t was an upside surprise. Stock market returns in 2017 astonished and pleased everyone! Heading into the year, the Bloomberg consensus of strategists projected equity returns in the mid-single digits. Instead, the S&P 500 Index realized a total return of 21.7% and finished close to its high for the year. Most strategists believed that bond returns would be flat to negative owing to a tightening of monetary policy leading to higher interest rates. That the Bloomberg Aggregate Bond Index achieved a 3.5% return for the year was considered a minor miracle.
First, what happened?
In December 2016, the consensus of market strategists held that the S&P 500 Index would increase in 2017 around 5.2% to 2356. See Table 1. This scenario seemed reasonable as market valuations were already high at the end of 2016, expectations for corporate profit growth in 2017 were moderate, and U.S. growth was projected to remain within the disappointing trend of 2.0%‒2.5% that had prevailed since the 2008‒2009 financial crisis.
Defying expectations, the S&P 500 Index finished the year at 2674, a gain of more than 19%. The main factor propelling markets was a pervasive sense of growing optimism in the private sector. During the course of the year, the administration relaxed regulations, which in certain sectors such as banking, finance, and energy had reportedly increased operating costs significantly. While it is impossible to measure the impact on operating margins, the new policy direction is considered positive. Areas of concern at the start of the year such as the disruption that would be caused by changing or cancelling major trade arrangements like NAFTA gradually faded. The real boost to the market came from the promulgation in December of the Tax Cuts and Jobs Act (TCJA) and the recognition that this legislation will materially lift corporate profits in 2018.
|Investment Strategists of Major Financial Institutions|
S&P 500 Index, S&P Earnings Per Share, US Economic Growth Rates, 10-Year Treasury Bond Yield Data
|S&P 500 Index (Year-End)||2,239||2356||5.2%||2,674||19.4%||2,875||7.5%|
|S&P 500 Index Earnings||$118.75||$127.37||7.3%||$124.96E||5.2%||$145.94||16.8%|
|Consensus U.S. Economic Growth||1.5%||2.3%||2.3%E||2.6%|
|10-Year Treasury Yields (Year-End)||2.45%||2.69%||2.40%||2.88%||Sources: Bloomberg, Standard & Poor’s, Barron’s|
The economic backdrop also improved in 2017 from the prior year. Most economists at the end of 2016 expected real growth of GDP to bounce from the depressed 2015 rate of 1.5% to around 2.3%. It is currently estimated that the economy did grow at that rate last year. The preliminary data will be available in late January. What was particularly heartening to investors was that in the second and third quarters, real GDP growth advanced at more than 3%, and that fourth quarter growth is likely to come in at close to 3%. Economic metrics are broadly favorable including the decline in unemployment to 4.1% in November, continued low core inflation of less than 2% per annum, strong consumption and rising investment outlays, both reflecting a marked improvement in consumer and business confidence indices throughout the year.
During the course of 2017, it became clear that the global outlook was also improving. Both the International Monetary Fund and World Bank increased their forecasts for global expansion for 2017 and 2018. Major global economies are growing in sync, which is unusual.
At the beginning of 2017, it was broadly expected that interest rates would rise. As shown in Table 1, yields of the 10-Year Treasuries were projected to increase from the year-end level of 2.45% to 2.69%. This outlook seemed consistent with the monetary policy of the Federal Reserve, which during the year hiked the target rate on Federal Funds three times and curtailed quantitative easing policies that had been in place since 2009. Notwithstanding the tighter monetary policy, the 10-Year Treasury yield on December 31 surprisingly stood at 2.40%, a decrease of 5 basis points from year-end 2016 levels, which explains the positive returns of fixed income securities last year.
All of the foregoing developments had a positive influence on investors and tended to steer them into equity markets. World equity markets soared in 2017 with principal European and Asian markets up strongly, in most cases in dollar terms by more than 20%.
Second, what is the outlook from here?
