Market Commentary: October 13, 2017
October 16, 2017
U.S. stocks and markets around the world continue making new highs fueled primarily by low interest rates and steadily improving global growth. We have now gone 335 days without as much as a 5% decline, the longest streak on record. Year to date the total return on the S&P 500 is approximately 15.5%. The technology and healthcare dominated NASDAQ has gained almost 23%. Smaller to mid-size indices are up about 10%.
The S&P 500 now trades at a little over 19 times this year’s forecasted profit and approximately 17.5 next year’s estimate of $145. While valuation is above the long-term historical average of 16 times earnings, we believe there are two key factors that should lead the market higher.
The first is the likelihood of a favorable interest rate environment over the next few years. While it is expected the Federal Reserve Board will raise interest rates by .75% to 1.00% by the end of next year, rates would still be at historically low levels and unlikely to choke off economic growth. And, if market rates behave the way they did after the first three rate hikes totaling .75%, increases should be tolerated reasonably well by the bond market. Previous increases produced little reaction. This can be explained by the very strong demand for U.S. government debt. Our yields, at 2.35% on the 10-year Treasury, continue to be significantly higher than European and Japanese sovereign debt.
The second important factor is the outlook for corporate profits. Low interest rates, benign wage and commodity inflation, a stable dollar, and global growth could drive revenue and earnings growth for another couple years. The International Monetary Fund (IMF) just revised global growth forecasts higher for this year and next. The new rates are 3.6% and 3.7% for 2017 and 2018, respectively. They cited the U.S., China, India, and the majority of emerging economies driving global synchronized growth. As we suggested earlier this year, we could see S&P 500 earnings ultimately approach $150 or higher. On that earnings achievement, stocks would be valued at about 17 times. Not particularly cheap, but very reasonable given where interest rates will be hovering.
There are a few other considerations to look at when sizing up the stock market.
One, and this was recently addressed by leading strategist Byron Wien in a Barron’s interview, is where we are in the business cycle. Wien makes the argument that revenue and profits normally do not peak until you have a big pick-up in corporate spending for plant and equipment. Since the manufacturing sector is only operating at 77% of capacity, we are a ways off from that becoming an issue for stocks.
Another consideration is investor sentiment. Even with the sharp run-up in stocks this year, retail investors are not overly euphoric. This is evidenced by their preference for bond funds over stocks since
June. On the institutional side, hedge funds are positioned very cautiously with increased cash levels and stock weightings on average under 50%. We view this as potential buying power should managers capitulate into a rising market.
Circling back to what looks undervalued, we continue to favor cyclical groups like industrial, technology and financials. These sectors still trade at a discount to the overall market, have solid revenue and earnings prospects for the next few years, and pay nice dividends. Also looking relatively attractive are the pharmaceutical stocks. Despite facing some pricing headwinds, new drugs in many important therapies are expected to be approved faster under the leadership of a new FDA Commissioner.
Finally, after lagging larger capitalization companies since the beginning of the year, there is a good chance small and mid-size domestic firms will begin to outperform. Should we get a lowering in the corporate tax rate to 25% or less, these companies will benefit the most. Most pay tax at the effective rate of 35%. Largemulti-nationalfirmswillgetabreakbutlessso. Thatisduetotheiroffshorebusinessalreadybeing taxed at a much lower rate. The effective rate for large multinationals is about 26%.
If the tax cut package being floated gets legislated, there will be a one-time reduction in the rate for offshore cash repatriated. There is an estimated $2 trillion cash overseas, $280 billion of it held by Apple. Other companies with large foreign parked cash sums include Cisco, Microsoft, Intel, Pfizer, Merck, and Gilead. If the reduced rate becomes law, these companies and shareholders stand to benefit through buybacks and dividend increases.
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.