Equity Outlook

Corporate Earnings Projected to Rise on Tax Cuts

Equity Valuations

Companies in the S&P 500 Index are expected to deliver 10% earnings growth on average year-over-year for 2017. Consumer staples, technology and industrials are all likely to post growth over 19%. However, despite this run, the market rally continues to outpace earnings growth, leaving the market seemingly expensive.

U.S. equities are now trading above their five-, 10- and even 20-year averages, with the forward price-to-earnings ratio of 18.2x outpacing the 20-year average of 16x. That means that even considering long timeframes, investors are challenged to find opportunities at reasonable prices. Although, we suggest that underlying the headline numbers, there are still opportunities to be had - if you know where to look. When analyzing broad indices, like the S&P 500, we note that a few of the largest weighted names are all trading at high valuations, likely skewing the casual observer’s inferences.

There are certain pockets of the market where valuations seem slightly more attractive, including the technology, healthcare and telecom sectors. All three sectors have Price-to-Earnings (P/E) ratios trading below their 20-year averages with technology at 18.6x (vs. 20.9x), healthcare at 16.6x (vs. 17.5x) and telecom at 13.3x (vs. 16.5x) according to Bloomberg.

In traditional value sectors, such as energy, where investors would expect to find more attractive pricing, market returns and earnings results have significantly differed. Earnings have been strong; expectations are for growth of near 137% year-over-year for 2017 - coming off lows in 2016. However, energy stocks’ returns declined 1% for the year. The story for technology companies, which are typically growth oriented, is somewhat different. Tech companies are expected to achieve 16% earnings growth for 2017, compared with a 38% jump in stock returns over the prior year.

These discrepancies reflect factors specific to each industry. The rebound in energy stocks has occurred off the bottom, following zero growth and even negative earnings growth among some companies in 2016. In contrast, technology stocks have performed fairly well for an extended period, but have seen more substantive growth over the last 12 to 24 months. 

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PE Ratios and Earnings Share

Most tech companies are generating strong earnings based on demand growth for their products and services. According to Factset, the technology sub-industry of semiconductors & semiconductor equipment is expected to grow earnings 37% for the year. That’s a key difference compared with the dotcom bubble in 1999-2000, when tech valuations blew through the roof more on hope and promises than actual earnings prospects. Tangible earnings are much better this time around.

For over three years, the S&P 500 forward P/E ratio has traded in a range around 18x. However, long-term averages are closer to the 15x-16x range. If we expect normalization, one would either expect a decrease in the numerator (P) or an increase in the denominator (E). In practice, this means a price correction or continued above average earnings growth. A material decrease in the earnings growth rate might be the long anticipated catalyst, at least temporarily, that stifles the raging bulls.

Interest Rate Impact on Equities

Even though inflation remains in check, most analysts and the Fed project three interest rate hikes for 2018. We see this, not as the Fed tapping on the brakes, but continued policy normalization. As long as we see continued economic growth and inflation at current levels or higher, the current path of interest rate increases should continue. Therefore, investors need to reckon with how rising interest rates could impact stock performance.

Higher interest rates will begin to compress multiples in the long run, and put pressure on high-debt companies over a more immediate timeframe. A company’s worth, at its essence, is the present value of its future cash flows discounted, net of debt. As the discount rate increases, the present value of those future cash flows decline, decreasing the value of the investment. To offset this negative impact, companies need to grow at a quicker clip. That means earnings growth would have to remain strong enough to negate multiple compression. Equities have benefitted from interest rates hovering near zero for a decade, leaving little alternatives for investors seeking higher returns. If valuations remain high or increase, at some point higher yields may make bonds more attractive relative to equities. With the 10-year remaining in a tight range, that time has yet to appear. An increase in expected inflation or a dip in demand from foreign buyers could work to hasten the move. However, until then stocks remain attractive on a relative basis.

The risk that rising interest rates pose to high-debt companies is also real. Nonfinancial corporate debt as a percentage of GDP had climbed to 45.3% ($731B) by the end of 2017, a return to the peak levels of 2009 - the height of the financial crisis. This could be particularly problematic for stocks should we see a decline in economic conditions. We continue to advocate for a quality bias in stock selection. This is particularly important for yield-seekers who may have inadvertently increased exposure to high-debt companies, which may also pay high dividends.

