While it’s always dangerous to make short-term calls, I suspect the U.S. market is due for a breather. I doubt the market will experience a substantial correction that would end the bull market; however, there are a few key reasons why it might be tough to make near-term advances.
The Fed recently raised rates for the third time since the financial crisis, and historically stocks tend to pull back modestly around the third rate hike.1 Meanwhile, the S&P 500 is up 5.29 percent year-to-date—that’s 25 percent on an annualized basis, having come down from a 38 percent annualized rate pre-rate hike2—and trades at an 18x forward P/E on 2017 EPS, up from 16.9x at the beginning of the year.3
In other words, the market has had a lot of movement in a short period of time, and appears to have priced in an earnings recovery. While S&P 500 earnings are projected to accelerate this year 10 to 11 percent from 2016, and the S&P 500 is up less than that, we need to remember that the market did quite a bit better in 2016 than last year’s earnings growth from 2015. Simply adding 2016 earnings growth to 2017, estimated earnings growth comes to 11.3 percent. But adding the S&P price returns in 2016 and YTD 2017 comes to 14.3 percent.4
Ultimately, I believe companies will raise earnings guidance. But we are at the end of the first quarter, a seasonally quiet period during which the media will tend to focus on macro events that could cause market jitters. Coming elections in Europe raise the possibility of volatility similar to what we had ahead of the U.S. elections,5 and with French GDP growing at a weak 1.1 percent in the fourth quarter, I wouldn’t rule out major upsets.
Despite this short-term pause, however, I am coming to the belief that this just might be a really big year for equities, driven among other reasons by investors’ preoccupation with politics over economic reality. I continue to be amazed by the number of supposed “experts” who proclaim the rally to be about Trump rather than earnings.
This is a year to focus on the micro rather than the macro, and when I listen to companies talk, I get a lot more bullish. I was struck by quotes just this past week from two very economically sensitive companies:
I simply do not buy the argument that this current bull cycle is getting long in the tooth. Yes, the average bull cycle lasts 8.9 years and we have just passed the eight-year mark, but there is a flaw in that reasoning. While the average cumulative S&P 500 total return in those previous bull markets is 490 percent,8 the index has only returned 311 percent since the low of March 2009.9 Bull markets run out of steam for two simple reasons: the P of the P/E gets too lofty (as in 2001) or the E gets decimated (as in 2008), not because of duration.
Historically, when the market in January and February starts as strong as it has this year, it suggests good things to come. Since 1945, there have been 27 years when the market was up in both January and February. In every one of those years, the market ended the year in positive territory. That implies, at worst, 5.3 percent downside from here.10 More importantly, in 25 of those 27 instances, the market gains continued and the year ended higher than the February close. The average return for those 25 years was 24 percent.11
Clearly, we need to be mindful of that old saying, “Don’t Fight the Fed.” As much as the comments from Reliance Steel and United Technologies are very optimistic, the market should start to fixate on the long-term impact of a tightening campaign from the Fed long before companies experience the dampening effect. We just think it’s far too early. And the consequences of sitting out this next leg up could be more impactful than what consensus seems to think.
There is also a case to be made for equity markets beyond the US. Central bank tightening in Europe is probably further on the distant horizon, and European economies are only starting to lift. This makes non-U.S. investing appear to be attractive. But with Europe consistently underperforming over the last four years,12 the uncertainty seems to argue for the benefits of a global strategy that includes exposure to the U.S. over one that doesn’t.