Originally posted at Briefing.com
2016 is coming to an end and it's doing so with a proverbial bang. It is remarkable really considering 2016 started with a proverbial bust. What lays ahead for certain is unknown to all, yet the capital markets sure do have some predilections about what might unfold in 2017.
Those predilections boil down to two words: stronger growth.
That outlook has been forged on the expectation that President-elect Trump and the Republican-controlled Congress will put their words into action and implement policies that lead to lower tax rates, reduced regulations, infrastructure spending, and a repeal and replacement of the Affordable Care Act.
In brief, there is a presumption that both consumers and businesses will have the capacity to spend more in 2017, driving faster rates of economic growth by way of a pickup in personal spending and business investment.
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The question before everyone today is, just how much of that expected growth has been pulled forward into stock market returns already?
The objective data says quite a bit, which is why our baseline—and fundamental—outlook for 2017 isn't wildly optimistic.
Still, we've been at this long enough to know that objective data oftentimes gets trampled on in a bull market by subjective viewpoints. That is precisely what happened in 2016, which is to say a big gain for the stock market in 2017 isn't improbable.
Valuation Stretched
In an effort to make our case on the influence of subjectivity in market returns, consider for a moment that S&P 500 earnings are expected to increase 0.1% for calendar year 2016, according to FactSet. Now consider that the S&P 500 is up 10.8%, before dividends, as of this writing.
If earnings ultimately drive stock prices, then it can be said the market in 2016 was riding in an autonomous vehicle.
The stock market got propped up by the "Fed put" earlier in the year, which is to say the persistence of low interest rates, and the Fed's abiding inclination to keep them low, underpinned buying efforts in the face of no earnings growth.
By the end of the year, though, the "Fed put" ceded its overwhelming influence to the "Trump put," which is to say visions of stronger economic growth driven by pro-growth policies overshadowed any negative news and unleashed some animal spirits in the stock market that haven't been seen for some time.
Briefly, all of the major indices rocketed to new record highs following the election on November 8, yet none went faster or further than the Russell 2000, which soared as much as 17% in a month's time.
The S&P 500, which is our proxy for "the market," jumped more than 6% in a month's time. Today it trades at 19x trailing twelve-month earnings and 17x forward twelve-month earnings. The former is a 23% premium to the 10-year average while the latter is a 20% premium to the 10-year average.
If one allows for the possibility of a cut in the corporate tax rate boosting earnings per share growth by 10%, the S&P 500 would be trading at 15.6x forward twelve-month earnings, which would still be an 11% premium to the 10-year average.
That consideration is why one can make the claim that a lot of good news has been pulled forward already in stock market returns and can objectively state that the market is trading with a stretched valuation.
The Shiller P/E ratio, or the CAPE ratio, which is based on average inflation-adjusted earnings from the previous 10 years, is trading at 28x earnings.
Not everyone subscribes to the validity of the CAPE ratio, yet the pertinent point making the rounds today is that the only two times it has been higher were in front of the stock market crash of 1929 and the dot-com bubble burst in 2000.
It would be remiss not to add that the CAPE ratio stood at 28.3 in January 1997 and went as high as 43.8 in January 2000, which is to say the bull market kept charging for roughly three more years until the dot-com bubble popped in a big way. The point being that a market can stay overbought for longer than one might think when animal spirits take over.
In any event, we feel compelled to make the same fundamental observation about P/E multiples today that we did at the end of 2015 when we said they suggest the market is fully valued at best and very overvalued at worst.
Spoilsports
The stock market is running into 2017 with a full head of steam. Buying efforts have been broad-based, sector leadership has been solid, and prices have been lifted by the rotation of money out of the safe-haven Treasury market.
Still, one can't help but think that there is a burgeoning element of complacency in the air that is raising the level of downside risk for the stock market in the near term since so many participants are now aligned with the thinking that the economic news flow—and all that embodies—will undoubtedly be made great again throughout 2017.
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Moreover, a growing number of participants are aligned with the thinking that the stock market is the place to be to capitalize on a stronger economy, which generates higher income growth and higher inflation rates.
Again, though, that outlook has been the basis for why the stock market is running at a full head of steam, so to carry on with the bullish bias in 2017, the reality of the legislative agenda and the incoming economic and earnings data are going to need to live up to the hype that has been embedded in stock prices.
The outstanding risk is that it doesn't base on some potential spoilers that could include, but are not limited to:
- The adverse impact of a stronger dollar, which could crimp earnings prospects for U.S. multinationals, lower sales prospects for exporters, weigh on commodity prices, and upset emerging market economies through capital flight and higher debt repayment burdens of dollar-denominated debt
- Disruptions in China related to its weakening currency and/or souring diplomatic relations with the U.S. that could manifest themselves in protectionist trade policies
- Heightened political and economic uncertainty in Europe emanating from Brexit negotiations, the migrant crisis, contentious elections in Germany and France, banking problems in Italy, and/or pushback on restructuring efforts in Greece
- A less cooperative Congress than expected (a lot of pro-growth hope is resting on the view that proposals will pass Congress easily)
- A spike in long-term rates stemming from a view that the Fed is behind the inflation growth curve and will be forced to raise the fed funds rate faster, and more than expected
We say every year that a list of risk factors can go on and on since it is easy to find things to worry about, so we purposely kept the list above short.
One of the biggest concerns we have right now, aside from the stretched valuation, is that the stock market isn't throwing off signs of being too worried about much of anything.
Some Deja Vu?
Might 2017 start, then, like 2016 did? It's possible if the dollar keeps running like it has been, so certainly something important to watch there.
Presumably, investors will be looking to take some capital gains that were deferred at the end of 2016 on the belief that investment income tax rates will be lowered in 2017. Such actions could lead to a squishy performance in January, yet the item on everyone's watch list should be the fourth quarter earnings reporting period and specifically the guidance that flows from it.
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According to FactSet, S&P 500 earnings are expected to increase 11.3% in the first quarter while revenue growth is expected to increase 8.1%. For calendar 2017, S&P 500 earnings are projected to increase 11.4% on revenue growth of 5.8% thanks in large part to the energy sector, which faces easier comparisons.
Will corporate America dial down earnings expectations due to a stronger dollar or will it instead emphasize optimism about strengthening economic activity and the implementation of pro-growth policies?
The answer to that question will be key, as will the happenings on Capitol Hill post-January 20 (Inauguration Day) when the stock market will be geared up to see if pro-growth words are busily being translated into legislative action.
What It All Means
The stock market at the end of 2016 hasn't been waiting to see much of anything. It has been banking on good things happening without knowing any specific details—or costs—of the policies that will presumably be enacted.
Accordingly, the prospect of a consolidation phase taking place in the early part of the year is high in our estimation as market participants stand back to see if the news flow validates the market's high valuation.
True to form, there will always be trading opportunities, yet the investment angles have been dulled by the post-election rally as just about every sector is trading at a premium to its 5-yr and 10-yr historical averages on a forward twelve-month basis, underscoring again that a lot of the expected improvement in 2017 has been priced in already. The only sectors that are not, based on FactSet data, are the health care and telecom services sectors, which aren't trading at much of a discount in their own right.
The objective data, therefore, suggest it may be prudent to trim positions in big winners and to wait to reallocate the sales proceeds at more attractive price points.
That could create some pain if animal spirits continue to ramp up in early 2017, yet investors have always been better served in the long run adhering to the rudiments of objective data rather than overpaying for the rally cry of subjective beliefs.
There is a lot of subjectivity in the stock market right now, which makes it necessary to take a step back to see if the objective facts as 2017 unfolds match the emotional hype that has brought 2016 to an end.
