Chief U.S. Equity Strategist Adam Parker looks at what’s changed in the investing landscape and how investors might want to position for the year ahead.
Our view of the world has materially changed in the past couple of months.
For the previous several years, we had been optimistic about U.S. equities, based on our expectations for low earnings growth and some expansion in the price-to-earnings multiple, the premium investors are willing to pay to own a stock. Conversely, we are now forecasting material S&P 500 earnings growth and projecting earnings per share will be 18% higher in 2018 than in 2016.
One way to view stock investing is the process of buying a little dream today in the hope of selling it to someone with a bigger dream later.
However, we believe multiples will contract modestly, and that a key investment controversy for 2017 will be: At what point does multiple-contraction start to offset the dreams and reality of higher earnings growth? Why multiple contraction? Simply put: With more uncertainty and more monetary tightening, we are no longer comfortable forecasting multiple expansion.
We can't help but think that the Republican sweep in November has created a more uncertain and volatile outlook for the U.S. economy and corporate earnings growth. Moreover, it seems likely that the distribution of outcomes from the Federal Reserve over the next two years is skewed toward more hawkishness than had been the case only a few short months ago.
Many other potential risks abound. These include a slowdown in China’s economic growth, elections and political uncertainty in Europe, a materially stronger dollar, and a big change to the slope and level of U.S. interest rates (i.e., no "rate Goldilocks").
This doesn't leave us outright bearish on U.S. equities. In fact, our base case year-end 2017 price target for the S&P 500, the benchmark of the broader U.S. market, is 2300, a couple of percentage points above the starting point for the year, plus the 2% dividend yield. That reflects our belief that a lot of optimism is already baked into our outlook and current market prices.
There are so many ways to gauge sentiment. We meet with investors, survey and poll them; we analyze hedge-fund exposure, ETF flows, futures positioning; we assess recent derivative trades, and research click data, among many other sources. In aggregate, the confluence of these metrics is pretty mixed right now. Certainly, sentiment is no longer negative enough to make a contrarian call—as it was in early February, 2016, for example.
In the end, one way to view stock investing is the process of buying a little dream today in the hope of selling it to someone with a bigger dream later. When we say that we are getting less optimistic, all we are really saying is that today's dreams are no longer that little. Investors are including materially lower tax rates in the base cases of their earnings outlooks. Economists are projecting higher growth and rates. The President-elect is tweeting victory laps about the market appreciation.
Yet, we struggle to see how corporate earnings and the management teams we are assessing could be as proactively enthused. How should chief financial officers think about what will happen to interest expense deductions? Will there be accelerated depreciation, or R&D credits? How should they think about capital use? What increasingly optimistic news are we going to start embedding in our earnings outlooks post-inauguration that hasn't already been contemplated?
A number of stocks are up a lot, for which we don't expect much incrementally positive news for at least the next couple of earnings seasons. So, to us, it is when, not if we should fade this recent reflation trade.
It is easy for someone to say that they are increasingly worried about the bigger picture but think things could remain okay for a while. Some believe that investors should just sell the inauguration. After all, what incrementally positive and exciting outcomes could be produced in the first few weeks after that?
We are getting more cautious and are trying to be prudent, given the market’s material appreciation. What are we monitoring? This is by no means an exhaustive list, but our signposts include: any signs of gridlock in Washington on taxes or regulatory reform; changes to the slope and level of the yield curve; Treasury vs. German and Japanese government bond gaps; tighter financial conditions globally and in the U.S.; material changes to the commodity complex and that component of the reflation thesis; and news about U.S. wage inflation as corporates report their earnings, among other items.
For now, we are upgrading Energy from market-weight to overweight and downgrading Industrials from overweight to market-weight. We are upgrading Technology from underweight to market-weight, and reiterating and further reinforcing our underweight in Consumer Discretionary.