Markets are all about expectations. The decrease in the highest marginal corporate tax bracket from 35% to 21% as a result of the TCJA legislation will have a meaningful impact on earnings. At this time, the consensus is for S&P 500 Index earnings to advance around 17% in 2018 to $146. It is possible that this estimate will increase perhaps to $150 over the next couple of months as earnings estimates are revised upward.
The current view is that U.S. real GDP growth in 2018 will rise to 2.6% or more. Perhaps half of the incremental growth is due to tax reduction that will stimulate consumption and investment. One positive aspect of the new tax law is the reduction in corporate taxes on the more than $2.5 trillion in foreign corporate profits held abroad, which hopefully will lead to their repatriation. However, it is not clear whether businesses will channel this capital into increased investment and higher wages or into greater share repurchases and dividends. No one knows for sure, but the former case would be far better for the economy in the long run. It seems that investors will benefit regardless of which choice corporations make.
The U.S. Treasury prepared growth forecasts for the U.S. economy based on the Senate version of the tax bill: 2.5% in 2018; 2.8% in 2019; and 3.0% thereafter through 2027. The average increase is 0.7% per annum over a ten-year period, of which approximately half will come from changes in corporate taxation.1 Many economists have pooh-poohed the Treasury one-page statement on the basis that the underlying detailed analysis was not released. There is considerable skepticism concerning the Treasury's position that the additional tax receipts generated from incremental economic growth will cover the projected increase in the deficit. Most economists do not expect that the stimulus from the tax legislation will be sustained. Bloomberg reports that major-institution economists currently predict that real GDP growth in 2019 will fall back to 2.2% with some estimates under 2%. We hope those forecasts prove too conservative.
In view of the foregoing, it is not surprising that market strategists expect the S&P 500 Index to continue to rise in 2018. The current forecast is for the index to reach 2875, about a 7.5% gain over year-end levels. Let's hope the strategists are more correct in their prognostications this year than last. Interest rates are expected to rise in 2018 with the 10-Year Treasuries ending at 2.88%, which could lead to losses for bond investors.
What is the risk of a meaningful correction in equity markets in 2018?
Historical data show that most severe downturns in stock markets occur in the face of recession. While we believe the likelihood of the United States experiencing a recession in the next two years seems low, the most recent survey of economists by Bloomberg estimates the risk of recession within one year at 15%.
Severe drops in the market are also associated with speculation. However, valuations do not seem excessive. See Table 2. The current market price/earnings ratios (P/Es) at the end of 2016 and 2017 of 18.85 and 21.40 respectively are high relative to the historical average of around 15x. However, the forward P/Es which value the market in relation to expected earnings over the next twelve months seem reasonable, particularly in view of current interest rate levels and economic growth expectations. Our position is that there is little likelihood that P/Es in 2018 will expand. This means that most of the gains in S&P 500 earnings from 2017 to 2018 have already been discounted at current market levels.
|S&P 500 Index Levels, Earnings and Price/Earnings|
|Current Price Earnings Ratios||2016||2017||2018|
|S&P 500 Index||2,239||2,674|
|S&P 500 Earnings *||$118.75||$124.96|
|S&P 500 Price/Earnings||18.85||21.40|
|* Actual earnings in 2016 and estimated earnings in 2017|
|Forward Price Earnings Ratios|
|S&P 500 Index||2,239||2,674|
|S&P 500 Earnings **||$124.96||$145.94|
|S&P 500 Price/Earnings||17.92||18.32|
|** Estimated earnings in 2017 and 2018.|
But what happens if there is a severe market correction?
