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Spilled Milk

Stock prices have been on the move. Many investors firmly believed that if the election went the wrong way, stock prices were destined to tumble.  Since that infamous day back in November, to the utter exasperation of those same investors, stock prices (measured by the S&P 500) are up a total return of 11.22%.  Year to date, the total return to stocks is 5.94% with February contributing an impressive 3.97%.

The upward move has in fact coincided with a flourish of positive economic data.  According to Empirical Research, much of the recent strength in stock prices can be attributed to improving economic fundamentals, as evidenced by the recent spike in the PMI index.  The PMI is a widely accepted indicator of current business conditions in the manufacturing sector.  In support of the manufacturing data, the employment data is equally strong.  According to Bespoke Research, jobless claims have fallen to their lowest level since 1973.

Although the run in stock prices has coincided with strong economic data, there is more.  Stock prices have also benefitted from a newfound optimism over proposed tax cuts, deregulation and an infrastructure build-out.   Expectations have run amok.  To date, there is nothing that has happened on the fiscal policy front to support the heightened fervor pushing stock prices higher.  There is a notable void of detail and a surfeit of spin.  The timing and ultimate impact of any proposals is either unknown or carries the greater risk of disappointing the markets with a failure to deliver.  True policy is needed to implement any changes and with the degree to which the messages are mixed, one wonders whether there is an intractable void in competence.

Against this disconcerting backdrop, there is some basis for sitting tight.  According to FactSet, earnings estimates look to have stabilized at $130 per share for 2017.  Earnings are perpetually subject to revision by Wall Street analysts, and almost always downward, as initial optimism fades.  For 2018, consensus estimates for the S&P 500 are now a lofty $145 per share, an 11.5% increase over 2017.  This would be the biggest bump in earnings since the 15% leap from 2010 to 2011.  One comment that has attracted some attention is the speculation that these earnings can be obtained without the benefit of any of the planned stimulus. 

Stock prices may well manage to trend for some time, if only due to the fly-wheel effect.  By many measures, stocks are overbought and sadly the alternatives are either overpriced, or don’t offer any substantive return.  Investors are caught between a rock and a hard place.   According to Bespoke Research, the advance decline line has tipped downward, meaning fewer stocks are behaving well, even though the market continues to rise.  This is not a great sign for the bulls.

The present risks include the fact that the Federal Reserve has said it will be raising interest rates.  This has historically made it difficult for both stocks and bonds (don’t’ fight the Fed).  In addition, there is the pervasive tail-risk, the risk of an extra-ordinary event or tweet that leads to an avalanche of unintended consequences.  Finally, the failure to implement on the promised policy agenda, and ongoing political contagion, will begin to disappoint investors.

In my opinion, it’s no time to be a hanger-on.  I think we can take some profits in stocks that have gotten ahead of themselves.  Technology, healthcare and financial stocks all come to mind.  On the other hand, some stocks in the energy and real estate space have been bringing up the rear and look as though we can add to positions.  The level of complacency among market participants has been high, and as once reluctant investors are pulled in, the risk increases.  This sets the table for some challenging times when some selling inevitably begins.

Overall, my expectations run similar to last month: guarded and without window dressing.  For the remainder of the year, I expect average returns from stocks and below average returns from bonds.  My worry is a good portion of these average returns have already arrived, and the rest will be delivered on the back of greater than average volatility and unrest in the financial markets. 

 

Bruce Hotaling, CFA

Managing Partner

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