January 14, 2017
As we embark on 2017, the mood in the market has turned, and Wall Street forecasts have gone from a multi-year low-return expectation to a much more optimistic mid-single digit range.
The question for investors is whether the return of pro-growth policies from the 1980’s and 90’s will be enough to drive the market higher or will the reasons behind the original low-return forecasts win out.
The Consensus View
Over the past several weeks I’ve spent quite a bit of time reviewing Wall Street expectations for the year ahead, and in this year’s forecasts, the change in the consensus view (from just two-months ago) is the most significant I’ve seen since March 2003.
A popular outlet for Wall Street strategists is the Barron’s Roundtable series, and a good example of the change in consensus can be seen here. In “Barron’s Annual December Survey of Strategist” the panel forecasted a gain in 2017 of 5%. That may not sound great, but this same group of strategist in September was projecting gloom “Barron’s Survey: Strategist Say Beware The Bear.”
As for the consensus ”themes” in this year’s forecasts – the four most prominent were: First, corporate profitability and earnings will improve with pro-growth stimulus and tax cuts. Second, interest rates will rise. Third, the dollar will rise. And fourth, the risk of a US recession in 2017 is low.
The Pros and Cons
Understanding the consensus view is usually time well spent, that’s because consensus is the herd, and understanding their perspective can be helpful in managing risk - especially in the latter stages of a market cycle.
So, are we presently late-stage in the market cycle? Probably. But in the near-term, the implementation of the new economic agenda (or lack thereof) is likely to be the primary driver of the markets. Thus far, the anticipation of change has spurred both the S&P 500 (+6%) and economic optimism.
Sentiment surveys for small business owners and consumers have surged from multi-year subpar readings to the best prints since the late-1990’s. In fact, small business optimism in December had its biggest one-month gain ever and is now at a high not seen in 15-years.
As investors consider these numbers an important point to note is that optimism is likely the single most powerful force in short-term market and economic activity. It can fade quickly, but for now, enthusiasm over lower taxes and a pro-growth agenda looks likely to remain a positive market factor in the near-term.
Another possible positive catalyst for the markets in the months ahead is cash. We now know that one of the drivers behind the 2016 post-election rally was the unusual amount of cash individual investors were holding in their portfolios. BlackRock recently released data stating that before the election, US individual investors had, on average, a cash allocation exceeding 30% of their overall savings and investments.
From an optimistic rally-on perspective, the return of individual investors to equities since the election is a good sign, and thus far, very reminiscent to the investor sentiment surge we saw in the spring of 2003, when stocks experienced double-digit gains over the next 10-months.
While optimism for a healthier economy and a renewed bull market is positive, it’s important to recognize that the fundamental risks that prompted the low-return expectations before the election are still present today.
The key components of the downside risks are:
First, the S&P 500 index, by nearly every valuation metric is trading in the top 85th percentile – that means the market is expensive. Valuation is not a short-term timing indicator – so this shouldn’t be interpreted as an imminent sell signal, but it does indicate a level of risk that is likely above average.
Historically, when markets are trading at a premium valuation, as they are today, over the next decade total returns are likely to be well below average. And to the contrary, when markets are trading at a historically low valuation the total return over the next decade tends to be well above average.
Second, mixed economic data has plagued the US economy for over seven years. Overall our growth rate has been trending at just a fraction under 2%. And the trend in the past two years has softened – most key economic measures peaked in 2014. The warning to investors is that the business cycle may be in the latter stages, and higher interest rates, a stronger dollar, and a Fed changing course could present significant risks.
Inside The Rally
The rally from the election through year-end helped push the market out of a multi-year sideways trading pattern. From a technical perspective that was very good news, but in the less exciting category was that the move in the market was heavily concentrated in the US financial sector, and on the negative side of the ledger bonds performed badly.
In fact, from the election through year-end global bonds lost as much as global stocks gained, and well-diversified investors saw a difficult truth that sometimes diversification hurts .
In the weeks and months ahead, it would be a very good sign for the rally to broaden out, and for bonds to stabilize. If that were to happen, the potential for 2017 to be a respectable year for investors across the spectrum of risk would likely improve substantially.
Moving forward, unpredictable political wrangling may well be the primary driver of market activity in the months ahead. The possibilities are varied, but market volatility should likely be expected to rise as traders, and active investors look to position or reposition based on signs as to how much (or how little) may change.
The challenge for investors in the coming months will be to weigh the stimulus that gets through the political process against the hurdles presented by higher interest rates, a stronger dollar, a Fed changing course, record corporate debt, low productivity, and an aging bull market with elevated stock valuations.
In my opinion, the risk of a “near-term” recession looks low, but the extremes on both the pro and con sides of the investment ledger create cross-currents unlike anything we’ve seen since 1980. To refresh our memories, in 1980, the market rallied as pro-growth policies were announced, but within a year, higher interest rates and a stronger dollar overwhelmed the stimulus and we slipped into a deep recession.
How the diverging forces ultimately play out in 2017 is not knowable - there is an unusually strong case to be made on both the positive and negative side. For that reason, I think it’s important for investors to remain open-minded to the possible outcomes.
Given the cross-currents and the likelihood that we are also in or approaching the latter stage of the market cycle, active investment management strategies focused on downside risk management are worthy of stronger positioning and consideration than passive buy and hold.
With that in mind, tactical US equity models today are positive, and as long as that remains the case, maintaining a normal weighting to US equity-based ETFs appears reasonable.
As for bonds, tactical models for intermediate and long bonds are negative. 2017 may be a good time to consider bond allocations with shorter maturities.
Closing thought, the US is trading at a 30% premium to other developed nations – a historic high. Valuation extremes like this tend not to last. History tells us that in the decade ahead international developed markets may offer investors better value than the US.