In this vein, JPMorgan recently published research indicating that 10-year Treasury yields below 5%, even in a rising interest rate environment, have historically correlated to rising stock prices. Trying to anticipate the changing environment, and high corporate debt levels, suggest it would be wise to start taking a more defensive position on equities long before yields on 10-year Treasuries reach 5%. 

PE Ratios and Earnings Share

Value vs. Growth

Bias Sluggish economic growth, which has averaged 2.2% in the current expansion, has set the conditions for growth stocks to outperform value since the market bottom in March of 2009. In an environment with scarcity of growth, investors have paid a premium for above average results. Famously, over long periods, the opposite is expected. Research consistently shows value outperforming growth.

This leads to the question, “If economic conditions are expected to accelerate, will value return to its rightful place?” Expectations are for the economy to reach growth rates in 2018 not yet seen during this expansion. This in turn would favor industrial, energy, financial and consumer staples stocks. We caution on projecting historical results on future performance. Again, today the growth oriented technology sector is driving consumer spending. Meanwhile, banks stand to benefit from deregulation and a rising interest rate environment – traditionally, a value play. It is a safe bet to stay focused on investing in good companies first and foremost.

While economic improvement is a key component when thinking about corporate results, there are always areas of concern. The declining productivity of debt to GDP is a wellknown phenomenon. As national debt levels grow, a larger portion of each added dollar of debt goes to service existing debt. This is true for corporations as well. However, even with the uptick in debt, growth companies have managed to grow cash reserves and maintain strong interest coverage ratios. Again, circumstances may be decidedly different this time and that may not bode well for the value bull in the short run.

The globalized economy and various other factors now driving growth have rendered the world decidedly different than in 1999 and even 2007. While the U.S. appears further along in the cycle, Europe, China and the rest of Asia appear to just now be hitting their stride. This international growth is likely to help extend out our cycle timeline. U.S. multinational companies will benefit from this reinvigorated foreign growth. That suggests that choosing between value and growth is not necessarily the right point of view. Investors should instead be focusing on good-quality companies with relatively low debt levels which are positioned to continue to benefit from diverse growth opportunities.

Volatility Risks for Stocks

Market volatility ended the year near all-time lows. The CBOE Volatility Index (VIX), known as the stock market’s fear index, registered nine of its 10 lowest readings since 1990 – the inception of the index. The MSCI ACWI Index also marked its longest period without a 5% correction since the index began in 1987. A contrarian might look at these data points and expect a regression to the mean.

Has the stock market become so high-strung that all economic news will have investors on pins and needles?

Volatility is driven by many factors beyond world events and headlines. Corporate structure also plays a big part. If corporate cash positions remain strong and debt levels are reduced due to tax cuts and economic growth, volatility may remain muted. Cash serves as a consistent source of value in a company and even dry powder. Leadership can choose to deploy this capital in a number of ways to stabilize the price of stock or take advantage of distressed opportunities should market conditions deteriorate.

With cash on hand, companies need to either invest in their own operations or return the money to their investors. As long as companies see their valuations at elevated levels, stock buybacks should not increase. Without prospects for organic growth, companies may choose to return value to investors through dividends.

“The Pullback is Imminent”

At times this seems like the most hated bull market on record. There is no shortage of pundits expressing their opinion that a correction is “due.” However, while the bears continue to pound the table for reversion to the mean, the market has not so quietly run up nearly 300% since March of 2009. Certainly, there are areas where valuations are stretched thin and Mr. Robert Shiller’s P/E is at its highest level in a decade. However, data suggests that there are still places to invest.

While the U.S. economy is entering its ninth year of expansion, economies in the rest of the world are much earlier in their cycle and may have room to grow. If this is the case, and we continue to run in a business friendly environment, many stocks may still offer opportunity. Well run companies with low debt levels and diverse operations should do well in such an environment.

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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

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International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

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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).