Be Careful What You Wish For, You Might Get It

We are at the point in the year where the season for giving thanks transitions into a season of wishes. Normally this enjoyable tradition is a thoughtful, well intentioned part of the holiday season.  This year, however, these lists probably have some additional and unique items.
President-elect Donald Trump’s name is likely on many wish lists this year. The range of the wishes associated with Mr. Trump are spread from loathing and disgust to supporting admiration.  Over time these two factions should come closer together as the critics move to Canada and the devotees become disappointed in the pace of change.
Another common wish is among the media and experts who are supposed to offer insight on events such as elections.  They are desperately trying to get one right.  Being totally wrong on Brexit and the U.S. presidential election has left a mark.  And the streak continued the weekend before last with a French primary election having another upset winner.  It has been a very bad 2016 for this group.
The Federal Reserve has some wishes.  They wish to raise interest rates.  Further they would like to see a pick-up in the inflation rate.  They’ll likely get this first wish before Christmas as the FOMC is expected to increase the fed funds rate by 25 basis points at their meeting later this month.  Looking forward, there are predictions for more fed funds rate increases in 2017 and some high profile Wall Streeters are predicting the 10-year note’s yield to exceed 5% (it’s currently at 2.4%).  It’s hard to imagine the U.S. economy withstanding a doubling in yields.
Wall Street has many wishes with a big one being an improvement in its standing.  As evident during the never ending political television ads during the campaign, it is a distrusted and cynically viewed part of our culture.  The legal profession should be grateful as Wall Street has easily (and by a wide margin) replaced lawyers on the bottom of the reputational totem pole.
Another wish from the stock market bulls is for more of the Trump rally.   Other than a slight pullback last week, U.S. equities have surged after the election.  The leaders have been the small cap stocks as well as financials, energy, and industrials.  The S&P 500, Nasdaq and Russell have all reached record levels since the election.  The Dow, with much fanfare, has made new all-time high, surpassing 19,000 while the Russell was up for 15 days in a row.
To help appreciate this spike since the election, we are including “performance since the election” with our regular year-to-date numbers for the major averages.  A significant portion of 2016’s gains have come within the past few weeks.
2016 YTD         Election
Dow Jones Industrial Ave             +10.0%                   +4.5%
S&P 500                                        +7.2%                     +2.6%
Nasdaq Composite                        +5.0%                     -1.2%
Russell                                          +15.7%                   +10.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
A notable number in the above table is the Nasdaq’s losses since the election.  This weakness has been blamed on worries over President-elect Trump’s immigration and trade policies which might increase costs for tech companies.
Valuation is another headwind for tech stocks.  Based on such measures as P/E, EBITDA (earnings before interest taxes depreciation and amortization) ratios, and dividend yields, ‘new’ technology (such as the FANG stocks) is expensive.  Granted these industries have greater growth potential but a good portion of that growth is priced in.
This rotation out of technology goes beyond valuation.  Donald Trump’s presidential victory represents the largest shift in government’s role in decades.  This change should not be underestimated.  As Anatole Kaletsky points out “political events can sometimes have a much greater impact than the monetary and economic “fundamentals” that investors normally consider more important.”[i]
Although the details of Trump’s economic plan are not fully known, generally, a more business friendly landscape is expected. Predictions are for a reduction of regulations (especially in banking and finance) and for increased fiscal stimulus primarily through greater infrastructure spending.
Whether the reason is politics or economics, the capital markets’ aren’t waiting for the inauguration.  They are pricing in stronger growth, higher inflation, higher interest rates, and larger fiscal deficits.  Stocks, interest rates, and the dollar are moving up.
Some are predicting a repeat of the economic cycle that began in Ronald Reagan’s first term.  And while there are some similarities, there are some critical differences.  In 1982, interest rates were at a generational inflection point which turned into 35 years of declining rates.  2016 might be another inflection point but in the opposite direction.  Not only are we without the boost that declining interest rates gave the 1980’s, rising rates will be a headwind.  And likely for many years to come.
In early 1980’s, stocks were despised.  Numerous magazine covers (remember this is before the internet when The Wall Street Journal, Forbes, Fortune, etc. were must have subscriptions) proclaimed the death of equities.  Very few wanted anything to do with Wall Street which translated into insanely low stock valuations and very attractive dividend yields.  It was huge news when the Dow climbed above 1,000!
Looking at the valuations, P/E’s were in the single digits 35 years ago.  In fact, in some cases the EPS (earnings per share) amount was greater than the P/E.  Blue chip dividend yields were also in the upper single digits.  A far different story from today where the S&P 500’s P/E trades at mid to upper teens and the dividend yield is barely over 2%.
Market sentiment changes quickly.  A month ago the market’s feared a Trump win and were declining every time a poll suggested he had a chance.  After the results Wall Street quickly changed its mind.  The biggest moves have been a rally in stocks, a drop in bond prices (higher yields) and a rise in the value of the dollar.
As enjoyable as the rally has been, we must keep in mind that investor sentiment can quickly change again.  While this doesn’t seem likely in December which is historically a bullish month, there is a Fed meeting next week. A 25 basis point hike in the fed funds rate is fully expected so the only surprise would be that the committee holds the rate the same.  Beyond the Fed meeting, the markets have built up some pretty lofty expectations for 2017.  Here’s wishing that the economy can deliver.
Jeffrey J. Kerr, CFA

[i] GaveKal Research, December 2, 2016
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional
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