Suspension of Disbelief
Looking back at 2016, US stock investors earned an 11.9% return, as measured by the S&P 500. That figure puts last year’s returns somewhere close to the historic average. Yet last year was no average year. Through the end of October 2016, stock prices had managed a return of only 5.8%. At that point, expectations were low – prices had been flat to down since the end of July, the only month to deliver any true incremental returns. Skepticism was running high and investors were holding higher than normal levels of cash, just in case. On election day, the unthinkable happened. Markets collapsed in panic, then normalized, and then managed to rally (returns jumped nearly 2x) into the year end. I don’t think anyone could have made this up.
The first question that comes to mind is, how did we get here? There is a clear movement around the globe from old school civic patriotism toward a more base nationalism. This was clearly evident in the June 23 Brexit vote. Similar rumblings have been taking place in Italy, Austria, France and Turkey to name a few. The primary drivers are economic disenfranchisement among white men, a growing sense of nationalism / xenophobia, and long simmering suspicion of political elitism at the top. Now the US has picked up the baton and is off and running.
The second question is, where do we go from here? Sadly, this is something akin to a leap of faith. My concern is that we experience spaghetti-throw leadership. My hope is the way forward involves thoughtful policy, with balanced leadership, clarity and purpose. At the moment, I’m shocked by the shaming of corporate leaders on Twitter. In my opinion, this form of demagoguery is antithetical to the spirit of US capitalist democracy.
The headwinds are there, but difficult to evaluate. An overly strong dollar and trade disputes will temper US corporate earnings and generally weigh down global growth. A border tax – would raise prices on most goods – and likely be damaging to a lot of the US technology industry. On the cup half full side, the ability of US firms to repatriate large sums of cash held outside the US is favorable. Lower corporate tax rates would in theory be additive to EPS, unless lowering the deductibility of interest on corporate debt acts as an offset. And, deregulating industry, the financial and energy complex, will likely be a tailwind, though important questions as to how, and when, may not be known for some time.
Talk is of expected higher economic growth. This is likely braggadocio. The fact is, productivity may well be crimped if the technology industry in the US comes under fire. Technology is one of our most important, and global industries. Labor, another primary factor of economic growth, may also stall, considering the full-employment economy, and a professed resistance to immigration. Some analysts have raised the possibility of a recession in 2018. In my opinion, it’s overly optimistic to assume a dramatic breakout in growth in the US.
I think the return/risk assessment favors stocks, but only with the premise they be held for a longer period of time. The near term risk of owning stocks is higher than has been the case in a long time. Overall, stock prices are full. Consensus EPS estimates for 2017 are in the $133 per share range. At a 17 multiple, that prices the S&P 500 at roughly 2,260, or approximately its current level. The market is ahead of itself, having pulled forward returns from 2017 into the tail end of 2016.
Sectors holding some interest are energy, financials and industrials. I assume oil prices remain in a range, and the energy sector continues its recovery. Financial stocks will see margin improvement with a normalized yield curve. Industrial stocks will generally benefit from stable energy prices, a focus on infrastructure and technological innovation. I am more inclined to own domestic stocks with a leaning toward value and smaller market capitalization. Our focus will remain on quality investments with strong fundamentals.
As 2017 unfolds, certain aspects of policy may develop clarity and hopefully become investible. Until that time, I believe a cautious stance is the most prudent. Please feel free to call so we can exchange thoughts and review the best course going forward.
Bruce Hotaling, CFA