Beware the Ides of March

The Trump presidency and the stock market are two perplexing affairs. Given their developments during the past few months, they would be fascinating on their own. Stocks reversed direction the day after the election and have rallied strongly as the Dow surpassed 20,000 and then 21,000. On the other side, the new administration has had an equally unique trip. Twitter has become a news outlet, executive orders are implementation devices, and no one knows what news is real or fake.

And while they are separate and independent (kind of), the stock market and the White House have had an undeniable connection since Donald Trump became President-elect. Naturally, the markets are more closely watching the president then the other way around. Investors are scouring the news wires looking for nuggets that will lead to economic growth. The latest example was last week’s Congressional speech which led to an explosive move on Wall Street the next day. All the major averages closed at record highs.

The speech didn’t contain much detail as there weren’t specifics concerning programs or initiatives nor a timeline for enactment. Yet it was enough that the indexes rallied more than 1% which was the first time this happened in the last 55 trading days. Here are the where the major indexes closed the week.

2017 YTD

Dow Jones Industrial Average +6.3%
S&P 500 +6.4%
Nasdaq Composite +9.1%
Russell 2000 +2.7%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.

The Dow has risen through three 1,000 point levels since the election – 19,000, 20,000 and, as of last week, 21,000. And while prices are up, there has not been the commensurate increase in earnings. Below is a graph of the S&P 500’s trailing P/E[i]. As can be seen, history shows other times of higher valuations, however, it will be important to see an acceleration of earnings. It would be much nicer to see this blue line move lower because the “E” is larger rather than the “P” getting smaller.

Turning to the numerator in the P/E equation, 63% of reporting companies “beat” earnings forecasts in the 4th quarter. This was higher than the third quarter number and toward the upper end of the range for the past several years. The “beat” rate on revenues was 57% which was also higher than the previous quarter and the highest in two years. Further progress for sales and earnings would be important support for stocks. Certainly, valuations could move higher, but as the chart shows, valuations don’t stay elevated for long.

Social media has become a central part of our culture. Presidential tweets, Facebook followers, and LinkedIn connections are now part of our routines. Wall Street, always trying to help (and make a buck) brought Snapchat public last week. In addition to fees on the deal, the investment bankers deserve a round of applause for the timing of the deal – the day after the markets close at all-time highs. We’d bet that they’ll be OK with the fees if they don’t hear an ovation.

SNAP IPO’d at $17 per share which was above the expected range of prices. It began trading around $24.50 and moved as high as $26 or 53% above the offering price. At the close of the first day of trading, the company was valued at $28.3 billion. To put this into perspective, Snapchat had a higher valuation than all but 173 companies in the S&P 500. This includes such organizations as Tyson Foods, American Airlines, Hershey, Yum! Brands, Molson Coors, Dollar General, Expedia, T. Rowe Price, Viacom, DR Horton, Chipotle, and Macy’s. Maybe social media companies are more valuable than struggling retailers (Macy’s and Dollar General) and restaurants (Yum! Brands, and Chipotle). Or maybe Snapchat can figure out how to fix their problems[ii].

Moving from stocks to fixed income, bonds got a punch in the nose last week. Multiple Fed heads were on the speaking circuit at the end of last week and they were unanimous in calling for a rate hike. The FOMC meets next week with a decision on Wednesday (the Ides of March).

Prior to these appearances, the market had only assigned a 33% probability for an interest rate increase in March. That moved to 88% by the end of the week. The 10-year Treasury note’s yield closed last week at 2.49% which was a jump from 2.32% the prior week.

It seems that many are worried over the Federal Reserve raising interest rates. The problem with this mindset is that the markets have already moved. Below are yield curves from last month, November and one year ago[iii]. The long end of the curve has clearly moved higher and, as the November and February 2017 yields are so close, this happened well before the much-ballyhooed December increase. The short maturities, the spot that the Fed can control, have not moved as dramatically. Until last week.

The three-month U.S. Treasury bill, which began the week at 50 basis points, spiked to 70 basis points by the end of the week. This is not a normal move for the short-end of the fixed income market. There was no immediate fall out last week, but it could be the start of increased volatility throughout the fixed income markets. This has potential to be an economic headwind as higher interest rates across the curve could increase corporate borrowing costs.

The combination of elevated valuations and rising interest rates aren’t typically part of the equations that lead to higher asset prices. However, the Trump Administration is teaching everyone that the old rules are subject to change. Wall Street, which encompasses plenty of fickle emotions, could change their view of things at any time. If, for whatever reason, support for the Trump Trade decreases, the capital markets could shift to a more volatile backdrop. However, unless signs of a recession start to appear, any pullback in prices should be contained. It could result in a much-needed correction with attractive entry points for investment capital. Or it could result in monthly Congressional addresses by President Trump.

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13901

[i] The Bespoke Report, March 3, 2017
[ii] ibid
[iii] Grant’s Interest Observer, February 24, 2017