The stock market continues to climb the proverbial “Wall-Of-Worry” – with the Dow Jones Industrial Average (DOW) up 8% through June 30, 2017. Standard and Poor’s 500 corporate earnings grew by 10% in the March quarter with a solid 7% revenue gain. Consensus earnings growth of large companies for 2017 and 2018 are 10% and 12%, respectively. The earrings rebound is clearly pleasing investors after a period in 2015 when the S&P 500 experienced an “earnings recession” that lasted through mid-2016. Once earnings growth commenced in mid-2016, the stock market responded swiftly on the upside with only minor pull backs.
The stock market is trading at 17.5 times earnings, higher than the 15.9x P/E average during the past 25 years. Low bond yields and inflation and the prospect of tax and regulatory reform are giving investors optimism about future earnings growth and they are willing to pay a premium for this potential.
We observe optimism and complacency in the market, which can be the perfect recipe for a short-term correction when negative news develops. The stock market declines or “corrects” by 5-8% in a typical year. Therefore, we will not be surprised if the DOW pulls back by 1,000 to 1,500 points before the end of 2017. Possible catalysts: 1) an unforeseen geopolitical event; 2) a reduction of earnings estimates for 2018; and/or 3) the Federal Reserve Board increasing interest rates faster than is currently expected. We are cautiously optimistic about the stock market but are being realistic about the near-term outlook and normal stock market behavior.
Economically, the US is experiencing steady growth. Job growth remains intact although it has been trending a bit lower with monthly non-farm job growth of 200,000. The US Bureau of Labor Statistics announced that 222,000 non-farm jobs were added to the economy in June 2017, much higher than the 179,000 estimate. Small business and consumer confidence edged lower last month, but still remain high. In May 2017 consumer spending rose 0.1% and disposable income increased 0.5%, underscoring consumers’ caution while building future purchasing capacity.
Portfolio additions: Small cap stocks and long-short equity funds. Small company earnings are expected to grow by 20% in 2018, in contrast to 12% for large companies, and they are selling at a modest valuation premium to large caps. These small cap stocks started 2017 by underperforming large stocks, but recently have rebounded, exhibiting strong relative strength to the broad stock market. We are also discussing with clients the inclusion of two “long-short’ funds for their portfolios. These funds have approximately half the volatility, as measured by standard deviation, of the stock market, yet participate with much of the market’s upside.
Rich Lawrence, CFA
July 12, 2017