“Alex, I’ll Take ‘Stock Market Trivia’ for $20,000.”

The Dow Jones Industrial Average, after many failed attempts, finally rallied above the 20,000 mark.  While it seemed like a lengthy, arduous battle, the reality is that it only took 64 days from the time that the Dow first crossed 19,000 to the time it got to 20,000.  In fact, this is the second shortest time between 1,000 point thresholds with the move from 10,000 to 11,000 taking only 35 days.
To be sure, it is easier to accomplish this with larger numbers as a 1,000 point move from 19,000 is 5.2% vs. 10% from 10,000.  This makes the move from 10,000 to 11,000, a 10% jump in 35 days, that much more impressive.  The real journey was that from 10,000 to 20,000 – it took almost 17 years as 10,000 was first hit in March 1999.
As some may recall, as the Dow got to 10,000 in 1999, the 20,000 mark was just around the corner on a trip to 36,000.  At least that’s what some popular pundits were confidently predicting.  Unfortunately, some stuff got in the way – the tech bubble, housing bubble, sub-prime crisis, great recession, etc.  It’s a reminder that some roads can unexpectedly get rough.  Before moving on, a trivia question on the Dow – prior to 20,000, what are the two 1,000 point thresholds that were only crossed once (obviously on the way up)?  The answer later.
Dow 20,000 is an exciting milestone but when do we get to 21,000.  From a momentum standpoint, stock prices have been moving from lower left to upper right since the election.  Also, the breadth of advancing issues vs. declining issues has been good which points to a broad participation.  Moreover, 67% of the S&P 500 are trading above their 50-day moving average which is a good sign.  Finally, the number of new 52-week highs vs. the number of new 52-week lows has been a support for equities.  This ratio expanded further last week as the Dow exceeded 20,000.
Valuation is another important metric.  On this front, U.S. stocks are not cheap.  The price-to-earnings ratios for the major averages are below.  The earnings component is based on as reported earnings for the trailing twelve months.[i]  The estimate is based on forecasted earnings for 2017.
                                                           Trailing                   Estimate
Dow Jones Industrial Average            21.11                       17.50
S&P 500                                              24.74                       17.52
Nasdaq Composite                              20.10                       19.15
While the numbers are not obscene, they are well above what is considered fair value which are levels in the mid-teens.  The forward-looking P/E’s are reasonable but, of course, assume a larger denominator in the form of higher earnings.    Part of that should be the result of a lower corporate tax rate and a stronger economy but neither is assured.
The P/E of the index provides an overall market valuation but breaking them down by sector gives a sense of where the opportunities and risks are.

