​A Geopolitical Exercise

Hutchens Investment Management |


Today, stocks are rallying as headlines read, “Markets rally as North Korean tensions ease.” This should not surprise long-term market followers as most instances of geopolitical fears quickly abate. While there is no timetable for the return to “business as usual,” the uncertainty subsides. This is not to say that the events leading up to the geopolitical uncertainty have disappeared, but rather digested by the market. The real change is in the perception of the geopolitical threat.

The reaction of the market to the saber rattling was classic. Momentum-oriented traders reassess their positions and risk is repriced. The pricing exercise results in a multiple compression of P/E’s and shares are liquidated. Non-committal momentum traders sell as prices rarely matter nor do the fundamentals of the underlying companies. None of the technology or biotech stocks sold last week had any economic involvement in the Korean crisis.

Bear markets result from economic deterioration, not from geopolitical events. More selling may return as headline — hungry media focuses on impending war and its aftermath, but barring actual confrontation, any selloff will be short lived. Each geopolitical crisis is different depending on market valuation and perceived risk of holding these momentum stocks.

That being said, stocks should continue to rally as geopolitical tensions decline. There will be some shift away from more speculative smaller companies as well as caution with Large Cap technology and biotech companies. We would expect the Industrial and Financial sector to benefit from the reallocation. Retail remains weak but in fact, it is more of a shift away from low tech brick and mortar to Internet convenience.

This trend will continue until a profitable balance is reached. Store consolidation will accelerate, along with changes in merchandising; it may take years to reach equilibrium. Consumers, particularly Millennials, will dictate the timing for retail spending in a world of both online and offprice. The FANG stocks have been tainted as Amazon (AMZN) and Alphabet/Google (GOOGL) disappointed on 2Q2017 earnings.



Other companies priced to perfection, such as Tesla (TSLA) and Nvidia (NVDA), cannot afford any mistakes. Excessive optimism reflected in current valuation may be justified for companies with accelerating corporate profits through 2018. Additionally, low interest rates justify higher than historical P/E’s.

Corporate Earnings: Locked and Ready

Earnings of S&P 500 companies rose over 10% in 2Q2017. Revenues were up a surprising 5.1%. According to FactSet, 73% of the companies in the S&P 500 reported EPS above estimates. For sales, 69% of the companies were above forecasts. Both earnings and revenues were above the 5-year average. As shown in the Table below, 10 sectors have reported year-over-year earnings growth in 2017, led by Energy, Information Technology, Utilities and Financials. The Consumer Discretionary sector reported a decline in earnings of 0.3%. Amazon reported EPS of $0.40 for the quarter, down 77.5% from 2Q2016. Excluding Amazon, the EPS for the Discretionary sector would be a positive 1.8%.

The forward 12-month P/E for S&P 500 companies is 17.4X, above the 5-year average 15.4X and the 10-year average 14.0X. Based on consensus earnings estimates the bottom-up 12-month target for the S&P 500 Index at the current P/E is 2,705, which is 10.9% higher than the 8/11/17 close. We anticipate earnings higher than as currently forecast.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors: David Minor & Rebecca Goyette
Editor:
William Hutchens

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
TSLA Tesla Motors Inc. 351.09 -15.39 -4.20 8,159,418 Trade
GOOGL Alphabet Inc. 943.26 -4.29 -0.45 1,074,806 Trade
NVDA NVIDIA Corporation 179.00 -1.76 -0.97 12,280,771 Trade
AMZN Amazon.com Inc. 955.10 -9.55 -0.99 2,641,787 Trade

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