The first quarter of the new year is complete and it has been another stellar quarter for the stock market so far, if not for the economy. The S&P 500 is up 5.7% year-to-date, which flies in the face of a meager 0.9% annual growth rate projected by the Atlanta Fed’s GDPNow Model for first quarter real GDP.
The stock market, of course, has been flying since last November, riding a wave of post-election enthusiasm built around the Trump Administration’s promises of tax reform, deregulation, and infrastructure spending.
In a manner of speaking, the stock market has allowed itself to be wooed by a lot of sweet talk and it is now betrothed to the idea of living happily ever after with pro-growth reforms. Eternal marital bliss is easy to imagine on a honeymoon, but as our nation’s divorce rate indicates, the reality doesn’t always match up with the fantasy.
That consideration is an important one for the stock market, because the honeymoon with the new administration is ending and the hard work of marriage is just beginning. We know this because the promises put forth on the campaign trail are now starting to make their way to legislative chambers where things are not quite as blissful.
How the lawmaking process unfolds there could go a long way toward determining how the bull market unfolds from here.
A POINT OF ORDER
The first order of business for the new administration was health care reform, which is concentrated on the platform of repealing and replacing Obamacare.
The GOP’s first attempt ended poorly with the House bill being pulled from a vote that assuredly would have had the bill going down to defeat. As expected, the Democrats were steadfastly opposed to the bill, but the key point as that there were plenty of critics within the GOP.
That initial defeat was a point of contention for the market since it has been told tax reform cannot happen until a health care reform plan is passed — and it is the prospect of tax reform that has been the main engine driving the market since the election.
To be fair, the matter of tax reform will be taken up even with health care reform falling by the wayside, yet the process will likely be more cantankerous and elongated than it would have been if a compromise on health care reform is reached.
August has been held out by administration officials as a target date for the passage of tax reform. There is a lot of work that needs to get done in the next several months, then, if that target date is to be met. The market may be content to ride things out until then, yet any notion that tax reform is being unduly delayed is apt to slow this bull market down and perhaps at times knock it back.
It’s not just a domestic issue, though, when it comes to politics and the bull market. It’s a global issue when considering some of the protectionist trade banter that has been heard, the incessant saber-rattling from saber-toothed North Korea, and the election uncertainty hanging over the European Union.
The early part of the second quarter is going to be dominated with talk (and maybe indecision) over the state of European politics and the fate of the European Union. That’s because the French presidential election will feature a first round of voting in late April and a second round in early May.
The outcome of that election is an important inflection point for global markets since it could upend the European Union if Marine Le Pen, the leader of the Front National Party, wins.
Ms. Le Pen’s populist message of protectionism for France resonates as a potentially upsetting factor since it involves a call to hold a referendum in France, if elected, on the matter of withdrawing from the European Union.
Ms. Le Pen is not the favorite to win the presidential election, yet her base of support has been building with the sluggish growth and high unemployment rate in France; moreover, market participants remain understandably leery of polling results given the surprising outcomes of the Brexit vote and the U.S. presidential election.
One might characterize a win by Ms. Le Pen as being a low-to-mid probability, but a high-risk event for a few reasons. First, because it is not expected, and second, because it will create all sorts of short-term angst about the fate of the European Union, the value of the euro and European sovereign debt, and bank exposure to European debt.
Conversely, her defeat would likely provide a measure of relief for global markets, which would no longer have to consider a worst-case scenario of a divorce from the European Union by its third-largest economy.
AN EVALUATION OF VALUATION
There is no getting around the issue of politics when it comes to considering this market, yet it isn’t just about politics.
What happens on the political front will either inflame valuation concerns or pour some cold water on them. The market sports a premium valuation, partly because interest rates are low and partly because expectations for pro-growth reform — and the stronger economic and earnings growth it is expected to produce — are so high.
At its current level, the S&P 500 trades at 19.6x trailing twelve-month earnings and 17.7x forward twelve month earnings. That’s a healthy premium to the 10-yr historical averages of 15.3x and 13.9x, respectively.
The good news is that earnings are growing again and they are doing so without any support from fiscal stimulus.
Per FactSet, calendar 2017 earnings growth is expected to be 9.8% with revenue growth projected to be 5.3%. That is down from 11.4% and 5.9% projected on December 31.
