Populism and Uncertainty
Stocks began 2017 with an undercurrent of optimism as prices touched new intra-day and all-time highs. The total return for stocks, measured by the S&P 500, was 1.9% for the month of January. The month was notable, if for anything other than competing events in Washington DC, in that it was both positive and dull. There were no trading days when the market moved up or down by more than 1% since the 1.11% move on November 9th, the day after the election. Often, when markets hit new highs, it clears the path to further price strength.
The shadow to this optimism is uncertainty. This is often measured by the VIX, or the volatility index. The VIX is the Chicago Board of Options Exchange Volatility Index, showing the implied volatility of the market using S&P 500 index options. The figure has been skulking in the 10% range since the start of the year. For some context, just prior to the election it was around 20% (its historical average), and during the financial crisis back in 2008, the VIX spiked into the 80% range. The implications of a high VIX are that options traders are actively attempting to position themselves for what they anticipate will be a turbulent market.
The VIX is frequently referred to as the fear index. It often happens that when investors are at their emotional limit, the VIX measure is high. Today’s measure is historically low. Yet, more and more well-known and vocal investors have begun to express discomfort with the US’s lack of direction, protectionist tendencies and militaristic posturing. The market appears to be discounting the rhetoric. There is a curious air of complacency among investors empowering them to make substantial bets on tough talk.
The tough talk, or bombast, has lulled market participants and created a high expectation. The rub is all the pro-business talk may or may not bring forth change. It will be quite a task to double GDP growth to the 4% level, as promised, on the back of an economic expansion now more than seven years old. The economy is at full-employment, and the outcome of certain proposals (tax reform, reduced environmental and financial regulations, fiscal spending on military and infrastructure projects) may ironically lead to inflation and other unintended consequences – but not growth. I suspect the complacency may have allowed investor and corporate confidence to run ahead of itself.
The most important measure of future stock prices, corporate earnings, are now being released for the period 4Q2016. According to FactSet Research, the growth rate for Q4 S&P 500 EPS currently stands at 4.2%, better than the 3.1% expected at the end of the quarter and of the 34% of S&P 500 companies that have now reported for Q4, 65% have beat consensus. If the 500 companies that make up the S&P 500 are going to generate the current consensus earnings of $130.76 for 2017 and $146.11 for 2018, they are going to have to get a move on. On the plus side, the resolution of the damaging oil price shock of 2014-15 will help, as will a more normal and steeper yield curve, and the addition of some fiscal stimulus the market has been begging for since 2008.
None of this will be clear, until it is. In a market such as this, we could cautiously step out of the car anticipating its imminent breakdown, only for it to rumble on down the road, without us. My impression of the way forward is to proceed, with a foot on both the gas and the break – a two footed driver. As expected, the big theme thus far has been the post-election landscape, though also as expected, companies are unable to quantify potential policy implications given lack of details. So, we wait.
My expectations remain somewhat guarded. I think average returns from stocks and bonds for the year ahead can be attained. My concern is that these average returns will be delivered on the back of greater than average volatility and unrest in the financial markets. We of course, cannot see this at the moment. With this in mind, I am happy to speak with you if we have not been in touch recently. My goal is to check-in, in order to reaffirm your asset allocation and near and long term investment goals.
Bruce Hotaling, CFA