Market Commentary: August 10, 2017

August 14, 2017

Despite a heightening of tensions between North Korea and the United States, the market is hovering near all-time highs. Lately the Dow Jones has been the stellar index with big stock price gains in components Caterpillar and Boeing. For the second quarter, both companies reported much better than forecasted profits, sales, and provided upbeat guidance. Including dividends, the Dow has gained about 13% year to date. The S&P 500 about 12%. The technology heavy NASDAQ is up an impressive 18%. For the S&P 500, over a third of this year’s gain has come from just five stocks–Facebook, Netflix, Amazon, Google, and Apple which combined only represent 13% of the index.

Fueling the markets strength has been better than expected corporate results for the second quarter. It looks like the overall profit rise will come in around 11-12% for the period once everyone has reported. Revenues look like they will be up around 6% over last year’s comparable quarter.

Also continuing to support the market has been the low level of interest rates, the declining dollar, and the likelihood that the synchronized global economic recovery will last at least through next year. With about 55% of S&P 500 revenues coming from overseas, this set-up should be a nice tailwind to corporate profits through 2018 and perhaps extending into 2019.
In terms of earnings and valuation, the consensus estimate for this year is about $132 for the S&P 500. Next year profits are expected to increase 11% approaching $146. On next year’s forecast, the market is trading at just under 17 times. Given the positives noted above, we believe profits could ultimately exceed $150 for the index. And, as we have put forward in earlier commentaries, we think the market could eventually achieve a high-teens price-earnings ratio given the favorable backdrop. We would not be surprised to see the S&P 500 Index trade up to 19 times peak earnings of $150 or better. That would put the Index at 2850, or 15% higher.

Stock groups that are poised to outperform include industrial, technology, select pharmaceutical and financials.

Industrial companies are benefitting from the decline in the dollar and a nice pick-up in overseas demand. Included in the industrial sector are defense contractors. Companies that we own in our Core Equity program are Raytheon, Harris, and Honeywell. They are seeing strong order growth from the U.S. government, our European NATO allies, and Middle East customers. Other industrials that are well positioned are Pentair, Waste Management, and Eaton. While these companies are trading near all-time highs, they are still reasonably valued given their strong global business outlook.

As we have referenced in the past, technology companies will similarly benefit from the decline in the dollar and a resurgence in global demand. Firms like Microsoft, Cisco, Intel, and Apple offer nice dividend yields and are priced at discounted valuations to the overall market. They will also be big winners if we get a lower tax rate on repatriated cash held overseas. Apple, in their second quarter earnings release, reported having almost $270 billion in cash, most of which is parked overseas. That represents over a third of Apple’s $800 billion market capitalization.

One of the least expensive groups in the market continues to be banks. A modest rise in interest rates and continued loan growth should support higher earnings over the next few years. Multi-national banks like J.P. Morgan and Citigroup, while benefitting from steady growth in the U.S., are also well placed in faster growing regions in Europe, Asia, and emerging countries. Adding to the groups’ relative attractiveness is that the top 30 banks just passed the recent rigorous Federal Reserve capital stress test. As a result, banks received approval to raise their cash dividends and repurchase stock with their excess capital.

Finally, and importantly, this favorable outlook for stocks assumes nothing out of Washington outside of less regulation. With Congress exhausted after unsuccessfully dealing with health care, they may turn their attention to tax cuts. We think this the most likely direction since comprehensive tax reform debate would mirror the contentious, long, and drawn out health care dialogue. While President Trump has argued for a 15% federal corporate tax, Speaker Ryan and other Republican leaders are pushing for 20%. Those rates, however, were proposed as part of broad tax reform. Since we doubt the latter can be accomplished anytime soon, the President and Congress may have to settle for a rate of 25%, down from 35%. The reason being that many Republicans do not want to see a major tax cut without any revenue offset. That said, if this were to become law, domestic companies would derive substantial benefit. Given the recent underperformance, small and mid-cap stocks should respond the best. Most are currently taxed at the full statutory rate of 35%. Benefiting less would be U.S. based multi-national firms. With about 55% of S&P 500 revenues coming from overseas, where tax rates are lower, the effective tax rate for many is already around 25%.

Bill Hegarty
Chief Investment Officer McDonald Partners LLC

The opinions and recommendations expressed herein are those of Bill Hegarty, Chief Investment Officer at McDonald Partners, LLC and do not necessarily reflect those of the firm and are subject to change without notice. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. The information contained herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company, or industry involved.