“Risk is good. Not properly managing your risk is a dangerous leap.”
— Evil Knievel
Strength in the stock market is driven by an expanding economy, not by the prospect of tax cuts. There will be some stimulative effect if the Tax Bill passes, but the immediate value will be more psychological than quantitative. That being said, there is nothing on our radar at this time to preclude a continuation of the bull market fueled by a favorable economic cycle and accompanying higher corporate earnings. In fact, new highs for the S&P 500 and the NASDAQ should not surprise, given the current 3Q earnings reports and the optimism for the coming four quarters. The most recent rally is led by earnings of the Technology sector with prices up nearly 3% last week and 34.6% this year, far outdistancing Healthcare at 19.2%.
Since the election, all major averages are up over 20%, while the S&P 500 and the tech-heavy NASDAQ Composite have risen 23.8% and 33.1%, respectively. Beginning in 2017, corporate earnings have strengthened and were up over 10% in 1Q and 2Q. Our proprietary earnings model (Ogden Research) has equal weight 3Q2017 preliminary earnings for 184 companies, up 12%. This trend is reflected in the S&P 500 earnings reported in FactSet and Thompson Reuters. Going forward, the S&P earnings are estimated to rise 11% for all of 2017 and 12% for 2018. These would be the best years since the 15% earnings growth in 2011. Additionally, it has been widely accepted that the $142 current estimate for 2018 could rise $10-$12 if tax cuts and overseas cash repatriation occur. The prospect of a gradual reduction in the corporate tax rate to 20% should have a minimal short-term effect on the market. Even with these estimates and a 3% economy, the stock market is not immune to a correction. The broad-based global recovery, with Europe and Japan growing over 2%, and India and China showing sustained growth, it is more likely a 20% correction would come from an exogenous shock outside the economic world.
Over the past eight years since the Great Recession real GDP has grown 19%, compared to 39% during the 1980’s and 43% in the 1990’s. The magnitude of the post-crisis growth has been ignored as many economists and market strategists predicted recession in 2015 when the Fed stimulation ended. Richard Bernstein notes:
“Stock market returns are not as extreme as some might suggest…The last five years’ return fall far-short of the typical end of cycle ‘blow-off rally.’ The last five years’ return of 14.8% is well- short of the median return of 21.4% that occurred in the five years leading up to prior bull market peaks (December 1930-July 2017).”
The valuation of the current market is 18X forward 4Q estimates in this, the third longest bull market in history. The bearish argument, once again cites valuation and longevity of the economic cycle and the bull market to conclude it is time to reduce equity holdings. Remember that those who ignored these dire predictions over the past few years are now better off today. Technically, stock market breadth continues to confirm price gains. (The cumulative A/D over the past 12 months reached a new record high on October 20th.)
Economic Rundown
Recent economic data remain positive.
? GDP – Real GDP grew at a 3% annual level for 3Q2017 beating most economic models. The often quoted Atlanta Fed predicted 2.5% while the New York Fed was at 1.5%.
? Consumer Sentiment – University of Michigan Survey rose to 100.7 in October, the highest level since January 2004. The Current Conditions Index was 116.5, up from 111.7 in September. Who needs a tax cut?
? Personal Income and Outlays – Personal income in September rose 0.4% month-over-month, compared with 0.2% in August. Wages and salaries, the largest component, also rose 0.4%. Consumer spending in September was 1.0% higher than August, as a 2.1% increase in durable goods largely reflected the hurricane-related vehicle replacements. Both PCE Price Index (+1.7%) and the Core (ex food and energy) PCE Price Index (+1.3%) remain below the Fed 2% inflation goal.
Housing
New Home Sales rose 18.9% year-over-year in September 2017, the highest level since October 2007. Regionally the South, which represents 60% of total sales which rose 25.8% due to hurricane deferred purchases. All other regions also grew; Northeast 32.3%, Mid-West 10.8% and the West 2.9%. These sales account for about 20% of total housing purchases. The lack of supply of existing homes may be driving buyers into this market. However, prices of a new home averaged $385,000, highest in history going back to 1963. High prices excluded most first-time buyers, as only 13,000 of the 667,000 SAAR new homes sales were priced $200,000 or lower. Existing Home Sales fell 1.5% to 5.4 million SAAR units in September. Supply was 4.2 months, down from 4.5 months one year ago (6 months is considered a healthy inventory.) Median number of days on the market is 34, compared to 39 in September 2016. While the median price is $245,000, inventory is limited.
The housing market is plagued by a lack of affordable homes. With new homes prices at $385,000 and existing homes at $245,000, housing remains out of reach for most first-time buyers. According to the National Association of Realtors, nearly two-thirds of renters believe it is a good time to buy a home, but weakening affordability and few choices in their price range have made it difficult. These comments are borne out in the data which show first-time homeowners representing 29% of purchases in September 2017, down from 34% a year ago. While many economists interpret the erratic home sales as a negative and late-stage phenomenon of the housing market, it is a supply problem. An equilibrium level will be reached by adding more affordable housing and/or rising wages for consumers. As a balance approaches a clear upward trend in housing will emerge, more indicative of early stage of the housing cycle rather than the late stage.
Investment Policy
Our investment policy remains optimistic. Fed policy is on a course of no surprises in the early stages of rising rates and in the absence of trade wars, lower taxes and reduced regulation, government policy is a positive for economic growth for the first time in nearly a decade. A selloff of not more than 5% is possible, but our view does not assume a meaningful decline resulting in a market correction of 10% or more. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderate rate increases, and strong consumer and business confidence. Despite the short-term negatives of two hurricanes, we expect the economy to break 2% annual growth in 2H2017 as slowly improving wages, housing, and Internet retail continue to reflect a healthy consumer willing to spend. It is highly unlikely given the increasing strength in the economy and the outlook for corporate earnings that the long- term bull market will be interrupted. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, a successful implementation of the Fed’s balance sheet reduction, will result in increased earnings and multiple expansion giving further upside for select domestic Large-Cap Technology, Industrial, and Healthcare sectors, and selected Financial 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
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