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
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