Sometimes, how you get somewhere isn’t as important as the fact that you arrived there. 2017 was that kind of year. The major stock indices scored huge gains in a move that chartists would describe as even, though there was some ugliness behind the scenes. Most of the ugliness centered around politics, but fortunately, politics doesn’t move the stock market like earnings and interest rates do.
There is no denying that politics had some bearing on the stock market’s movement in 2017, but fundamentally speaking, it was the persistence of low interest rates and the resurgence in earnings growth that sealed the deal on a very good year for the stock market—the best since 2013 for the S&P 500.
THE TALE OF THE TAPE
The numbers prove just how good a year it was.
The list of statistical accomplishments could go on and on as there was plenty of return cheer to go around.
The so-called FAANG stocks—Facebook (FB), Apple (AAPL), Amazon.com (AMZN), Netflix (NFLX), and Alphabet (GOOG), formerly known as Google—took a bite out of the bears, gaining 53%, 47%, 56%, 55%, and 36%, respectively. Their leadership and that of another heavyweight—Microsoft (MSFT)—had a huge pull on market returns.
Really, though, there were a lot of other major success stories.
Dow component Boeing (BA), for instance, surged 89%; casino operator Wynn Resorts (WYNN) added 95%; homebuilder D.R. Horton (DHI) jumped 87%; machinery giant Caterpillar (CAT) climbed 70%; drug company Abbott Labs (ABT) increased 49%; and beverage company Constellation Brands (STZ) rose 49%.
The point is that there was a lot of support underpinning S&P 500 price returns in 2017. In fact, 374 out of 505 stocks registered a gain in 2017 and 219 out of 505 members scored a gain more than 20%.
POLITICAL VOLATILITY ONLY
2017 was a year marked by low volatility in the stock market and high volatility in Washington D.C., where President Trump took over the Oval Office, and the GOP assumed control of both houses of Congress, starting in January.
That was reportedly the ticket to repealing the Affordable Care Act, introducing a major infrastructure plan, cutting regulations, redoing trade agreements, and completing the first major overhaul of the tax system since 1986.
To be brief (and understated), the administration didn’t get everything done it set out to do. Two things that did get done, though, were cutting regulations and passing a tax bill, the chief feature of which is a permanent reduction in the corporate tax rate to 21% from 35%, starting in 2018.
Those were both very market-friendly developments, and one could argue that so, too, was the inability to fully repeal the Affordable Care Act, which has been a boon for the health care sector. The individual mandate penalty was repealed as part of The Tax Cuts and Jobs Act.
During the legislative affairs, an investigation into Russia’s meddling in the U.S. election, and allegations that the Trump campaign colluded with Russia, carried on behind the scenes under the leadership of Special Counsel Mueller, the former Director of the FBI.
That investigation generated its share of sensational headlines, and is still underway, but the salient point for our purposes here is that the stock market was not unnerved by any of it for any length of time.
The same can be said with the administration’s drive to pull out of the Paris Climate Accord, to renegotiate NAFTA, to threaten trade sanctions against China, to curb immigration, and to stifle North Korea’s nuclear ambitions.
Those happenings, and others, like the Charlottesville incident, often made big political waves that had political pundits drowning in their analysis. For the stock market, though, they were little more than a ripple, evidenced by the fact that the S&P 500 had cruised into December without a pullback of at least 3% since November 2016—its longest streak ever.
Politics certainly created its share of noise in the echo chamber, and it promises to do so again in 2018 with the mid-term elections looming, yet the stock market for a multitude of reasons managed to tune it out.
A CURVE BALL
The key reasons that the market was able to cancel out the noise from Washington were the persistence of low interest rates (partly because inflation remained low), strong earnings growth, a synchronized pickup in global economic growth, and market-friendly central banks.
The Federal Reserve raised the target range for the fed funds rate three times in 2017 and began what is going to be a very long balance sheet normalization process.
The remarkable thing about these moves, which are intended to reduce policy accommodation, is that they were taken in stride by the stock market, which is a credit to the Federal Reserve’s communications policy.
The effectiveness of that policy was rooted in the Federal Reserve’s repeated reminders that it expects the pace of interest rate hikes to be gradual, yet it was borne out in the stock market with a succession of record highs for the major indices following the rate hikes and the projection that the Federal Reserve sees scope for three rate hikes in 2018.
While the Federal Reserve’s rate hikes hit home at the front of the Treasury yield curve (the 2-yr note yield rose 62 basis points in 2017 to 1.88%), the back of the yield curve was operating in a different world.
The yield on the 10-yr note dropped seven basis points in 2017 to 2.41%, which led to the narrowest spread between the 2-yr note and the 10-yr note (53 basis points) since October 2007.
