Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The S&P 500 experienced its first noticeable volatility day on Tuesday with the index falling by more than 1% for the first time over 109 days. Should investors expect more to come in the near term?
Stovall: I think so. We’re in the ninth year of this bull market. We’ve only had one other bull market last this long, and that is the bull market from 1990 through early 2000. In that ninth year, there were 95 days in which the S&P 500 rose or fell by 1% or more in a single day. So, using that as a guide, because it’s obviously not gospel, I would tend to think that we could end up with more volatility. I think we were spoiled in year eight of this bull market because we only had 23 such days as compared with 85 days in the prior eighth year of a bull market. There’s no guarantee that we will see a lot more market volatility, but my feeling is the older we get in this bull market, the more expensive we become in this bull market. And, the questioning of whether some of President Trump’s programs will come to fruition will also add to volatility.
EQ: The post-election run has largely driven by expectations of the Trump administration’s pro-growth policies. Could this be a sign that the market’s confidence in these policies coming to fruition—at least this year—starting to waiver?
Stovall: Yes, I think that’s certainly a possibility because most investors realize that if legislation does not get passed in the first year of this administration, it’s going to become more and more of a challenge. In 2018, we have a midterm election year, and traditionally you don’t have meaningful legislation get passed then because of the risk of challengers using those issues to potentially unseat the incumbents whose local districts might not like what get passed. So, usually nothing happens during national elections or midterm election years.
There’s been an awful lot of hype with the Trump administration, in particular, the kinds of benefits there might be for corporate earnings in the form of tax reductions and repatriation of foreign earnings, combined with infrastructure spending. But, why the Trump administration chose to start with Obamacare, a quagmire that has pretty much challenged anybody else that has attempted this, is beyond me. Basically, they have to come to a decision before they can move forward and do something that would be meaningful for US economic growth.
EQ: In this week’s Sector Watch report, you looked at the Fed’s projected pace of rate tightening. For the most part, the market seems to be comfortable with the 2017 timeline. With that said, how dependent is the Fed’s monetary policy on the administration’s ability to deliver on its fiscal stimulus going forward?
Stovall: I really think that they are two distinct items. The Fed is raising rates because they want to recalibrate the difference between the Fed funds rate and inflation. At the same time, they want to make sure they get ahead of any inflationary curves. They expect the economy to grow by a little less than 3% for all of 2017. As a result, the Fed wants to raise rates while they can, and are thinking that if they end up seeing much more stimulus filter into the economy because of Trump’s administration, then they will address that should that time comes.
EQ: You also noted that EPS expectations for the upcoming earnings season are beginning to come down, stretching the valuation of stocks. What would we have to see in order for fundamentals to catch up?
Stovall: Well, there’s an old saying that prices lead fundamentals. So, with the stock market price having climbed more than 14% since election day, the wisdom of the crowd assumes that there will be some economically stimulative legislation that will drive earnings growth down the road. But we’re not seeing it as the 2017 earnings expectations have gone from close to 12%, now down to 10%. If the historical pattern holds, we might end up with something closer to 5%.
And even if you were to think the Trump tax cuts will really benefit 2018 earnings, well, since the beginning of the year, 2018 earnings expectations have also come down, albeit very marginally. But still, the trajectory is not what you would expect if the fundamental picture is expected to be improving. So, I would pay very close attention to first quarter earnings reports to see how well they do against expectations, and also listen very closely to whatever guidance is provided from management because that would give us an idea as to whether prices are justified by the fundamental expectations.
EQ: Just how stretched are valuations right now from a historical context?
Stovall: Right now, P/E ratios look very expensive. If you look at a trailing 12 months GAAP basis, which includes everything, we’re looking at the second most expensive bull market at 25 times. The most expensive bull market was the tech bubble, which topped out at 30 times. Looking forward, the P/E on coming 12-month earnings is at 18.3, which trades at a significant premium to the long-term average of a little more than 16 times. So, even if we get the 10.3% earnings growth for the first quarter of 2017, on a trailing 12-month operating basis, we’re looking at a 19.5 P/E ratio. Whether you look at trailing GAAP, trailing operating or projected operating, we’re all looking at valuations that are much higher than historical averages. So, that’s another reason why need to see a pickup in the pace of earnings growth in order to justify these higher prices.