2017 3rd Quarter Letter
Many investors remain hesitant to invest in the stock market based on concerns regarding the duration of the current economic expansion. While this is the third-longest expansion in US history, it is also among the weakest. Since 2009, US GDP growth has averaged 2.1%, the slowest since 1949. While most economic recoveries experience sharp upturns, the current expansion has been weighed down by excessive regulatory burdens and restrictions on capital. These restrictions have resulted in improved bank balance sheets but have also reduced monetary velocity.
Growth stocks have excelled in this environment as their higher rates of earnings growth and cash flow make them attractive vs. other sectors of the market. Despite the recent strength in the equity markets, only 33% of individual investors describe themselves as bullish. This is below the historical average of 38.5%, and has been declining as the market has moved higher. Individual investors have been net sellers of stocks throughout the current cycle and remain largely on the sidelines. This sentiment is inconsistent with the extreme bullishness often associated with market tops.
As recently as June, the Fed stated its intention to raise short-term interest rates 25 basis points by December and to expect additional rate hikes in 2018. However, Fed policy is likely to change following the recent hurricane damage. In addition, recent inflation data of 1.4% falls well below the Fed’s stated 2% target. Based on Fed funds futures data, the odds of a rate hike in December have fallen to less than 20% vs. 36% a few months ago. Fed funds futures don’t anticipate another rate hike until September 2018.
While many investors are concerned about rising short-term interest rates, we feel the Fed will remain cautious on further rate increases as inflation remains benign. However, as economic growth has picked up and US banks have improved their balance sheets, the Fed has become more comfortable with reducing debt. We feel the Fed will proceed slowly in the unwinding of its balance sheet while keeping an eye on asset prices. Since the financial crisis, Fed policy has favored large institutions when it comes to lending. The Fed’s new emphasis on small business lending should lead to improved job creation as small businesses produce over 80% of new jobs in the US.
For long-term investors, the primary determinant of stock prices is growth in earnings per share. While the economic backdrop and direction of interest rates are also key factors, stocks are ultimately priced as a multiple of earnings. Many investors have been surprised by the strength in corporate earnings this year as the consensus felt profit margins had peaked. Lower regulatory burdens on business have been a primary factor. Compliance with government rules and laws is a greater encumbrance on small companies than large ones, and regulation hinders small business formation, growth, and job creation. Because regulatory compliance has a high fixed cost, small businesses face a greater per-employee cost of adhering to government regulations.
Corporate earnings will likely remain strong into 2018 due to the small number of earnings revisions. The three-month earnings revision ratio, which indicates the number of companies revising earnings higher vs. lower, currently stands at 1.26. This is the highest reading in 6 years. Typically, earnings estimates for a given year will start the year at a high point and be revised lower, by an average of 7%. With the small number of earnings revisions, investors may begin to feel the consensus S&P 500 earnings estimate of $145 is achievable in 2018.
Based on earnings expectations for 2018 of $145.00, the S&P 500 market multiple is valued at approximately 17.5x earnings. Robert Bender & Associates’ PEG ratio, which measures the price-earnings ratio of a company relative to its growth rate, now stands at 1.29x for 2018. The number of new highs on the New York Stock Exchange reached 394 in recent weeks. Typically, investors have become more cautious when the number of new highs approaches 800. We feel the overall market multiple could remain steady into 2018 as earnings growth keeps pace with the stock market.