Mindful that we are in one of the most extraordinary uninterrupted rises in equity values in the last 50 years, the question arises whether risks are accumulating and a severe correction is in store. It is virtually impossible to know beforehand when a down cycle in the market will take place. We were amused that Paul Krugman, who professes to know just about everything there is to know in the economic universe, recently admitted that even he lacked the ability to forecast a downturn in the market, stating that “Sooner or later, something will go wrong...but I can’t tell you what that something will be, or when it will happen.”2 It is not surprising that equity strategies based on market timing have produced poor results.
|S&P 500 Index|
Data on Market Declines and Recoveries, 1956 to Present
|Date||S&P||Date||S&P||High‒Low Months||S&P % Change||Recovery Date||S&P||Low‒High Months||Total Cycle Months|
We can frame the risk in the market by looking at downturns over the last 60 years. What we find is that common stocks have been very resilient. Table 3 provides data on market corrections of around 15% or more since 1956. The average decline of 12 downturns of the S&P 500 Index was about 30%. Some of the drops in the market were particularly hurtful as in the downturns in 1973, 2000, and 2007 when the Index fell around 50% because of extraordinary economic or market conditions. In 1973, the U.S. economy was faced with extreme dislocations in energy supplies and very high inflation which lasted until the early 1980s. In 2000, there was a bubble in the valuation of technology shares which ended badly. In 2007, the market was pummeled due to the collapse of global mortgage markets and excessive leverage of major financial institutions.
To experience a 50% loss in one's investments is gut-wrenching, but in every case, investors who maintained their equity positions recovered their capital. The data on the 12 downturns indicate that the decline from peak to trough averaged a little more than 12 months while the recovery took twice as long, averaging around 25 months. The key point is that at the extremes, the full cyclical period from peak to trough and back to peak can last more than seven years, as was the case in the 1973 downturn, and nearly seven years, as reflected by the 2000 correction. This means that investors have to maintain reasonable liquidity positions to meet current and future cash requirements to obviate the risk of having to liquidate common stock positions at depressed prices.
Notwithstanding the 12 downturns shown in Table 3, the total return of the S&P 500 Index from Q1 1956 through Q3 2017 was 9.9%. Dividends reinvested in the Index contributed about 3.3% to total return. In this regard, Table 3 overstates the risk because it does not consider dividends that shorten the downturn cycle periods.
The foregoing analysis of the market clearly shows that long-term investors are rewarded the most. Yet we worry that the leadership of the United States is increasingly focused on short-term gains rather than long-term prosperity and stability. While a sound case could be made for reducing corporate tax rates for competitive and investment reasons, most of the balance of the tax legislation will have no lasting economic impact. After seven years of expansion, and particularly when the country requires increased investment in infrastructure, education, and research and development, this is not the time to increase the government deficit to stimulate consumption. There are clear longer-term problems ahead related to Social Security, Medicare, Medicaid and other entitlements. Since the financial crisis, the postponement of addressing the burgeoning Federal debt was made possible by low interest rates. However, the probabilities are that interest rates will rise and our debt service obligations will become increasingly burdensome on the Federal budget and will crowd out important priorities.
Until now in the current bull stock market, we have not pared back our equity exposure in accounts unless directed or liquidity needs required asset reallocation. This strategy has paid off. Three observations, however, lead us to take a more cautious stance. First, the upward boost to the economy from the recently passed tax bill is not likely to sustain economic growth, and current forecasts show growth decelerating in 2019. Second, corporate profits after realizing the significant one-time adjustment from lower tax rates in 2018 are also likely to experience slower growth next year and beyond. Third, there are signs that investors are becoming increasingly exuberant: witness the action in selected technology stocks and cryptocurrency valuations.
There is a tendency on the part of investment strategists to look for one or two events that will trigger a market correction. Yet it is entirely possible that the current bull market will suffer a natural death from exhaustion. Equities continue to offer the most attractive potential long-term returns compared to fixed income securities. However, investors need to be mindful that returns if positive will be slim, probably below trend, and that losses for an extended period are possible, all of which raises the need for caution on the part of institutions and individuals who are drawing down portfolios to meet current operating expenses.
Stratigraphic Asset Management, Inc.
- Department of Treasury, “Analysis of Growth and Revenue Estimates Based on the U.S. Senate Committee on Finance Tax Reform Plan,” Washington, D.C., December 11, 2017.
- “Can the Economy Keep Calm and Carry On?” Paul Krugman, NYT, January 1, 2018.