Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: After taking a backseat in the spotlight since the election, the Fed is now coming back into the forefront as Fed Chair Yellen testified in front of Congress this week. What were some of the key takeaways for you from what was said?
Stovall: Well, I think for me, the key takeaway is that the Fed is still reminding us that another rate hike is on the table for March, and even though Fed funds futures point to only about a 25% likelihood that they will raise rates in March, and they would rather wait to raise rates in June. She also reminded us that their decision is data dependent, and with core CPI coming in stronger than expected as well retail sales, I think it gives additional reason for the Fed to stick to its three rate tightenings in 2017.
For now, I don’t think she sounded dovish. I think she is letting us know that a continuation of the rate-tightening program is what the Fed really wants.
EQ: The S&P 500 has moved past the 2,335 target that CFRA has for 2017. While we know price movement isn’t linear, how does this impact your outlook, if at all?
Stovall: As of now, it does not impact our outlook. It’s something I discussed in the latest CFRA IPC notes, in which I wrote:
Vince Lombardi supposedly once said “I never lost a game. I was only behind when time ran out.” The S&P 500 is currently trading above our year-end 2017 target of 2335. In early December, when this target was established, full-year 2017 EPS were projected at $131.02, according to aggregates compiled by S&P Capital IQ. Today, the forecast is slightly lower at $130.31. Also, the y/y projected gain in core CPI was 2.1%, versus today’s 2.3%. Target prices are a reflection of earnings growth estimates and inflation expectations. While our year-end target is indeed below the current level, we remind investors that during up years since 1945, the average closing high-low difference was 25% and nearly 85% of all up years endured a YTD decline at some point along the way.
EQ: In this week’s Sector Watch, you looked at the small-cap segment of the market. It’s been significantly outperforming the large-cap indices since October. What are some of the main drivers for this surge thus far?
Stovall: Actually, while small-cap stocks significantly outperformed the S&P 500 in the latter two months of 2016, on a year-to-date basis, small caps are up 1.8% through February 14 versus 4.4% for the S&P 500. So small-cap stocks have actually taken a breather. Now the question is, do they have the ability to catch a second wind and work their way higher? My feeling is yes, they can do so because the relative P/E ratio looking at 2017 earnings is actually below its longer-term average. The average is a 20% premium while the relative P/E based on 2017 earnings is an 18% premium. So really, the stocks are not overvalued on a relative basis, even though the market itself, in our opinion, is at best fairly valued and at worst overvalued.
I think the driving factors for small caps is you have fewer impediments based on imports and based on international exposure. So a strengthening dollar is less likely to be adversely affecting revenues and earnings of small-cap companies. Also, if the Trump administration is likely to spark some economic growth, it’s the smaller-cap companies who run lean and mean that are likely to benefit the most.
EQ In the report, you also noted that while there could still be some upward potential left in this run, investors should proceed with caution. You mentioned some of the tailwinds, but for investors looking at small caps, what are some headwinds they should be aware of? Should they be looking at individual companies or use a small-cap index ETF?
Stovall: I had mentioned on a relative basis that the small caps don’t really seem out of line currently and are looking more attractive as we move into 2017. However, on an absolute basis—meaning what is the P/E for small caps as compared with its own history—the group is actually looking pretty expensive. The median absolute P/E for the S&P SmallCap 600 over more than 20 years is 21.6. Today, it’s trading at 25.1, or a 16% premium to that longer-term average. I also found that if you use a similar comparison with earnings growth and inflation, which I used for the large-cap stocks, then basically we are within less than 0.5% for the year-end target for small-cap issues for the end of 2017.
So our feeling is that you’re probably better off looking to buy individual issues. Interestingly, only 10 stocks in the S&P MidCap 400 and SmallCap 600 carry 5-STARS, or Strong-Buy recommendations, by CFRA equity analysts.