Consumer Discretion      20.51          Consumer Staples      21.42

Energy                             139.17        Financials                  16.09
Healthcare                        19.21         Industrials                  19.48
Materials                          20.03         Technology                 22.92
Telecom                           16.13          Utilities                      17.15
These calculations are done by Bespoke Investment Group and are based on trailing twelve month earnings numbers.[i]  On their face value, energy looks extremely overpriced but we would assume that the earnings number was dramatically reduced by write offs forced by the collapse in commodity prices.  This P/E should come down in 2017 as oil prices have stabilized and the industry has cut expenses.
On the other hand, telecom and financials look undervalued.  However, telecom might be facing growth obstacles while financials are dealing with heavy regulations.  Both industry landscapes might improve under the Trump administration but the market appears to be waiting for the policy details.
Last week we got a first look at economic growth for 2016’s 4th quarter.  GDP was reported as growing at 1.9% which was below the expected 2.2%.  GDP is calculated by adding consumption, government spending, investments, and exports and then subtracting imports.  Investment was much stronger in Q4 vs. Q3 and a big component of this was in mining, shafts, and oil and gas infrastructure.
This is a little misleading as there wasn’t a lot of investment in this area as it was only slightly positive.  But this was the first quarter since Q4 of 2014 that this calculation was positive.  As the energy industry adjusted to the fall in oil and gas prices, wells were shut down and capital investments were written off.  The result was a negative number in the GDP formula from the energy industry throughout 2015 and the first 3 quarters of 2016.
Another noteworthy number from this report is that investment in industrial equipment is at an all-time high.  Businesses are investing in equipment as this amount has exceeded the level reached before the financial crisis.
Inventories grew in the 4th quarter which reverses a trend of falling inventories levels for 6 straight quarters.  Importantly there was no large drop in demand during this period of declining inventories.  In other words, companies cut back on inventories as they anticipated slowing demand that never happened.  Historically, this leads to a sharp recovery of inventories as businesses re-stock which is helpful to economic growth.
Another positive report from last week was the University of Michigan Consumer Sentiment report.  This is a monthly release and its latest reading was 98.5 which is a multi-year high.  Consumers are feeling upbeat about their situation and this should be supportive of stronger economic growth.
One conclusion in summarizing the above is that the economy is doing well but it has already been discounted in the capital markets.  This data along with such things as the job market, productivity, and the housing market suggest a pretty good economy.  Market valuations and dividend yields further suggest that stocks have already priced this in and are looking for a continuation of this growth.
Turning our focus from backward to forward, we are facing uncertainties.  The Federal Reserve will be raising interest rates in 2017 which could be a headwind.  Also, it could lead to a stronger dollar which slows exports and pressures the emerging markets.  The global financial system is very much linked together so disruptions in other markets could make their way to our shores.  This would be an unexpected problem.
As we know, there’s a new sheriff in town.  This was clearly demonstrated in President Trump’s first week in office.  One thing we can assume is that there will be some gigantic shifts that take place.  They will impact the economy and there are going to be winners and losers.
Concerning the new president, the chart below is something to keep in mind.[ii]  It shows the performance of the S&P 500 for the 60 days prior to a Republican inauguration day and the 60 days subsequent.  As you can see, stocks after President Trump’s victory have outperformed prior GOP presidents.  However, there is a clear decline in past examples and it begins around inauguration day.  2016 was a year to expect the unexpected so maybe this trend is broken with this Republican president.
Returning to the beginning of this newsletter, the answer to the question of the two Dow 1,000 point thresholds that were only crossed once are 19,000 and 5,000.  The 19,000 level could be easily crossed again as it’s only 5% away.  Obviously, a normal 10% correction puts that level in play.  Let’s hope that the 5,000 number is never in doubt.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

[i] The Wall Street Journal, January 28-29, 2017
[ii] The Bespoke Report, January 27, 2017
[iii] Topdown Charts, January 2017

Republicans and Russians and Bulls…. Oh My

