Coming out of the great recession, growth stocks outperformed because growth was scarce. Now, attractive valuations are scarce and money seems to be flowing to sectors that do not appear to be so overvalued.
All in all, the first quarter of 2017 was a positive one for equities, and a relatively calm one at that, especially when compared to the dramatic selloff experienced in the first quarter of 2016. As measured by the average daily change, the S&P 500 Index had its quietest quarter since the third quarter of 1967 and the CBOE Volatility Index posted its second lowest quarterly average ever, according to the Wall Street Journal Data Group.
Stock markets continued to move in a very pronounced fashion from an environment where a rising tide lifts all boats to one emphasizing individual stocks and sectors. This changing dynamic was evident last quarter in the rotation that occurred after the presidential election when funds flowed out of bonds and into equities, resulting in wide return dispersion. In the first quarter, the rotation evolved further with money flowing from domestic stocks into international and emerging market stocks as investors sought less expensive areas in which to deploy their investment dollars.
Emerging market currencies underwent a fairly precipitous drop beginning in 2011 before finally reaching a bottom in early 2016, concurrent with the bottoming in oil prices. Oil prices and emerging market currencies have rebounded since then, contributing to the surge in emerging market stock performance. China, which makes up 25% of the emerging markets index, is expected to see further declines in GDP as it transitions to a consumer-oriented economy, but GDP growth at 6% is still enviable by many standards. Chinese stocks, as measured by the Shanghai Stock Exchange (SHCOMP), returned 3.85% in the first quarter.
Foreign developed market equity performance was driven largely by improving economic data which made valuations look more compelling. The Eurozone’s recovery appears to be modestly gaining steam as exports improve and the housing market recovers. The value of the U.S. dollar versus foreign currencies has fallen lately, contributing nicely to the returns earned by U.S investors in foreign equities. The greenback was down 3.00% in the first quarter and flat in 2016 after being up approximately 20% in 2015.
In the domestic market, U.S. large-cap equities led both mid and small-cap equities in the first quarter. Although their returns were still positive, small- cap stocks lagged considerably. Given their double-digit returns in 2016, the argument could be made that small caps got ahead of themselves, and their relative underperformance in the first quarter was a cool down from getting overheated in 2016.
While domestic equities look expensive across the board right now, small caps are perhaps the most expensive. At 127% of their 15-year average, small-cap growth stock P/E ratios are quite high versus historical norms. Likewise, large-cap value stocks are trading at 123% of their 15-year average P/E, even though the historical average P/E itself is only around 16.205. Although still elevated, the cheapest area is in mid-cap growth stocks which are trading at a P/E of 20.5 relative to their 15-year average of 18.2 or 112%.
The expectation is that 1Q earnings will be higher than they have been in some time. That is good news given that the market is somewhat expensive. (The earnings data for the first quarter will not be available until after the publication of this document.) Analysts expect earnings for S&P 500 companies to grow by 9.1% in the first quarter from a year earlier, the fastest pace since the fourth quarter of 2011. Analysts acknowledge the somewhat easier comparisons relative to the same earnings period a year ago, but still the news is encouraging. Indeed, should earnings come in better than expected, it will be for the third quarter in a row, indicating that the earnings recession may be behind us. However, although earnings appear to be in a sweet spot, it is unlikely to be sweet enough to completely justify current P/E levels.
When companies release their earnings expectations for the upcoming quarter, they often get revised lower by analysts as the quarter progresses. Initial first quarter 2017 estimates were only revised down by 3.6% during the quarter, well below the average downward revision of 4.50 to 5.00%. This implies that there is more confidence in earnings going forward, and is a strong indicator of growth in the marketplace. Although earnings have indeed improved, that improvement has sometimes been a function of cost savings. Investors may soon begin to pay less attention to bottom line earnings while focusing more on top line growth to get a better sense of a company’s prospects.
