The first half of 2017 is complete and it has been a very good year so far for the stock market. The S&P 500 is up 8.7% while the Dow Jones Industrial Average is up 8.1% and the Nasdaq Composite is up 14.5%.
It has been a remarkable move considering the first half of the year has been dominated by political uncertainty, sluggish economic growth, and a more hawkish-minded Federal Reserve. To be fair, it has also been accented by strong earnings growth.
So, at this half-way point, the question is, what next?
No one can say for certain, yet there is some resonance to the expression, “quit while you’re ahead,” knowing that the stock market’s valuation is stretched and there is a coming clash of the titans.
TAKING STOCK OF BATTING AVERAGES
First quarter real GDP increased 1.2%. The Atlanta Fed’s GDPNow model forecast for real GDP growth in the second quarter currently stands at 3.2%. That averages to 2.2% for the first half of the year which is consistent with the average annualized real GDP growth rate for the last 20 years.
On the inflation front, the PCE Price Index is up 1.7% year-over-year and the core PCE Price Index, which excludes food and energy, is up 1.5% year-over-year. Both readings are just about average for the last 20 years.
The P/E multiple for the S&P 500 on a trailing twelve-month basis is 19.3.x. On a forward twelve-month basis, it is 17.7.x. That is well above the historical averages of 15.4x and 14.1x, respectively, for the last 10 years.
GDP growth is average and PCE Price inflation is about average, yet the S&P 500 P/E multiple is well above average. How can that be?
Well, many argue it’s because the benchmark 10-year Treasury note yield is well below average, which enhances the relative appeal of owning stocks over bonds.
Of course, with the 10-year Treasury note sitting well below its 20-year average, it’s pretty clear that bonds, despite their low rates, have held plenty of appeal themselves for a lot of holders.
It goes to show, however, that interest rate risk factors prominently for both markets, each of which has basked in the low growth-low inflation environment that has kept policy rate hikes and market volatility to a minimum.
A LESS FRIENDLY SHIFT BY THE FED
There is a shift that has taken place over the last six months or so. It’s not a tectonic shift — not yet anyway — but it’s a shift that has created some tremors and it involves the Federal Reserve.
The world’s most influential central bank has raised the target range for the fed funds rate three times in the last six months, it thinks another rate hike will be likely before the end of the year, it is projecting three more rate hikes in 2018, and it has revealed a plan to begin normalizing its balance sheet “relatively soon” if the economy evolves broadly as it anticipates.
In brief, the stock market-friendly Fed is getting a little less friendly by taking steps to remove its policy accommodation.
The stock market has taken the nascent shift in stride thus far, relishing the notion that the Fed’s tightening actions are reflective of an economy that has gotten stronger and is expected to get stronger.
The Fed’s hopeful outlook has been predicated on the tightening labor market; however, it has yet to be corroborated with stronger wage growth, robust spending activity, and accelerating inflation.
A LOSE-LOSE SITUATION
The Fed’s hopeful growth outlook hasn’t been validated yet by the Treasury market either, which has seen long-term rates drop in the face of the Fed’s rate hikes and the spread between the 2-yr note yield and the 10-yr note yield narrow to just 81 basis points from 130 basis points when the Fed raised the target range for the fed funds rate to 0.50% to 0.75% last December.
Today the target range for the fed funds rate is 1.00% to 1.25%.
Three rate hikes in the last six months, then, have been accompanied by a flattening yield curve that has been led by a drop in long-term rates. That move suggests one of two things: either the market thinks the Fed is about to make a policy mistake, choking off the recovery by removing too much accommodation too soon, or that it has a resolute belief in the low growth-low inflation environment persisting for some time yet.
Notably, neither case supports the Fed’s view of economic matters and that is setting up a potential clash between the markets and the Fed.
If the Fed has it right, long-term rates would have to adjust accordingly, which would create some pressure on premium equity valuations. If the Treasury market has it right, then there would be pressure on the high earnings growth expectations embedded in the premium market valuations.
It’s a bit of a lose-lose situation, then, for the stock market, which would admittedly hold up better under the latter scenario than the former because the latter would presumably assure the persistence of low interest rates.
The other factor in the mix is politics.
In the first six months of the year, there has been a clashing between parties, within parties, and with both friends and foes of the U.S. government.
There is currently an investigation under way into Russia’s interference with the U.S. election, and, as The Washington Post recently alleged, into the matter of whether President Trump obstructed justice, which is an impeachable offense.
What there hasn’t been is any signed legislation for health care reform, infrastructure spending, or tax reform. All of that remains locked up in the Washington compound of all talk and no action.
Market participants have been told by the administration that the reforms are going to happen. The timing remains in question, yet the administration’s intentions do not.
The problem is that it takes three — the House, the Senate, and the president — to tango on legislative matters and all three parties seem to have two left feet now, which is raising reasonable doubts as to whether these reforms, and particularly tax reform, get done before the end of the year — if at all by the midterm elections.
Those doubts have slowed the stock market’s post-election rally, but they have not derailed the stock market, which has posted a series of new record highs in the last six months.
The strong earnings and sales growth seen in the first quarter provided the most welcome fundamental distraction as it communicated an encouraging message that economic activity, while not great, is still holding up fine without any benefit from fiscal stimulus.
It offered the added reminder, too, that earnings growth potential could be even greater if tax reform, which includes a lowering of the corporate tax rate and a favorable cash repatriation tax rate, comes to pass.
MORE IN THE POLITICAL MIX
There is more to the political variable right now than just the administration’s pro-growth agenda. There is the unresolved matter of raising the debt ceiling; and the geopolitical climate is unsettling.
North Korea has been the most unsettling force of late, yet the Middle East is simmering with a diplomatic rift between Qatar and several neighboring nations, including Saudi Arabia over the TV network Al Jezeera that continues to be friendly to its host nation, Qatar, while casting a jaundiced eye towards its neighbors. Venezuela is imploding, and there has been recent terrorist action by ISIS in England.
We offer a very brief synopsis of matters here simply to highlight the point that it’s an interconnected world. What happens outside our political borders can impact the behavior of the capital markets just as easily as what happens — or doesn’t happen — within our political borders.
WHAT IT ALL MEANS
The stock market has continually defied calls for a correction and it has continued to create a fear of missing out on further gains by establishing new highs in the wake of a body of headlines in the first six months that have been more negative than positive.
The stabilizing force has been the strong earnings growth and the persistence of low interest rates.
It stands to reason, then, that the destabilizing force would be disappointing earnings growth and/or rising interest rates that lessen the relative appeal of owning equities.
The government and the Federal Reserve are going to have an increased say in how those factors play out in the back half of the year, which we anticipate is going to be more volatile than the first half of the year primarily because those forces will be defining the trading/investing issues for the market.
According to FactSet, the average price return for the S&P 500 since 1929 is 7.13%. The S&P 500, therefore, has done better than average through the first half of the year when volatility was low, which is more reason perhaps for participants with a shorter-term outlook to quit while they are ahead.
The near-term risk is elevated and the fallout could be pronounced if the market has a clash with the twin titans, the Federal Reserve and Washington DC.
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