Donald Trump was sworn in as the 45th President of the United States on Friday.  The inauguration was as anticipated including all of the tradition and pomp.  The oath of office, the speeches, parades, balls and celebration, all were done as expected.  Looking forward, it may be a while before we get this degree of predictability out of the Trump administration again.
Everyone knows the general direction the Trump administration wants to move.  There is risk that the implementation of this direction gets complicated.  Issues such as tax policy, cabinet appointees, trade policy, fiscal budgets, foreign relations, and regulations are things that need to be worked out and wrinkles could easily arise.
On election day, the stock market had a sudden change of heart regarding Donald Trump and has signaled its approval ever since.  There is little debate that Washington’s economic influence will shift from hindrance to supportive.  Lower corporate tax rates, reductions in business regulations, and fiscal programs and incentives will boost economic growth.
An important question centers on how much of these positives have already been discounted.  In anticipation of these tailwinds, the Trump rally has carried stocks to record highs.  As U.S. equity valuations are above the historically normal levels, this then leads to another question – are we getting a little ahead of ourselves?
If the new administration’s transition goes smoothly and its policies and programs get implemented without problems or delays, the economic impact could arrive quickly.  This would be stock market friendly for both the current levels as well as higher prices later in the year.  However, if President Trump and his team encounter problems with execution of the plans and programs, the stock market could correct.
History shows that a president’s first year in office can be tough.  Below is a graph showing the presidents that had a recession in his first year.[ii]  This might be caused by uncertainty surrounding a change of direction or battles with Congress or decision making errors. At this point, President Trump might be an exception as there no signs of a recession.  Still there are many variables that still could cause problems such as trade wars or a spike in inflation.
If the January stock market is any indication on the economy or new president, the short-term message is unclear.  After moving higher in the first week, U.S. stocks have traded sideways.  Last week the major averages closed marginally lower.  The Nasdaq, which underperformed after the election, has been the leader in 2017.
2017 YTD
Dow Jones Industrial Average                                              +0.3%
S&P 500                                                                                +1.5%
Nasdaq Composite                                                                +3.2%
Russell 2000                                                                          -0.4%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
In fixed income, bond yields rose last week but are around the same level as they started the year.  The 10-year Treasury note closed the week at 2.466% up from 2.38% the prior week.
One of the most popular predictions for 2017 is that the U.S. dollar will rise against other currencies.  Expectations for higher interest rates together with stronger economic growth make the greenback more desirable.  Last week, however, the dollar index fell and it is down 1.47% in January.  Maybe dollar bulls have gotten tired.
Commodities are higher in 2017 as the CRB commodity index is up 0.78% for 2017.  Crude oil and natural gas are lower but precious and base metals are higher.
Although it is very early in the earnings reporting cycle, the results have not disappointed.  63% of reporting companies have exceeded EPS forecasts which is about average. The story on the revenue part of the income statement is different.  More than half of the reporting companies have missed analysts’ revenue estimates.[iii]  The amount of companies reporting will be much higher in the next few weeks and we’ll keep readers informed how the results are.
Putting everything together, we think there are a few consensus views for 2017’s capital markets.  Many strategists and managers are calling for U.S stocks to be moderately higher for the year.  It seems that the expectations are for high single digit gains for equities.  As mentioned above, conventional wisdom also looks for a rising dollar and higher interest rates.  These experts appear to not overly concerned with potential obstacles and potholes as they believe all of them are manageable.
We would like to share in this optimism but have some concerns.  First, current events rarely play out as smoothly as everyone expects.  Given the proposed and expected changes in Washington, there is a lot that could go awry.  With stocks at record levels and elevated valuations, any deviation from a smooth Trump transition that results in stronger economic growth might cause stocks to dip.  If the stock market develops some doubts over President Trump or the economy, we would expect prices to correct.  We wouldn’t expect a nasty bear market, but a correction that adjusts valuations to more normal levels.  It promises to be an interesting year and we look forward to the opportunities in front of us.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

