US Market Viewpoints: First Quarter 2017
The momentum from the post election rally continued into the new year. Stocks were strong this quarter having their best start to the year since 2013. The themes this quarter were volatility remained historically low, confidence is still robust and governing can be a grind. Volatility remains at record lows as there were only two days in the quarter where the S&P 500 moved more than 1%, positive or negative. This is far from normal. It was the third least volatile quarter since 1967. Confidence remains very strong as consumer and small business owner optimism has not swayed this year. Finally, getting things done in Washington isn’t always a smooth process. Expectations of sweeping changes in DC are proving to be more difficult than expected. The first attempt at the healthcare bill was unsuccessful, but largely shrugged off by the markets.
The Federal Reserve (FED) raised interest rates by 0.25% in March. This is only the third time they have increased rates since the financial crisis. The expectations are for further interest rate increases this year with the market pricing in three additional raises. This sets up for the Fed to raise rates every other meeting. The Fed’s timing is a crucial indicator. Raises in consecutive meetings has historically signaled lower stock returns in the following 12 months. The economy is improving but far from overheated, the Fed does not have to be overly aggressive in raising rates.
The top performing sectors this year were technology, health care and consumer discretionary. Tech rebounded as there was some concern they could be one of the losers with the administration change. The fears were overblown and earnings from the tech sectors were very good for Q4. This helped lift the sector 10.2% in the quarter. Health care stocks were very out of favor last year but rebounded 8.3% in the first quarter. There was no direct action on drug pricing and no change in healthcare laws which, helped the sector recover. Consumer discretionary stocks did well as consumers spent money on selected items. This was not broad based as department and mall based stores struggled.
The energy sector was the only sector with a negative performance. It fell 7.3% as crude prices slipped. The supply of oil is starting to decline, but oil companies are still working off high inventory levels. Financials and telecoms were some of the other lesser performers both up only 1.6% and 2.1% respectively. Small caps stocks underperformed larger cap names in the quarter. Finally, growth oriented stocks did much better than value names.
We remain positive on stocks in the near term (rest of the year) but are beginning to grow cautious about our medium-term outlook. The year is off to a great start and there are a lot of positive things to be excited about for stocks. The valuation for the market has shifted into overvalued territory in our opinion and this is what has us a cautious. The S&P 500 is trading at 17.6 times 2017 earnings. The five-year average is 15x and the 10-year average is 13.9x. Valuations are a poor timing tool for the market but do help shape expected future returns. When the market is overvalued or expensive it does not mean the returns will immediately turn negative or that future returns will be negative. It does signal that future returns (medium term) will be lower than historical averages.
Other risk factors we see in the market are the Fed’s next moves and the Trump administrations ability to move forward with their plans. The Fed is signally they want to raise rates and a concern is they start to raise rates too quickly. This could throw the rally off course. Wall Street has not been too concerned to date with the lack of progress from Washington. The first 100 days of an administration usually are some of the most productive. So far there has not been a lot of success on the legislative front. Expectations are high from investors that there will be tax reform legislation with infrastructure spending coming in a close second. No progress here could lead to a pull back in stocks. Other things we are watching are the level of margin debt and the lack of buying from corporate management. Margin debt can sometimes be a sign that a bull market is reaching its late stage. Margin debt is at its peak for this cycle. CEOs and other upper management have pulled back on buying their own shares this quarter. They appear to be optimistic about their businesses just not their stock! Both margin debt levels and insider buying can be contrarian indicators.
Despite our concerns, there is a lot to be positive about in the near term. Corporate earnings growth is expected to be in the high single digits to low teens this year. This is a welcome change after the earnings recession from last year. Inflation is low which will not force the fed to raise rates quicker than expected. Also, lower inflation levels historically allow valuations to run at above average levels. Consumer and small business sentiment is very strong. This is considered soft data by economist and they like to see hard data like retail sales, capital expenditures and industrial productions figures to follow through. The hard numbers have been good but not nearly as strong as sentiment. If they pick up even a little it will be positive for stocks. The legislative agenda has not gone as expected but regulations are being reduced. This has been welcomed by many in the business community and could trigger more spending by corporations.
In general, there is no reason to sell stocks today. We are optimistic that this year will be another positive year for stocks. We do expect volatility to return this year and we caution you to be prepared. Things have been very complacent and that is not a normal environment for stocks.
You can read our 2016 Fourth Quarter US Market Viewpoints here.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.