Brother, can you spare a dime?[i]

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