It is not unusual to see earnings growth estimates come down, yet it is atypical to see the market go up as sharply as this one has with earnings growth estimates coming down. That speaks both to the underlying price momentum in the market and the expectation that earnings growth will ultimately be stronger on the back of fiscal stimulus measures that could include corporate tax cuts and/or a tax repatriation holiday.
Accordingly, it will be increasingly important for incoming economic and earnings data to corroborate the robust growth expectations embedded in current multiples. Failure to get the promised reforms passed in Washington in the manner the market has been expecting should prompt some multiple compression.
Yet, even if the reforms are passed, we are reticent to think it will be a moon shot for the market since so much good news on the earnings front has been priced in already and interest rates would presumably be headed higher.
Thus far, interest rates haven’t played the role of spoiler for the bull market.
Long-term rates have had some moments of weakness, yet there have been some offsetting periods of strength too. The result is that the yield on the 10-yr note (2.50%) is roughly the same as where it began the year.
Interest rate differential trades have provided a measure of support as US Treasury yields have had some relative appeal for foreign buyers faced with ultra-low yields at home (if not negative yields) and weaker currencies.
At the same time, Treasuries have continued to benefit from a safety trade as worries that the stock market has gotten ahead of itself have fostered new inflows.
Another interesting twist on matters is that the Fed has raised the target range for the fed funds rate twice since December 14 for a total of 50 basis points. The yield on the 2-yr note is up 13 basis points since the close on December 13 while the yield on the 10-yr note is only up three basis points.
The backdrop of a flattening yield curve is peculiar to say the least when pitted against the narrative that the stock market is being driven by visions of much stronger economic growth and knowing that banks have helped lead the rally on the notion that their earnings prospects will improve with an expansion in their net interest margins.
The behavior of the Treasury market will need to be watched closely. It looks out of sync now with the growth narrative. At the same time, if there is a spike in long-term rates, it will pique added concerns about stretched valuations.
Right now, the Treasury market isn’t acting up enough to spark a correction in the stock market and the Fed isn’t banging its tightening drum loud enough yet to spark one either.
In terms of the Fed, it is sounding more upbeat about the economic outlook, yet it is still forecasting a gradual path toward normalization. The stock market so far continues to buy what the Fed is selling based on the view the economy is getting stronger to warrant — and to handle — a higher fed funds rate.
Incoming economic data will eventually indicate if that is in fact the case.
THE BOTTOM LINE
The high P/E multiple for the market reflects high expectations, yet it also reflects the growing risk with riskier assets like stocks if something bad was to happen.
Sector valuations are stretched across the board.
Every sector, with the exception of the telecom services sector, is trading at a premium to its 5-yr and 10-yr historical P/E averages according to FactSet. That doesn’t mean these sectors are destined to go down big in the near term, but they could if the mood of the market changes for any number of reasons. It also suggests long-term return prospects will be constrained.
For all intents and purposes, the stock market has remained in a blissful state. It has ignored most of the hemming and hawing about President Trump’s leadership style and has remained focused on his leading, pro-growth ideas.
Having done so, the market has risen to new record heights, suggesting its marriage with the Trump Administration has gotten off to a good start.
Most marriages do. It is when times get tough and outside influences start affecting the close-knit dynamic of newlyweds that the true mettle of a marital union shows itself — or not.
To be sure, times won’t always seem this good for the stock market, which has risen 10% since election night and hasn’t experienced a daily decline of 1.0%, or more, since early October — the longest such streak since 1995.
Hopes are high, which goes with the “I dos,” and volatility is low, which is often the case at the start of a new marriage. Everyone pulls for the marital union to last when the vows are exchanged, but unfortunately, there isn’t always a happily-ever-after ending.
If the Trump Administration’s pro-growth reform vows don’t get kept, there might not be one for the stock market either.
In any case, stretched valuations today suggest it is prudent for investors to have a good understanding of their risk tolerance and the timing of cash needs if they are looking at their equity holdings as a source of funds. The post-election honeymoon phase is ending, which means the potential for marital discord and downside risk is rising.
As always, I look forward to catching up with you soon, and I look forward to entertaining your questions.
John P. Swift, CFA, CPA
Chief Investment Officer & Managing Partner