Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: After a year of waiting, investors can now expect the Trump tax cuts to finally become reality. How has this impacted Wall Street’s expectations for 2018 for the S&P 500 overall, and from a sector perspective?
Stovall: Well, it actually started to inflate expectations—not only on a broad level, but also on the sector level. This week, S&P Capital IQ consensus earnings estimates is now showing a 12.3% gain for earnings in 2018, versus last week’s estimates for a 11.2% advance. That’s more than a one percentage point increase in less than a week alone. Also, when we look on the sector level, we find that nine of the 11 sectors have seen boosts to their 2018 estimates, with the top three (Energy, Financials, and Technology) being anywhere from 6.7% to 8.1% above where they were just a week ago. Only Health Care and Utilities saw a decrease in their earnings estimates. So, I think as the weeks move forward and analysts get a clearer picture of what the tax cuts will do for corporate profits, we will see these earnings estimates rise even further.
EQ: In this week’s Sector Watch, you identified three distinct characteristics of 2017’s astonishing performance. First was number of new all-time highs, second was the lack volatility days, and third was a wider-than-normal sector dispersion. How wide was the gap between the best- and worst-performing sectors this year?
Stovall: The gap was almost 46 percentage points, where we had Technology up almost 40% and Telecom down about 6%. Essentially, it’s a very wide percent change between the best and the worst performing sectors. That’s pretty interesting because it is above the average dispersion of 43 percentage points and median dispersion of 38 percentage points since 1990. Also, a lot of the average was influenced by Tech and Telecom in the late-1990s, which show a very sharp outperformance relative to the other sectors in the S&P 500.
EQ: Putting that into a bit more context, what does that tell us about the market, and what it has done historically when this has occurred?
Stovall: What it basically says is that not all great years are followed by similarly great years. While it might be human nature to forecast recency—meaning that what’s happening today is what will continue to happen—rather, what history says is we end up getting more for less. Unfortunately, it’s more volatility for less of a return. In fact, even though we only had eight days in which the S&P 500 was up or down by 1% in a single day over the past calendar year, history says we’ll probably more likely get back to the average of closer to 50 days.
In addition, rather than getting the average 10% price increase that we’ve seen over the past 27 years, we’re more likely to see only half of that. So, while it’s still likely to be higher, the market is expected to post good returns, but not great returns.
EQ: In this type of scenario, particularly the wide sector dispersion, would investors be better off riding with the winning sectors, playing for a rebound, or doing a bit of both perhaps through strategies like the Barbell Portfolio?
Stovall: It’s probably better to diversify, especially this late in a bull market cycle. The Barbell Portfolio, which will be released during the first week of the New Year, basically points to the 10 best-performing and 10 worst-performing sub-industries of the S&P 500.
Since 1990, a combination of these 10 and 10 has outperformed the S&P 500 itself more than 80% of the time. Of course, that’s not a guarantee, but what it basically says is that you are focusing on the extremes—the extreme winners and the extreme losers—thus you have exposure to both momentum and value. Should they take leadership positions, you will benefit from that.
We’ve also gone 22 months without a decline of 5% or more, and historically, we see these kinds of declines every six months. So, I would not be surprised if we do get a digestion of recent gains, and should that happen, I think investors will definitely gravitate toward those areas that have been underappreciated recently, that being the more defensive Utilities, Consumer Staples as well as Health Care sectors.