A flattening spread is often viewed as a harbinger of slower economic growth, yet the dovish policy accommodation still being provided by the European Central Bank and the Bank of Japan fueled an interest rate differential trade that tamped down long-term rates here and created some possible misdirection about the economic messaging coming across in the flattening yield curve.
The Federal Reserve, and other major central banks, will play a key role in the market’s behavior in 2018. The Federal Reserve, however, will soon be directed by Jerome Powell who will supplant Janet Yellen in February as Chairman of the Board of Governors.
The stock market was comforted by the notion that Mr. Powell is a “status quo” successor to Ms. Yellen. Time, and economic circumstances, could change the market’s impression of Mr. Powell, yet the stock market after his nomination acted as if it believes that MR. Powell will continue the gradual and well-communicated normalization of interest rate begun under Chairwoman Yellen’s tenure.
ECONOMY LOOKING UP
There was a lot seen in 2017 from an economic standpoint. Most of it was good, which drove the outperformance of the cyclical sectors:
The blemish on growth optimism has been the lackluster growth in average hourly wages. A pickup in wage growth is a key to stronger levels of consumer spending that don’t necessarily need to be driven by debt.
Higher wage growth, though, could also be the fuel for higher inflation that has been missing in action for some time and has been baffling Federal Reserve officials.
The “low-flation” in 2017, though, facilitated the persistence of low interest rates, which, in turn, facilitated multiple expansion.
WHAT THIS MEANS TO INVESTORS
The S&P 500 closed 2017 trading at approximately 18.2x estimated 2018 earnings—a 28% premium to the 10-year average. The stock market constantly rationalized the premium multiple based on interest rates remaining low. An added support factor was the belief that the cut in the corporate tax rate would drive stronger earnings growth in 2018 that has yet to be reflected in analysts’ estimates.
Accordingly, the S&P 500 was often referred to in 2017 as trading with a full valuation, but not necessarily being grossly overvalued. That criticism was left mostly to cryptocurrencies, which burst onto the scene with a trading mania that has not been seen since the dot-com bubble days.
Take low interest rates away, though, and the valuation assessment might take on some more cynical tones.
The tone at the end of 2017, however, was one of respectful optimism for continued gains in 2018, but most likely more modest than 2017 because of the full valuation from which the market is starting.
From our vantage point, we see a market that gets riled up more by minor setbacks than it does by further gains. We think that’s because the stock market hasn’t had a meaningful setback in a long time; therefore, when a pullback does happen, the anxiety about it being the start of something big is more palpable than the enthusiasm is for additional gains.
This investor sentiment is also consistent with human’s natural risk aversion. When I was in consulting we performed tests of investor behavior and marginal utility which suggested to us that the average investor feels a certain amount of pain from a loss of $1, and to feel the same amount of joy the investor would need to experience a $2 gain. Think about that for a moment. It takes twice as much gain to generate the same level of joy as compared to a loss. This has profound effects on investor behavior, and investor’s risk aversion will come into play, as it always does, in 2018 by exacerbating small, to some, meaningless negative information.
Our viewpoint is admittedly refutable based on the low reading for the CBOE Volatility Index, which doesn’t connote a lot of concern about downside risk in the near term. Nevertheless, there is a lot of hand-wringing when the technology sector, for instance, sees a 1% decline or when the S&P 500 starts strong and finishes on its lows for the day.
Neither of those things has happened a lot in 2017, which has produced a succession of record highs for the major indices.
Still, we would contend that the angst associated with those developments, when they happen, reflects tacit concerns about valuation and this bull market being long in the tooth.
As a reminder, bull markets don’t just die of old age. Bull markets typically die when a recession arrives, or the fear of a recession takes over.
A recession fear is not prominent at this juncture, which is why the desire to buy on dips still outweighs the inclination to sell into strength.
Be that as it may, there are a lot of stocks that have made big moves and a lot of passively-managed funds that have done the same. Might it be time to do some selling? The answer will boil down to individual risk tolerances and a bid to maintain prescribed weightings in the equity portion of a diversified portfolio.
The stock market might not be overvalued in a relative sense, yet bear in mind that it is being propped up in an absolute sense by the persistence of low interest rates.
If, and when, those interest rates rise, total return prospects will diminish—and they could diminish quickly if interest rates move up at a rapid pace and/or the crowd-funded momentum of this bull market gets pulled.
The stock market may not have a down year in 2018, yet it may find it difficult to have another fantastic year like it did in 2017 if everything doesn’t go just right with low interest rates, low inflation, and strong earnings growth.
The year ahead will be an adventurous one. They always are.
There will be some familiar themes, but the main storyline will not change: interest rates and earnings will hold fundamental sway over the market in the absence of exogenous shocks.
Thank you for your readership throughout the year. Best wishes for a happy, healthy, and prosperous 2018!
As always, I look forward to catching up with you soon.
John P. Swift, CFA, CPA
CEO & Chief Investment Officer