Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Oil prices have fallen to a new 10-month low, and are now on pace for the worst first-half performance in four decades. Is there something bigger going on here that investors should be more concerned about?
Stovall: I think what is going on is we’re simply getting more and more supply, but we’re not seeing an increase in demand that would help offset that supply. It’s obviously not something that a lot of people had anticipated because, just a couple of weeks ago, our economic forecast was looking for oil to average above $53 a barrel for 2018. Now, the estimate is for an average of $48 a barrel. I think what’s happening is that we’re just seeing Libya and other countries increase their oil output, and it’s not being offset in an increase in demand. I don’t think it is the foretelling of a global recession, however, because that’s what the world feared in early 2016. We found that it was an oversupply combined with a lack of demand. It seems as if it’s that kind of scenario, part two.
EQ: Energy year to date has been by far the worst performer of the S&P sector groups. It is the only double-digit decliner. That said, CFRA rates it at marketweight right now. How would you describe the Energy group from an investor’s perspective at the moment?
Stovall: I would describe the Energy as sort of a wait-and-see. We had it as underweight and we just felt that it had fallen more than we thought it was going to fall. We were obviously early on that call. So, we have it as a marketweight right now. It is in an earnings recovery mode where Energy is expected to see a near-300% increase in earnings in 2017. Granted, if you come from two years of declines, you’re starting from a very low base and any kind of an improvement makes for a magnified percentage change. But also, this increase in earnings for the Energy group is what is helping to propel S&P 500 earnings growth for 2017 and 2018. Right now, since that number remains stubbornly above the 10% level, we would tend to say that earnings currently have yet to be adversely affected.
EQ: Speaking of first half performances, the S&P 500 is up almost 9% thus far in 2017 despite no shortage of headwinds and a lack of major catalysts. In this week’s Sector Watch report, you offered your outlook for the second half of 2017. Has the first half set the table for a continued run, or has the market gotten ahead of itself?
Stovall: I think you aptly described the first half as being fraught with headwinds, yet the market was still able to remain standing, despite these very strong areas of resistance. I think that investors believe that the Trump administration will put through some sort of tax cut—maybe it’s not going to be a sweeping tax reform, but something will be done to level the playing field in terms of US tax rates versus those around the globe.
Also, we are beginning to see an organic improvement in economic growth, which is translating to an increase in top line as well as bottom line growth for companies in the S&P 500. In fact, today, S&P Dow Jones Indices reported that share buybacks have fallen more than 17% year-on-year, and as a result, companies are still increasing their top line and bottom line, even though they are not getting the assistance from the reduction in the overall share count. So, I think investors believe there is growth potential ahead coming from the government as well as coming from the economy on its own, and that will translate into a continued improvement in earnings, which is coming out of this earnings recession that it saw in the latter part of 2015 and the first half of 2016.
EQ: Of the 10 sectors, you also maintained your ratings of being overweight Industrials and Materials, while underweight Consumer Staples and Real Estate. How much of this still hinges on the Trump administration’s ability to deliver on certain economic policies?
Stovall: I think that there is some expectation that we will see an increase in some sort of infrastructure spending, which will benefit the Industrials group. Let’s face it, looking out into 2017 and 2018 in particular, we expect to see a pickup in earnings growth for the Industrials group, which is expected to grow more rapidly than the S&P 500. The Materials category is also expected to see a bit of improvement. Unfortunately, they do tend to have a higher correlation with Energy, so that might be dragging them down in the near term, but we still believe that the Chemicals companies, which dominate the Materials category, will benefit should economic growth improve as well.
As for Consumer Staples, they took it on the chin recently because of the increased competition from Amazon (AMZN) and Whole Foods (WFM), and so many of your traditional food retailers are feeling the pressure from a very low-cost provider. Lastly, with Real Estate, the Fed keeps telling us that based on its dot-plot forecasts that it wants to raise rates at least one more time this year, three times in 2018, and who knows how many times in 2019. They continue to put upward pressure on interest rates, and our belief is that it could keep Real Estate from being a relative outperformer.
EQ: In terms of headwinds, you noted that the major concerns right now are known risks reflected in current valuations. That said, what are some potential tailwinds that could potentially propel the market in the second half?
Stovall: First off is the very low level of inflation. With us at 1.7%, we have now just entered the upper range of the lowest quintile of inflation going back to 1948. When you look at that low level of inflation, the average P/E for the S&P 500 has been 23 times, and we are currently trading at 24 times on a trailing 12-month GAAP basis. So, while we might be slightly overvalued, maybe by as much as 5%, I think that a pullback could occur pretty much at any time. They tend to happen every nine to 12 months, and as a result, we could see a slippage in prices, but because I don’t see a recession on the horizon, I think it would represent a good buying opportunity rather than a reason to bail.
Interest rates remain low relative to history. Normally, what we see is the Fed funds rate is about 1.5 percentage points above the core rate of inflation. With Core CPI year-on-year at 1.7%, that would imply that the Fed funds rate should be 3.2%. That translates to a 10-year yield that is basically rivaling the dividend yield of the S&P 500, and whenever we have had the yield on the S&P 500 essentially equal to that of the 10-year note, we have seen double-digit increases in the coming 12-month period, and have seen the market rise more than 80% of the time. That is obviously not a guarantee, but it implies that you don’t really have a lot of substitution attractiveness offered by bonds over stocks.