more financial stocks, as many financials benefit from increased rates, the existence of rate movement, or the widening between short and long term rates, all of which we expect to occur over the next year. You should expect us to weight more heavily toward financials in the coming quarter.
Small and Mid-Caps
We continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. Despite the strengthening of the dollar in 2015, the dollar has weakened in the second quarter of 2016. Nevertheless, we view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in the smalls and mids include the higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.
The general information provided in this publication is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation.