“As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit.” — Jesse L Livermore
There is no doubt that the “hit the ground running” President has created uncertainty in the political world. But the economic data are positive on balance, and the seasonal January/February weakness of the past two years has been averted. Last week’s announcement of the introduction of a tax reform package within the next few weeks is favorably reflected in stock prices. Through Friday, the 1-year return for the broader averages is +24.2% for the S&P 500 and +32.9% for the NASDAQ Composite. These returns are compared with the near-lows of a year ago February. Since the election, the so-called Trump Rally has lifted the S&P 500 and the NASDAQ 8.4% and 10.4%, respectively. Small and mid-cap stocks, represented in the Russell 2000 Index have risen 16.2% over this post-election period.
Investors, rather than shifting strategy to adapt to Trump machinations, should keep a close eye on the slow-but-steady improving economy and the better outlook from corporate earnings. The almost daily meetings with business leaders will have more economic significance than the green card fiasco, or even the temporary travel ban. Despite the rapid succession of Executive Orders, in reality Washington moves slowly. Improvement beyond the 2% real GDP growth will happen, but not overnight. A move to 2.5% for 2017 would be a welcome improvement. Meanwhile, the bears are citing the bond market for telling of an economic slowdown as rates settle back from recent cyclical highs. The benchmark 10-year Treasury yield flirted with 2.60% in early-December, but fell back to 2.34% last week. (Over the past few sessions, the yield has climbed above 2.44%.) Stocks on the other hand, remain in rally mode.
It has been our contention that the economy was improving prior to the election and that an expansionary fiscal policy would lengthen the duration of the business cycle, with only marginal initial improvement in the level of growth. Productivity gains could change this outlook. Rather than adapt investment policy to a Trump Presidency, investors should stay the course, concentrating on economic improvement and those companies which will benefit from a healthy consumer, technological efficiencies, and improving corporate earnings. Noneconomic policies are just that and, while interesting news, rarely affect the bottom line.
The Evolving Consumer
The financially healthy consumer is settling into a pattern of sustained spending. Housing is showing more stable growth but at levels low by historical standards. As we have discussed in prior reports, the problems of the housing depression are near resolution. Going forward the main driver of housing growth will come from Millennials, the largest generation ever with 85 million participants, whose appetite for housing is more in concert with an encompassing lifestyle with work, leisure and home are interrelated. Unlike previous generations, a short commute, walk to restaurants, and an urban housing environment rather than suburban living, are on their radar. Baby Boomers for the most part, are retiring later and are opting for sameness rather than total retirement. These shifts will be gradual, adding stability to housing growth over a longer cycle.
Consumer spending has experienced the paradigm shift away from brick and mortar, moving to online purchases. Comparison shopping was never so easy. Large retailers are burdened by high-cost stores, which serve as places to view products before purchasing online at a cheaper price. Today, walking into a store many find inventory low or nonexistent, sales are lost to online retailers, like Amazon, when the item is price compared. Alternative use for the enclosed and strip malls will evolve as innovative owners find ways of incorporating the urban living concept, favored by Millennials, into their stagnant real estate. Today, combinations of housing, leisure and work are already being developed.
Accompanying this lifestyle will be the implementation of convenience of a cheaper overall price. Autos, while still a necessary mode of transportation, could drop to only one per family. In urban settings, Uber, Lyft, or other forms of transport for short drives will be used. Savings on cars and commuting expenses could be shifted to leisure and recreation, including travel. Already the shift away from landlines has affected the business models of the larger telecom companies. Verizon just announced a reinstating of unlimited data plans. Companies are now being forced to accede to consumer preferences rather than “business as usual.”
Earnings are the lynchpin to rising stock prices. Over the past two years, corporate earnings growth has limited equity performance. The Energy sector is the blame for overall negative quarterly comparisons. In reality, earnings have remained stagnant because of lack of productivity, strengthening US dollar, a cautious consumer, and onerous government regulations. As employment rose, wages did not. Only recently have we seen a pickup.
The good news is that earnings have turned the corner. For full-year 2017, Thomson Reuters estimates S&P 500 earnings to increase 8% over 2016. Should the corporate tax level be passed during the year as expected (this seems likely and will be retroactive), a decline from the current 35% rate to 25% is estimated to add 8%-9% to the bottom line. The current proposals are for 15% (Trump) and 20% (Ryan), but given fiscal constraints, a 25% seems reasonable. Also, a tax break in the repatriation of foreign earnings held overseas is likely. This could add an additional 3%-4% to profits. These changes would come as the economy is moving above 2% real GDP and inflation is slowly rising above the 2% minimum level. Many market analysts will be surprised when there are productivity gains along with margin and multiple expansion.
Wall Street will reward those companies benefitting from economic momentum as earnings are rising. Growth, rather than cyclical companies will be the major beneficiaries. Many companies that were disrupters will be disrupted. This is happening to FedEx (FDX), as it happened to Yahoo (YHOO). Companies like Amazon (AMZN) (cloud computing) and Facebook (FB) (mobile) are examples of companies disrupting their own business. Apple (AAPL) and Microsoft (MSFT) seem to be moving in that direction. Companies combining innovative technologies with consumer preferences will succeed. In fact, a substantial number of the 185 Unicorns (private companies value at $1 billion or more) with accumulative value of $664 billion are consumer oriented. As the market continues to improve we would expect many of these companies to go public. Successful IPO’s often give a boost to overall stock prices.
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity. It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary fiscal 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, financial, industrial and technology companies. To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.