[i]  The New Yorker, January 2017
[ii] DoubleLine Funds, January 2017
[iii] The Bespoke Report, January 20, 2017

Brother, can you spare a dime?[i]

Actually, can you spare 4 dimes?  Last Friday the Dow Jones Industrial Average came within less than one half of one point ($0.37 to be exact) of 20,000.  Throughout the afternoon there were several attempts to get to that level but the bears defeated each try.  Perhaps they should have passed the hat among the floor brokers on the New York Stock Exchange to get the spare change totaling $0.37 and then start the celebration.  On second thought, it’s likely that no one had anything less than a $20.
While round numbers aren’t supposed to mean anything, there was disappointment in getting so close to this number without pushing through.  Below is an hour by hour chart of the Dow on Friday showing how many times and how close we got to 20,000.[ii]  It was close but no cigar.



Not reaching 20,000 is a calculation anomaly and there’s no real significance to surpassing it.  But, obviously, there were large sell orders at that point on Friday.  And while there was some dismay over not getting there, the stock market had a good start to 2017 as the Trump rally rolled on.  The three major averages had good weeks and all reached new intraday records on Friday.  Here are the numbers for the first week of 2017.
YTD 2016
Dow Jones Industrial Average                                                      +1.0%
S&P 500                                                                                        +1.7%
Nasdaq Composite                                                                        +2.6%
Russell 2000                                                                                  +0.7%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
Interestingly, last week’s leaders were December’s laggards.  For example, health care, which was the only sector to post a meaningful decline in 2016, was up almost 3%. On a wider measure, if you divide the S&P 500 into 10 deciles, the two worst performing deciles of 2016 led the way last week up 3.52% and 2.24%.  At the other end of the spectrum, last year’s best performing decile was up only 1.08% last week, last place.[iii]   To be sure, it is only one week but there was a clear rotation as we began the new year.
Bond yields ticked up on Friday after December’s employment report showed that job growth was a little under expectations but wages were up.  Since this might be an early sign of inflation which could lead to more Fed interest rate increases, yields moved higher (lower prices).  The yield on the U.S. treasury 2-year note closed at 1.19%.  The 10-year note’s yield finished at 2.41% and the 30-year bond ended the week at 3%.
Fixed income yields spiked higher after the election driven by forecasts of stronger economic growth and fears of larger government borrowings to fund President-elect Trump’s infrastructure programs.  On a short to intermediate term, it appears that yields peaked in mid-December and have trended lower since.  We would expect yields to drift a bit lower before resuming their climb.  For those bond fund holders that got punished in the November and December selloff, this might present an opportunity to lighten up.  Or at least shorten maturities.  We would look for bonds to resume their selloff (higher yields) later in the year unless there is a shock or signs of a recession begin to develop.
As we know, stocks have moved a long way since the election.  The potential for a more business friendly Washington has increased optimism concerning the economy and the stock market.  And while the regulatory landscape will change, the speed and the degree of this transformation is unknown.  This heightens the risk that stock prices have gotten a little ahead of themselves.
To illustrate this point, below is a chart showing the S&P 500 price and the trailing earnings.[iv] The bright blue line represents the S&P 500 price and the dark blue line is the index’s trailing twelve month earnings per share (EPS).  The two lines generally move together but, as shown, the lines have recently diverged. In order for this to return to its historical relationship, one of two outcomes must take place – 1) higher earnings or 2) lower stock prices.
Of course, it’s possible that the lines move farther apart with the S&P 500 climbing higher.  And, there is general agreement that corporate earnings will rise in 2017 due lower tax rates and a reduction in costly regulations.  However, current valuations are elevated as the rally since election day has priced in a lot of these positive developments.
While that graph shows the S&P 500, the chart below focuses on two of Wall Street’s recent favorites.  Goldman Sachs price jumped 30% in the weeks after the election and has played a huge part in getting the Dow to the 20,000 neighborhood.   Caterpillar is another darling that is materially higher since the election.  These two companies are poster children for the upcoming economic improvements.  Goldman Sachs will benefit from reduced banking regulations and Caterpillar will be helped by increased energy exploration and infrastructure activity.
The chart clearly shows how GS and CAT’s stock prices have been moving from lower left to upper right.[v]  Further it shows a dramatic widening between the stock price and earnings.  While analysts will probably raise the earnings estimates for both companies, they must move them a lot higher to get valuations back into a normal range. Otherwise we could see pressure on their stock prices.  And since they are market leaders, this could have a broad impact.
An area that we’ve been encouraging clients to consider is the international markets.  Both the developed and emerging markets are out of favor and could represent opportunities.  They have underperformed the U.S. stock markets since the Great Recession.  Moreover, these markets have been further pressured during the last couple of years as the U.S. dollar has strengthened and commodity prices have imploded.
One of our themes for 2017 is that we’ll see a consolidation for the greenback.  If this happens, it will offer some relief to the emerging markets.  Also, from a valuation perspective, international stocks look appealing.  Here is graph showing the valuation of the U.S. stock market vs. an index of developed markets and an index of emerging markets.[vi]  Both developed and emerging markets trade at much more reasonable valuations as compared to the U.S.
Despite falling short of Dow 20,000, the U.S. stock markets had a good start to 2017.  It’s said that the key to a good prediction is to forecast an event but don’t provide a timeline.  So with that in mind, we predict that the Dow will exceed 20,000 but remain mum on when.  In addition to that valuable nugget, we expect a digestion or even a correction for U.S. markets.  How severe a pullback, if we get one, is unknown.  But it could be a good entry point as we expect U.S. equities trade higher later in the year.  For this reason, we are keeping the “Dow 20,000” hat nearby.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

[i] Harburg and Gorney, 1930
[ii] Bespoke Investment Group, January 6, 2017
[iii] ibid
[iv] DoubleLine Funds, January 2017
[v] Zerohedge, January 2017
[vi] DoubleLine Funds, January 2017

