2017 - 1st Quarter Letter
The stock market continued to move higher in the first quarter as investors were encouraged by the rebound in US corporate profits and the growth trajectory of the economy. Business executives and investors remain upbeat over further growth in profitability through corporate tax reform and deregulation. While the Federal Reserve has stated its intention to raise short-term interest rates in 2017, the subsequent rise in the dollar will likely be watched closely as higher rates are contemplated. While a rise in the stock market’s P/E ratio is unlikely in 2017, stocks could continue to move higher on the strength of corporate earnings.
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 important factors, stocks are ultimately priced as a multiple of earnings. During the fourth quarter of 2016, after-tax corporate profits increased 22% year over year, the highest rate of earnings growth in nearly five years. This can be attributable to easy comparisons with the prior year due to the plunge in oil prices in 2015. Still, profits grew to 9.2% of GDP in the fourth quarter, up from 7.8% the prior year.
Aggregate growth in S&P 500 earnings is currently expected to rise 7% in 2017, yet many of these forecasts don’t include the impact of lower corporate tax rates. Potential changes in tax policy could result in upward revisions to S&P 500 earnings. If the effective corporate tax rate were to fall to 20% from the current 27%, it could add $12 to S&P 500 earnings for 2017. This would be an increase of 12% over 2016, and earnings would reach a level of approximately $133.00. Profits could receive an additional boost from a reduction in the tax rate on repatriated cash from overseas. This could benefit health care and technology companies since they are among the largest holders of overseas cash. Historically, companies have used repatriated cash primarily on stock buybacks and dividend increases.
Since small businesses are responsible for more than 80% of new jobs in the US, lower regulatory burdens could further boost the economy. 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, compared to large companies.
Many investors continue to underestimate the impact of high corporate cash levels. As the new administration is perceived as more business friendly, companies have started to increase investments in capital expenditures and inventories. Cash levels remain at historically high levels, and these figures tend to discount corporate cash held abroad. This high level of corporate cash should prolong growth in dividends, stock buybacks, and merger and acquisition activity.
Although the Fed has initiated higher rates, many central banks worldwide are maintaining ample liquidity and easy monetary policies in an effort to boost growth. The Fed has consistently stated its goal is to maintain a 2% inflation rate. We see very little evidence of inflation or price pressures that define an out-of-control economic expansion. Although there is some evidence of commodity and wage inflation, these metrics are consistent with moderate GDP growth. While interest rates are rising, they remain at historically low levels, particularly this far into an economic recovery. As it contemplates further rate hikes for this year, the Fed will likely keep an eye on the value of the dollar verses other currencies. A sharply higher dollar could make US products less competitive overseas.
Based on earnings expectations for 2017 of $134.00, the S&P 500 market multiple is currently valued at approximately 17x earnings. Robert Bender & Associates’ PEG ratio, which measures the price-earnings ratio of a company relative to its growth rate, now stands at 1.20x for 2017. While the stock market has moved higher in the first quarter, the number of new highs on the New York Stock Exchange reached 227 in recent weeks. Typically, the number of stocks reaching new highs approaches approximately 800 near market tops. We feel the overall market multiple could remain steady this year as earnings growth keeps pace with the stock market.
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