2017 Outlook
Did 2016 “Steal” 2017 Returns?
 
 

2017 Outlook

Did 2016 “Steal” 2017 Returns?

 

If there is one axiom of investing that fits the past two years we believe it’s follow the earnings trends. Relatively flat earnings meant the stock market barely budged for 18 months (between January 2015 and July 2016). Only as earnings projections finally started to move higher, did equity prices follow.

Although some pundits have ascribed the recent market rally to the Trump victory, what really changed was the upcoming earnings inflection—even before the election. Historically the fourth quarter is seasonally strong for equities, and 2016 was no different. S&P 500 earnings growth for the entire year 2016 was a paltry 0.6%, and yet the S&P 500 appreciated by 9.5%1, all of which came later in the year. During the fourth quarter of 2016, the market began to price in 2017 earnings that were projected to be 12.0%1 greater than 2016 earnings.

That's the good news. The bad news is the markets in 2016 have seemingly "stolen" some 2017 returns—the earnings inflection has largely been priced into the market. Now it gets tough, as we examine variables that could move the baseline:

  • Initial earnings estimates are usually too high . . .
    Over the last 30 years, only twice has the S&P 500 delivered an earnings number that was equal to or higher than initially expected2, implying that the 2017 earnings numbers are probably too high.
  • . . . but 2017 estimates may not include all good news  . . .
    The $132.87 estimated EPS for the S&P 500 in 2017, published pre-election, does not factor in any Trump fiscal policy reform. Hence corporate tax cuts, tax repatriation of cash holdings and infrastructure spending all could have a positive impact on S&P 500 earnings. Either way, the dollar and the Fed will likely serve to moderate the tails.
  • . . . and multiple expansion could drive prices higher
    While earnings growth is the key input to any forward projections, the multiple paid for those earnings is vital and may continue to move higher:

    First, we haven’t yet reached euphoria. When the market goes from undervalued, it typically ends at not just slightly overvalued (as it is today), but really overvalued. Moving from the optimistic to euphoric stage as investors chase out of bonds and into stocks would lead to further multiple expansion.

    Second, the quality of earnings could improve. Since this bull market commenced, it has consistently traded at a discount to its ‘fair value’, as measured by a multiple of current interest rates. I suspect that this gap will continue to close not just because rates move up, but because earnings growth driven by top-line growth deserves a higher multiple than earnings growth driven by anemic revenue growth plus margin improvement/stock buybacks. And top-line growth could occur in 2017.
 
Evaluating fair value: Mind the gap
 
 
 
 

Source: Bloomberg as of November 28, 2016, Morgan Stanley Wealth Management GIC; EPS is Earning-Per-Share.
Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Indices are unmanaged and not available for direct investment. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

 

 

So we expect the U.S. market to deliver a low single-digit year, unless fiscal policy reform drives earnings estimates higher or P/E multiples expand with an improvement in earnings quality.

From a tactical standpoint, we don't believe the value rally is over—trends don't generally stop at average; historically they overshoot. Many professional investors remain underweighted in value stocks (especially financials)3, and we suspect ultimately they will need to correct this before value outperformance ends.

Within developed markets outside the U.S., we are most optimistic on the recovery in Europe for the simple reason that expectations are even more depressed. Regardless of region, however, the conclusion for 2017 is that, as in past years, equity performance will be largely dependent upon the ability for companies to deliver earnings growth. 

 
Head of Applied Equity Advisors Team
 
 

1 Factset as of 12/31/2016. Estimates provided herein are subject to change and may not actually come to pass.

2 Price return not including dividends.

3 Barron’s, January 7, 2017

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