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:
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.