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Narrative

October ends with Halloween.  Apart from All Hallows Eve, and the Day of the Dead, there is a distinctly scary tone to the way Americans choose to celebrate the holiday.  It has somehow evolved into something folks just do each year, and it carries a frightening narrative.

Outside of the world of fabricated ghosts and goblins, there is a broader narrative at play, driving strength in the financial markets.  The underpinning of the narrative is the high level of anticipation in improved GDP figures (job growth and higher wages) with stimulus from tax cuts (both personal and corporate) and incentives to capital spending anchored in a renewed emphasis on active fiscal policy.

So far, we have not seen evidence this is anything other than a story.  But the stock market has another view and continues to march on.  Stocks, measured by the S&P 500, returned 2.2% for the month of October, and are now up a cumulative 16.9% year to date.  If we look back to the beginning of 2016 (a 22 month window) stocks have been up 16 of those months (a .727 batting average) and have generated a total return of 30.9%. 

It’s hard to determine how much of this story is already priced into the markets.  Certainly, influential people in the system are perpetuating it, as the Treasury Secretary recently threatened a dramatic drop in stock prices if tax cuts and reforms were not enacted as prescribed.  From my perspective, the strong returns to stocks is principally the result of a remarkable recovery in US corporate earnings.

We are in 3Q17 earnings season, and according to FactSet Research, as of 10/27/17, 76% of S&P 500 companies have reported positive EPS surprises and 67% positive sales surprises.  The blended earnings growth rate for the S&P 500 is 4.7% for the quarter, well up from the previous estimates in the 3% range, and without the hurricane related hit to the insurance industry, the blended earnings growth rate is 7.4%.

As the market is a discounting mechanism, meaning it extrapolates future outcomes, the current behavior of stocks implies a rosy future.  This is supported by the collective outlook of stock analysts’ predictions for future earnings.   Most people do not realize that between CY14 and CY16 S&P 500 earnings ground to a halt.  Mired at 119, earnings were dead flat for a three year span.  Today, according to FactSet Research, analysts are projecting near double-digit bottoms up earnings growth for the S&P 500: 130.8 for CY17, 145.8 for CY18 and 160.3 for CY19.

The underpinnings of this growth inflection are tied to several existent factors.  Synchronized global growth is spurring demand at multi-national companies.  The low value of the dollar is making US exports more affordable.  The continued stabilization in oil prices is allowing the energy industry as a whole to recover.  There is some confidence that the new leadership at the Federal Reserve will continue to prudently manage monetary policy.  All of this is taking place in spite of considerable concern that the tax reform and cuts that will ultimately spur the economy (and thus further corporate earnings growth) may never be implemented. 

Then, there is the scary Halloween narrative.  We collectively keep telling ourselves nothing is the matter – there is not a monster under the bed.  We try and put on a brave face, but the fear is there.  Washington is in disarray, and we often hear the monster either via Twitter, or bombastic claims in news reports.  The level of doubt rises.  This flies in the face of optimistic analyst earnings forecasts and stock returns we do not want to give up.

As we approach year end, we can take satisfaction in an extended period of stock price appreciation.  There will inevitably be an unsettling event that sparks selling.  Over the next few months our effort will be to take some profits in stocks that have outsized positions in portfolios, to lock in returns and raise some cash to allow a degree of comfort going forward.  Please feel free to check in if you would like to discuss further.  We are also taking a close look at realized capital gains, though I have to say there are not many off-setting losses after the period in the markets we have had.

 

Bruce Hotaling, CFA

Managing Partner

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