2016 Wrap-up and Outlook for 2017
Posted by Team HFM on January 09, 2017
“Oh what a relief it is.” – Yes, after living through such a dismal market opening in 2016, seeing the S&P 500 up almost 1.5% during the first two trading days of 2017 certainly is a relief – particularly since it is added to the rally that started the morning after Election Day, which in total has added almost 7% to the index. Unfortunately, for as much as we hope to glean the full year’s performance from the initial trading days of a year, there is little if any predictive information there.
Actually, our expectations for the markets in 2017 and beyond are based on current valuations, the expected performance of the economy, corporate earnings growth, historic market reactions to similar circumstances and investor optimism. So let’s start by looking at current valuations. The S&P 500 closed at 2,270.75, just a fraction of a point lower than the all-time high it reached on December 13th of last year. When compared to what the S&P 500 companies earned, that is about 21 times 2015’s actual earnings and 17.1 times analysts’ prediction for 2016 earnings. Since 1990 that P/E ratio for the S&P 500 has averaged 19.7 for reported earnings and 16.6 for the current year’s estimated earnings. Based on these ratios and their historical averages, the market is slightly more expensive than average, but not overly so.
Historically, markets that have been slightly expensive, like the current markets, have subsequently produced moderate to poor results over the ensuing 10 years. Over the shorter term, there is very little correlation between the market’s valuation and the subsequent return. Yet, we believe that a fully valued market does put some constraints on the market’s ability to grow in the short term. When you look through the lens of the P/E ratio discussed above, there are only two factors that can move the market, the P/E ratio itself and earnings (Market Price equals the P/E ratio times the Earnings). One or both of them have to increase for the market to go up. Admittedly, there are numerous financial and economic forces that affect these two factors, but essentially, that is what the market boils down to.
Earnings recovered quite nicely in 2016. The fourth quarter hasn’t been reported yet, but it looks like they are about 20% higher than they were in 2015. Since the S&P 500 was only up 12% in 2016, that means the P/E ratio actually decreased slightly last year. Expectations are that earnings will grow another 10% in 2017. Both growth rates are a little higher than historical averages, in part because the losses that the energy companies sustained in 2015 brought down the total market earnings. In 2017, if the P/E ratio holds steady, that would imply a market return of about 10%.
Given the current market optimism, a steady P/E ratio is not a bad assumption, although that certainly could be affected by changes in economic growth and interest rates. There is certainly a lot of optimism that economic growth could improve significantly this year, given the rhetoric coming from the new administration. Our feeling is that many, although not all of the proposals by the new administration will be helpful to economic growth in the intermediate to long term. However we are concerned that the effect in the short term may not be as good as market participants are hoping for. The tipping of this delicate balance of hope versus reality in either direction could alter the change in the P/E ratio for better or worse. Furthermore, even though economic growth has been anemic since the 2008 recession, the recovery has been quite long putting the economy in what may be the later stages of its cycle. A significant increase in growth at this point could produce excesses that would negatively affect the P/E ratio. Given the strange nature of this economic recovery, even though that sounds logical it may not occur.
The most striking example of this is the unemployment rate, which at 4.7% is well below the 50 year historic average of 6.2%. More rapid economic growth could bring down unemployment rapidly enough to spark higher wage inflation, a precursor to higher overall inflation and higher interest rates, all of which would hurt P/E ratios. A unique feature of this recovery, however, has been the high number of people who have dropped out of the labor force, yet remain employable. Because the methodology for calculating unemployment does not include these people the unemployment rate may not be as low as it seems. Higher economic growth could draw these people back into the labor force, mitigating the pressure to increase wages.
The bottom line is that we believe that 2017 could be very similar to 2016, with a return of about 10% plus or minus 2-3% with a similar volatility (which in 2015 and 2016 included a 10% to 12% mid-year pullback).
This brings us to interest rates and the bond market. Prognostication in this market is much more dangerous relative to our preview of the stock market and to our past bond market forecasts. As you may know, bond yields trend for very long periods. The yield on the 10 year Treasury bond started increasing in 1945 and peaked in 1982. The reversal lasted until this past summer when it hit a low of 1.32% on July 6th. No bell rang to indicate that in fact that was the low, but it is our feeling that it was. Market forecasters have been labeling various other points over the last 4 years as the actual lows, only to be disappointed. Actually picking a major turning point is notoriously tricky. Hopefully we are not falling into the same trap.
Given the very long-term nature of interest rate moves, we are not expecting a rapid rise. The Federal Reserve has indicated that it will increase its overnight lending rates this year, probably 3-4 times and very likely only 0.25% each time. This will push up shorter term interest rates, but longer term rates (maturities of 5 years and over) are more affected by inflation and economic growth. We discussed inflation, which would certainly push up interest rates, if it occurred. Also economic growth may be somewhat stronger and cause rates to rise. Neither of these is a foregone conclusion. Counteracting those forces would be demand for U.S. Treasuries by foreign buyers whose economies are still weak and whose own bond markets have yields well below U.S. Treasury yields. (Note: buying bonds pushes up prices which move in the opposite direction of yields.) Also yields have already significantly increased from their lows as the markets reacted strongly to the presidential election. In fact the yield of the 10 year Treasury bond climbed from its 1.32% low to 2.6% before backing off to 2.43% over the last couple of days. As a consequence of these forces, we believe longer term rates are more likely to bounce around in a more sideways pattern than they are to rise significantly.
Some comments on other asset classes we use in smaller amounts:
Small Cap stocks had a great 2016 with a 21.3% performance for the Russell 2000 index. They are somewhat expensive compared to Large Cap stocks now, but given their lower exposure to exports and the relatively high dollar, they can continue to do well.
International stocks were only up 1.6% in 2016, significantly underperforming other equity asset classes. These stocks have been cheap for a while now and have benefitted from their home countries’ weak currencies. However, their anemic domestic economies proved to be a drag on their performance along with the currency loss when translating their performance into dollars.
Within the higher yielding asset classes, MLP’s, high yield bonds and bank loans had great years with returns of 18.3%, 17.1% and 10.1% respectively. International bonds returned 2.1%, about what domestic bonds returned and preferred stocks lagged with a loss of 4.2%. If we are right about interest rates, higher yielding bonds will in general outperform their more conservative counterparts in 2017. (Note that many HFM clients have exposure to these asset classes in the Satellite Bond portion of their portfolios. Short-term high yield bonds make up about 1/3 of the James Alpha fund, the Oppenheimer Senior Floating Rate Fund invests in bank loans and the Goldman Sachs Strategic income fund has exposures to a variety of fixed income securities, including high yield.)
Putting it all together, we are looking forward to a reasonably good year from the markets in 2017, while maintaining a slight bias toward the equity markets. We wish you all a happy, health and prosperous new year!