Stock prices began 2018 right where they left off in 2017 – measured by the S&P 500, stocks recorded a total return of 5.7% in January. The market’s buoyancy is uncharacteristic. The last true down month in the stock market was October 2016, 15 months ago. The steady month over month returns have in effect hypnotized investors into thinking this ongoing melt up is normal. The monthly variability of returns to stocks in 2017 was 1.1%, the lowest measure our research produced in any year dating back to 1982 (the average monthly standard deviation was 4.2% during that time).
While I am uncomfortable with the pattern of returns, I think there is a fundamental basis for the strength in stock prices; the primary factor being earnings. US corporations are delivering parabolic improvements in earnings, not seen in years. According to FactSet Research, 4Q 2017 corporate earnings reports are outstanding, coming in with a blended growth rate of 13.4%. In the last month alone, CY 2018 estimates for the S&P 500 earnings jumped 5.3% (from $147 to $155), representing the largest increase in estimates over the first month of the year since 1996.
Other factors supportive of the earnings inflection are the surprisingly weak US$ and turbo-charged global economic growth rates. The weak US$ is difficult to understand. Given the backdrop (Fed raising rates, wage inflation), one would expect the currency to strengthen. Equally supportive is a healthy global economic revival boosting economic output and trade. The IMF recently revised its global growth forecast to 3.9% – more customers buying more US made goods.
A fly in the ointment will inevitably appear, and the most likely catalyst of more normal behavior (regression to the mean) from stock prices will be higher interest rates. When rates rise, equity risk/returns often do not look as favorable. The yield on the US 10-year Treasury note rose to its highest level in nearly four years recently. Inflation and unemployment data imply the Federal Reserve will remain on track to raise interest rates throughout the year. The old adage, “don’t fight the Fed” may well lead stock investors to take pause.
The next spoiler to emerge will be skyrocketing US deficits. Estimates are the Treasury will have to borrow up to $955 billion to make it to the September 30th fiscal year end, more than twice the year prior. Lower tax receipts means we borrow more. To induce lenders, interest rates will continue to rise. Higher borrowing costs, on more debt with reduced tax receipts is a prescription for trouble. Akin to a gambler or addict, leadership in Washington has opted for economic (and political) bliss today, at the expense of our children and grandchildren. Eventually, someone will have to make hard choices.
Future investment returns are being pulled forward. On the back of the one-time tax cut benefit, consumers and corporate America have their wallets out. This will spur a flash of growth, but not long-term fundamental growth. Further, expectations are lofty, regulations (financial and environmental) are withdrawn, and animal spirits are now alive unlike any time since the late 1920s or 1990s. It’s no longer a fear of the stock market “crashing” or heading into a downward spiral, it’s now the fear of missing out, the age old driver of unbridled human behavior, greed.
Finally, the market place is changing in ways we cannot foresee. For example, the emergence of ETF’s as primary investment vehicles, the emergence of crypto currencies as the next big thing, and the devolution of asset class correlations have made for a “wild west” backdrop. A melt down, or at least some mean reversion is inevitable. Our hope is that any downturn is measured and stair-stepped. With this in mind, our effort is to guard against foolish impulses and focus our work on the investment policy we’ve discussed and put in place for you. We are rebalancing over exposure to stocks and trimming specific over-weight holdings. Changes to the tax code did not affect the favorable 15% long term capital gains rate. Please feel free to give us a call if you would like to discuss our views in more detail or any changes to your profile.
Bruce Hotaling, CFA