The Stock Market Continues to Climb Higher Amid the Risk of Tax Reform
The U.S. stock market continued its climb higher last week, piercing the 25,000 level and then some for the Dow Jones Industrial Average and 7,000 for the Nasdaq Composite Index. While the focus was on those moves, the S&P 500 held its own as well as it and even the small cap laden Russel 2000 marched higher.
Now for some perspective – the S&P 500 is on its longest running rally since World War II. The index hasn’t seen a monthly close lower in more than a year and since March 2009 the S&P has more than quadrupled. And while we tend to focus on the S&P 500 — as it is a far better barometer of the overall market in our view — the Dow too has soared, climbing more than 280% since March 2009.
Several experts, including our own Chief Macro Strategist Lenore Hawkins, have pointed out the economy is not as focused as people are when it comes to the turning of the calendar from 2017 to 2018. Last week, we received several pieces of economic data that show things are on solid footing – not on fire to be clear. For instance, the December ISM Manufacturing Index and November Construction Spending data show the economy continues to hum along despite weaker than expected December auto sales and job creation figures. Outside the U.S., data on the economies in the Eurozone, Japan and China pointed to a strong end to 2017.
That leads us to the following question – with the market trading at nearly 21x expected trailing earnings, and as we discussed on last week’s Cocktail Investing podcast, odds are more tax reform led increases coming for EPS expectations, what’s next? We shared some of our concerns in last week’s Monday Morning Kickoff and discussed them on last week’s podcast, but in short, they center around the risk that tax reform expectations could fall short when it comes to the impact on the economy at a time when the market’s valuation is increasingly stretched and volatility has left the building. Much to ponder.
Here’s what we’ll be watching next week to see if those concerns are increasingly warranted.
On the Economic Front
Following last week’s usual start of the month economic data – ISM Manufacturing & Services, several jobs reports, auto and truck sales data, factory orders and construction spending – this week brings several key pieces of data that we’ll be assessing. First is the November Consumer Credit report we’ll be looking to see if the sharp climb in total outstanding consumer credit continued its climb after hitting $20.5 billion in October, the largest increase since November 2016. A portion of that increase could be tied to post-hurricane spending and rebuilding, but given MagnifyMoney’s annual post-holiday survey that found most Americans put an average of $1,054 of debt — about 5% more than last year — on high-interest credit cards, we’re becoming increasingly concerned over not only consumer debt levels, but the corresponding debt servicing as well. More disposable income going to debt payments that could rise as the Fed raises interest rates further takes away from consumer spending, a key ingredient for the domestic economy.
Given those survey findings as well as commentary from Tematica Investing Select List holdings Amazon (AMZN) and United Parcel Service (UPS) as well as outsized December same-store sales results from Select List holding Costco Wholesale (COST), this week’s December Retail Sales report should be a barn burner. Like always, the devil will be in the details and with Macy’s (M) reminding us that it is tracking to close another 19 locations on top of the 100 it announced last August, a good Retail Sales report doesn’t wipe away all the woes facing brick & mortar retail. We continue to see retail disruption being had as part of our Connected Society investing theme.
The third piece of economic information, we’ll be watching here at Team Tematica is the inflation data. Stripping out the recent move higher in oil prices, there has been thought to “the fate of currently low inflation” as the Fed put it in its December meeting minutes. As we look at the coming inflation data this week and in the coming months, we’ll be looking to see if it supports the Fed’s stated goal of boosting interest rates three times in 2018… or not.
And while it tends not to receive as much as attention as other economic reports, given our concern over the growing mismatch between employer needs and available worker skill sets, and what it could mean in terms of businesses investing their incremental tax reform cash-flow we will be closely scrutinizing the November JOLTs data. Aside from the record amounts of cash sitting on corporate balance sheets, it’s hard to fathom businesses investing additional cash to be had thanks to lower tax rates if they can’t hire employees with the needed skills. While this fuels our Tooling & Re-Tooling investment theme, it stands as a headwind for the economy and the ability to boost GDP expectations. We expect to hear much more about this in the upcoming earnings season.
On the Earnings Front
This week we have a handful of earnings reports on deck and no investment conferences. In terms of the company’s that will be reporting, we have WD-40 (WDFC), homebuilders Lennar (LEN) and KB Home (KBH) as well as realtor Re/Max (RMAX) and Delta Air Lines (DAL). Among those reports, we’ll be looking to determine if housing prices can continue to climb and if so, does that mean they will soon be part of our Affordable Luxury investing theme? With Delta’s results, our focus will be on international travel and what it means for our Rise and Fall of the Middle Class investing theme.
Toward the end of the week, we get the usual financial sector earnings barrage with reports from Blackrock (BLK), JPMorgan Chase (JPM), PNC (PNC) and Wells Fargo (WFC). These results should clue us into the tone of coming business investment activity as we parse through loan activity. Of course, given our concern over consumer debt levels mentioned earlier, we’ll be watching consumer related charge-offs and delinquency data as well.
As these reports trickle in, we’re going to get a greater sense as to the potential impact tax reform will have on 2018 EPS expectations. As that solidifies, we expect to see further upward revisions in S&P 500 earnings expectations for 2018 and subsequent price target increases. So far, most of those increases have relied on EPS growth, not multiple expansion and as these revisions roll in, we’ll be looking for any divergence from that.
Amid the short list of earnings reports, we have the 2018 CES tradeshow, which runs from Jan 9 – 12 and odds are will once again be a big focus for investors. Based on the pre-show buildup we expect to hear quite a bit across our Connected Society and Disruptive Technologies investing themes. From 5G to haptic virtual reality to more smart home devices and autonomous vehicle news, it’s apt to be a busy week and that doesn’t even touch on the super-sized TVs as well as organic light emitting diodes (OLED) ones we expect to hear much more about. We’ll be talking much more about this on this week’s podcast and sharing how to thematically position one’s portfolio in Tematica Investing.
Do Valuations Matter?
Written by: David Lebovitz
The S&P 500 has had an impressive start to the year, rising over 4% year-to-date with only three days of negative performance.
However, as the equity market has moved higher, investors have become increasingly concerned about valuation. While it is difficult to ignore the fact that the S&P 500 forward P/E ratio currently sits at 18.5x, well above its 25-year average of 16.0x, we believe elevated valuations may be justified for three reasons. First, 2018 earnings growth is expected to come in around 15%, suggesting investors will be compensated for paying a higher price, and second, inflation and interest rates are both below their long-term averages. In an environment of low rates, low inflation, and healthy earnings, perhaps it is appropriate for stock market valuations to be above average?
Finally, valuation is not a great predictor of short-term returns. As we show on page 6 of the Guide to the Markets, valuation tells you very little about what will happen over the next year, but a decent amount about what to expect over the next five years. For those who are still skeptical about equities given current valuations, it is important to remember that bull markets tend to go out with a bang, rising by an average of 26% during their final 12 months. This makes sitting on the sidelines expensive, particularly in a world of low interest rates.
So are valuations concerning? They have our attention, but we remain cautiously optimistic that equities can continue to push higher. However, late cycle markets require a more nuanced approach to investing, meaning active management will be essential. As such, we continue to see opportunity in the more value-oriented sectors of the market, with energy and financials being two of our favorite ideas.
Low inflation and yields can support higher multiples
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