Greetings this New Year from our new office facilities in Westborough, MA. We hope you will find time to stop in if you are in the area!
Our office is clearly not the only new development since we sent out our October Outlook. The United States has a new President, and a new political party controls the Executive Branch for the first time in eight years. The same political party holds the Executive Branch and both houses of the legislature for the first time in six years. We have a new Fed Funds target range of 0.50% to 0.75% after the FOMC raised rates by 25 basis points on December 14, only the second interest rate hike in over 10 years. There is, it seems, a somewhat different mood permeating the US markets since the election in November. Optimism has swept the Dow, S&P and NASDAQ, lifting broad equity indexes to new highs, while this same optimism has hit the bond market rather hard. In our view, this mood change may be based on assumptions which could whither somewhat as actual policies begin to form and political realities unfold in the New Year. We’ll discuss all these topics further-on in this month’s Outlook.
After our Market Outlook, we continue our discussion of Behavioral Finance which we began in October. As promised, this month we will review a handful of specific behavioral biases.
The S&P 500 and Dow broad indexes were up double-digits in 2016, very different from the prior year’s flat 1.38% (a return which amounted to less than its dividend yield).
Please remember how the year began. On January 7, last year, Money.cnn.com posted: “Dow Has Worst Four-Day Start to a Year on Record”. Marketwatch.com’s January 15th headline read: “US Stocks Post Worst 10-Day Start to a Year in History”. On January 16, the Financial Times’ (ft.com) headline confirmed: “Wall Street Makes Worst-Ever Start to a Year”. The media narrative seemed to be that recession was all but certain.
In October, we cited the “unloved” nature of this bull market. Suddenly, we find the anchors of CNBC on “Dow 20,000 Watch”. As we write, this absurd vigilance has been going on for the better part of three weeks in the media, with often breathless updates every 15 minutes or so. The anticipation is palpable, but the stakes could not be lower. Reiterating a point that we’ve made in this publication a few times; the level of the Dow, the S&P or any other index is meaningless—yet so much attention is paid to it. Index levels (like “Dow 20,000”) are simply the product of the formulaic construction of the underlying constituents. Index levels speak nothing about whether stocks are “expensive” or “cheap”. About the only thing we can glean from “Dow 20,000” is that the bull market is still on.
For a more nuanced and descriptive look at what market levels may be inferring we must turn to relative price multiples.
This chart is the December 30 update of the September 30 P/E chart we printed in our last issue. Our comments then: “[stocks] while not particularly expensive, have not been cheap, we are definitely seeing pockets in the market that can now be described as historically expensive. We do not apply this view to the market as a whole. So-called “value stocks” which tend to share high-dividend/low P/E ratio valuation and lower volatility characteristics now appear quite richly valued. As the chart to the right depicts, some areas of the “value” style are trading 115%-116% of their historical averages.”
As you can see from the updated chart, large-cap value stocks have edged up since then to 117.5% of their historic multiple. But notably, small cap value stocks went from 107.1% on Sept. 30 to 136.9% of their multiple in just 12 weeks! This is a nearly 28% multiple expansion, and is explained primarily by the fact that the small cap value stock universe (as defined by Russell) is about 1/3 financial companies. The real measure of an advancing stock market is in P/E expansion, and here CCR Wealth Management sees the true impact of US Presidential Election. Expanding P/E’s are generally a symptom of higher earnings expectations in the future.
In our post-election client portfolio reviews we have frequently mentioned Productivity, Policy, and Politics as the likely drivers of both return and risk in 2017. Productivity, as measured by GDP, has been solid here in the US, and the third quarter 3.50% GDP (after the third revision) can even be called mildly impressive given the subdued nature of this eight-year recovery. Policy on the other hand is a more complex topic. Economies have historically been guided and nudged by monetary policy and fiscal policy. To us, evidence suggests monetary policy has been exhausted as an effective stimulus in the US and abroad. While much of the stock market’s recovery since 2009 has been attributed to extraordinarily low interest rates for a prolonged period, there are dangers. Investors, particularly retirees, have been forced into larger equity allocations to achieve the required rate of return on their nest-eggs. Lifelong expectations of holding a less risky portfolio in retirement that distributes sufficient income have not been met because monetary policy both here and abroad has been left to singlehandedly support markets, tame unemployment and grow economies. Fiscal tools, such as tax reform or infrastructure investment have been largely left in the tool bag. Even in Europe, Mario Draghi introduced language after the ECB meeting last month that suggested a possible admission that such extreme monetary excursions may have run their course without fiscal reform. Having largely failed to meet their inflation goals, a policy of possibly extending QE was announced, but with tapered monthly bond purchases. Perhaps a trial balloon of sorts, the announcement seemed to sow some temporary chaos in European financial markets. It’s becoming clearer that without fiscal stimulus, the EU recovery will continue to flounder.
The run-up in equities (and interest rates) since the election is an anticipation of fiscal stimulus here in the US. The promise of fiscal stimulus as policy versus fiscal austerity will be welcome in many sectors of the economy, including financial, energy and healthcare. Fiscal stimulus in the form of infrastructure spending would also be welcome.
Lastly comes Politics, which dove-tails with both productivity and policy. While we see productivity and fiscal policy as being net positives for the US, we view politics as a bit of a wild card both here and abroad. Equity and bond returns, as well as volatility are likely to be defined by political rumblings around the world in 2017 in our view.