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. “i

In this season of traditions, resolutions and predictions for the New Year are especially popular ones.  But for anyone making (or reading) 2017 forecasts, we have a question – don’t you remember 2016?  Brexit?  Trump?  The Cubs?  It was the year that made virtually every professional prognosticator look pathetic.  Having lived through 2016, how can anyone make predictions for 2017 with a straight face unless it’s the result of an uncontrollable character flaw?
Indeed, last year’s surprises covered many parts of our lives – politics, sports, weather, and of course, the markets. Concerning finance, the year started in turmoil with global capital markets falling (U.S. stocks fell over 10% into February marking it as the worst start to a year for the stock markets).  Then, remarkably, the U.S. stock market regained these losses before the end of the 1st quarter.
Of course, this was followed by Brexit in June with its 2-day plunge and then yet another historic recovery.  This bounce in stocks led to an important breakout above a two-year trading range which continued into the U.S. elections.  The market gyrations and volatility on election night as well as Donald Trump’s victory were not expected.  After the election, U.S. equity markets had a much stronger tone and rallied into year end.
Here are the year-to-date returns for the major averages.  Also, we are including the move from the election which shows how much of the year’s performance happened in a six-week period.
YTD 2016            Since election
Dow Jones Industrial Ave.                  +13.4%                  +7.8%
S&P 500                                              +9.5%                    +4.6%
Nasdaq Composite                              +7.5%                    +3.6%
Russell 2000                                        +19.5%                  +13.5
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
Below is a graph of the S&P 500’s 2016 journey broken down by month.ii  The graph’s line is green in positive months and red in negative months.  Also, the monthly returns are at the bottom of each month.  The graph illustrates the year’s big moves we mentioned above.  It shows how dramatic the January/February drop was.  Further, the amazing Brexit move stands out at the end of June and, finally, it is easy to spot the trading around the election and the climb into mid-December.
The fixed income markets had some volatility as well. Bonds had a strong first half of 2016, some headwinds in the 3rd quarter, and a bad 4th quarter.  For the buy and hold investor who doesn’t follow the developments day-to-day or even month-to-month, it may have appeared to be another boring year.  The 10-year treasury note started 2016 at 2.25% and ended the year at 2.45%.  Pretty innocent on the surface.  But this masks some volatility during the year.
At the beginning of 2016, the markets were expecting 3 or 4 rate increases by the Fed.  Instead, as the economy lagged, rate hike expectations were pushed further into the future and accommodative monetary policies continued.  This helped bonds as yields fell (higher bond prices) and by the beginning of July the yield had dropped to 1.38%.  The yield moved higher in the 3rd quarter as the job market was strong along with some other positive data.  From the election to mid-December, yields exploded higher (bond prices plunged) as the markets anticipated higher economic growth under a Trump administration as well as larger fiscal deficits.  On a total return basis, the 10-year note lost 3.69% in 2016.
Crude oil spiked 45% in 2016 while natural gas climbed even higher, up 59%.  Both commodities started from depressed levels after imploding in 2015.  Gold had a strong year into September but declined badly in the 4th quarter as the dollar strengthened and interest rates moved higher (both bad for gold).  For the year, it was up 8.4%.
2016 was a good one for the dollar as the index (vs. a basket of currencies) rose 3%.  Against the major currencies, the greenback was up 3.2% against the euro, down 2.7% vs. the Japanese yen, and up 7% against the Chinese yuan.  Some bigger notable moves included a 19% rise against the British pound and a 14% decline vs. the Russian ruble.
Turning to international stock markets, Brazil spiked 39% and Canada climbed 17%.  Within Europe, Germany and France were up mid-single digits.  Japan was flat and China fell 12%.
Below is a diagram of 2016 returns for various global asset classes.iii
Let’s hope that the Trump presidency has a better start to the New Year than Mariah Carey.  While the optimism surrounding the economy and stock market should carry into the new year, expectations are lofty.  Tax reform, regulation reductions, and infrastructure programs are assumed to implemented quickly and easily.  In general, the consensus is that Washington turns into an efficient machine that will support the economy while still effectively addressing society’s problems.  At the risk of making a 2017 prediction, that’s not going to happen.
And how long the Trump honeymoon lasts is a critical question concerning the rally in equities.  Traders have become so smitten with the president-elect that stocks charts are transformed into billboards supporting the new administration as the one below was entitled “Make America Great Again”.iv
Unmet expectations and implementation delays could result in disappointment which could trigger a correction.  Of course, it’s unlikely that the markets would wait for an actual misstep to occur, but rather, some selling might take place before the new administration learns where the bathrooms are.
History offers some thoughts on President-elect Trump’s 2017.  Since 1928, there have been four times that a Republican replaced a Democratic President.  In each of these four examples, the S&P 500 declined at least 6.5% for the new president’s first year.v  Maybe a statistical coincidence or maybe a correlation.  Nevertheless, something to keep in mind as the term begins with so much enthusiasm and optimism.
While it will be tough to compete with 2016, this year could offer its own fireworks and surprises.  There are important elections in Europe (Germany and France) and we know how they changed things last year.  International relationships and trade policies will be altered which will have unintended consequences.  U.S. monetary policy should be tighter than recent years and, who knows, we may even get a budget out of Washington (something that hasn’t happened in years).
At this time last year, no one could have predicted what eventually happened in 2016.  It is equally impossible to accurately foresee 2017.  Whatever happens, there will setbacks as well as opportunities.  Here’s hoping a lot of the latter and few of the former.
Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

i Lao Tzu, 6th Century BC Chinese Poet
ii Bespoke Invesment Group, The Bespoke Report 2017
iii Deutsche Bank, Bloomberg Finance LP, Mark-it Group
iv Stocktwits, Mike DiBari
v Bespoke Invesment Group, The Bespoke Report 2017