Luminous Times: Looking Ahead With Optimism About 2017

Key Points

  • Can the sharp rally in stocks be solely attributed to the results of the presidential election?
  • Confidence is rising among business leaders, consumers and investors…will it be rewarded?
  • Investor sentiment (as always, perhaps) is likely to be a key determinate of equity market behavior in 2017.

In conjunction with the publishing of a summary of Schwab's 2017 outlook across asset classes; this report is a more detailed summary of my 2017 outlook, with a dash of rear-view mirror analysis of the year just ended. Each of the broad topics discussed below will be further unpacked over the next couple of months in individual reports.

What a difference a couple of months make. Much of the stock market’s sharp rally since the presidential election has been credited with, well, the presidential election. There is no question we are witnessing rising business, consumer and investor confidence in keeping with the more business-friendly proposed policies of the incoming Trump administration. That said you could have looked in the rearview mirror on Election Day and seen an improvement in the economy along with a return to positive earnings growth.

Economic inflection

As you can see in the chart below, the surge in the Citigroup Economic Surprise Index began in the third week of October. This index measures how data releases have compared to consensus expectations.

U.S. Citigroup Economic Surprise index

Source: FactSet, as of December 30, 2016.

Remember, this index measures relative change, not absolute growth. But it emphasizes the power of rate of change and offers an opportunity to again relay one of my mottos: Better or worse usually matters more than good or bad when it comes to the stock market. In other words, when things stop getting worse and begin to get better (the inflection point), it’s typically the launch pad for stocks given that they are one of the key leading economic indicators. A common error of equity investors is waiting until the economic data is good, instead of keying off the inflection point from deteriorating to improving.

Earnings inflection

The inflection point has also occurred in corporate earnings, as you can see in the chart below. Aggregate S&P 500 earnings spent four consecutive quarters in an earnings recession; with the third quarter of 2016 marking the turn from negative to positive. However, earnings actually bottomed in the first quarter (at the low in year-over-year change); helping to explain the market’s 25% move from the February 2016 low to December's high.

S&P 500 operating earnings growth

Source: Thomas Reuters, Yardeni Research, Inc, as of December 30, 2016. 3Q16-4Q17 based on estimated earnings growth.

The jump in earnings growth to 12% currently expected for 2017 helps ease a valuation concern. On forward 12-month earnings, the S&P is presently trading at a 17 multiple; only slightly higher than the 20-year median. And as you can see in the table below, inflation remains (for now) in a “sweet spot” of sorts for valuations historically.

Inflation table

Source: Bureau of Labor Statistics, FactSet, as of November 30, 2016. Inflation is y/y % change based on core CPI. P/Es based on forward 12-month earnings.

Bond yield inflection

Another factor impacting stocks in 2016 were bond yields, but perhaps not as many might have expected. The 10-year Treasury yield fell sharply in the first half of the year, but rebounded equally sharply in the second half of the year. We have all been taught that rising bond yields cause trouble for stocks…but not always.

As you can see in the chart below, we are presently in the third major era of a positive correlation between bond yields and stock prices.

Correlation between S&P 500 and 10-year bond yields

Source: FactSet, The Leuthold Group, as of December 30, 2016. Rolling 10-year correlation between monthly % change in S&P 500 and 10-year bond yields.

All three periods were characterized by deflation/disinflation; during which time yields were rising from an extremely low base, thereby not breaching a level which would choke off growth. In addition, if bond yields are rising due to growth improving, but without inflation taking off, stocks tend to do well in this environment.

Looking ahead

Early in 2017 we will all start grappling with the connection (or possible lack thereof) between campaign promises and policy reality. President-elect Trump has elevated tax cuts/reform, increased fiscal spending, and regulatory overhaul to the top of the priority spectrum—all laudable pro-growth policies. However, the continued pressing of his isolationist, anti-trade, and pro-tariff promises could serve as a detrimental offset to the pro-growth agenda, highlighted below.

I liked this comment from Oxford Economics: “Recent Treasury Secretary [Steven Mnuchin] and Commerce Secretary [Wilbur Ross] nominations indicate a desire to press hard on the fiscal accelerator while using the trade brake pedal with parsimony." Let’s hope.