Coming out of the recession in June of 2009, growth stocks outperformed because growth was understandably scarce. Today, following eight years of a bull market in U.S. stocks (one of the longest in history), it is attractive valuations that are scarce, and, as a result, money is rotating toward companies that do not appear to be so overvalued. When attractive valuations are scarce, results become magnified, as seen this quarter in domestic sectors. Compared to their 20-year average forward P/E ratio, there are only three sectors that are currently trading under their historical norm – technology, telecommunications, and healthcare. Other sectors are trading at a fairly significant premium. The performance disparity between the best- and worst-performing sectors was more than 2000 basis points this quarter. Information technology, healthcare, and consumer discretionary were the strongest performers, gaining 12.57%, 8.37%, and 8.45% respectively. In comparison, the energy sector, which trades at 20.7 times forward earnings versus its 17.3 historical average, was one of the worst performing sectors, with a return of -6.68%, nearly 2000 basis points below technology.
The equity market tailwinds of expected fiscal stimulus, tax cuts, and deregulation persist, but they have diminished as investors begin to realize the difficulty of getting such measures through the legislative process.
Organic growth has improved worldwide and its breadth is supportive of earnings. Going forward, the question becomes how to determine how much of the equity market surge since the election has been a function of the Trump effect (i.e., expectations of lower taxes, fiscal spending, and deregulation) and how much has been a function of organic growth as evidenced by improving coincident indicators reflecting the true state of the economy. While encouraged from an economic growth perspective, it now appears that tax reform, fiscal stimulus, and deregulation may be delayed. And, although the S&P 500 posted its largest quarterly gain since the end of 2015, indicating that improving economics “trumped” the disappointment surrounding the Trump Agenda, the anticipated delay is still a cloud on the horizon and a bit of a damper on financial markets.
Improving global economic conditions are anticipated to continue. The U.S. economy has been trudging along and now the hope is that growth will finally become self-sustaining and provide the equity market with renewed confidence that current valuations are justified. Top line revenue growth should begin to reflect the improving fundamentals, and companies across the board will benefit.
The issue then becomes somewhat more granular in terms of how wage growth and inflation will increase costs and impact revenues. Investors are hopeful that administrative and policy factors, such as tax cuts and deregulation, will effectively negate those concerns. Regardless, investors need to see earnings, economic data, and political initiatives continue to improve in order to reduce the perception that the equity market is expensive.
Our outlook for equity returns is that while the economic environment is more sustainable, we would be surprised to see a repeat of the double-digit returns of 2016, although equities remain a more attractive choice than fixed income. Indeed, the lack of attractive options may be the biggest argument for the sustainability of the current stock market rally.
Although equities are expensive, they are still relatively cheap compared to bonds. When bond yields are compared to the stock market’s “earnings yield,” which measures earnings as a percentage of share price, earnings yields are still higher. Barring some sort of economic or political shock, bond yields must go higher before money is compelled to leave the equity market in favor of the bond market. Certainly, should the yield on the 10-year Treasury rise to 3.50% or 4.00%, then bonds become a reasonable substitute for equities, and some money can be expected to flow from the equity market to the bond market.
Headwinds include the outcome of critical elections in France, Italy, and Germany. The Brexit vote and Trump victory have fueled anti-establishment sentiment that could see several key elections won by right-wing populist parties. Victories for these parties could possibly negatively impact the stability of the European Union and the common currency, the euro.
The proposed tax cuts, deregulation, and fiscal stimulus are tailwinds for economic growth, if they come to fruition. While the Trump agenda tailwinds are still blowing, they are not blowing as hard as they once were. Certainly, if corporate tax reform is successful, the benefit would go straight to the bottom line, particularly for small companies. The impact of increased infrastructure spending depends on how it is executed, and when. The current proposal hints at spending of $100 billion per year, mostly in partnerships with the private sector, so it is difficult to predict how large the impact on GDP might be.
But a certain degree of reality does appear to have set in. The inability of the governing party to pass the legislation to repeal and replace the Affordable Health Care Act calls into question the ability to pass tax reform or an infrastructure package. The S&P 500 pulled back 3.00% in just three days following the failure of the House to repeal Obamacare. Congress still faces the upcoming deficit battle. If the positive political initiatives that have been largely discounted by the stock market begin to lose more steam, then politics suddenly change from a tailwind to a headwind and more pressure will be on true growth to pick up the slack.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).