2016 - Fourth Quarter Letter
As 2016 came to a close, investors began to adjust their portfolios to take advantage of the expected policies of a new administration. Stocks moved higher as investors believe corporate earnings could receive a boost from lower tax and regulatory policies and a pro-growth agenda. While the Federal Reserve recently increased its outlook for short-term interest rates in 2017, the subsequent rise in the dollar will likely be watched closely as higher interest rates are contemplated. While a further 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 most of 2016 investors proceeded cautiously as they awaited the results of the presidential election. With the election of Donald Trump, investors quickly shifted gears to position themselves for major changes in economic policy. Investors now feel corporations could receive a significant boost to profits from lower taxes and reduced regulations. Aggregate growth in S&P 500 earnings is currently expected to rise 7% in 2017, yet many of these forecasts don’t include the majority of Trump’s proposed reforms. These forecasts rely primarily on incremental gains in earnings and a rise in energy company profits as the price of oil has rebounded. Mr. Trump’s proposed agenda could result in significant 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.
Since small businesses are responsible for more than 80% of new jobs in the US, lower regulatory burdens could be a further boost to 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. Profits could receive an additional boost from a reduction in the tax rate on repatriated cash from overseas. This could particularly 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.
For the first time in several years, the stock market seems less concerned about the prospect of higher short-term interest rates. Although the Fed recently raised short-term rates a quarter point, the market now seems comfortable with the fact that higher interest rates will accompany a higher rate of GDP growth. Several market forecasters have raised their GDP forecasts to between 2.4-3.00% for 2017. While interest rates are rising, they still 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 vs. other currencies. A sharply higher dollar could make US products less competitive overseas.
After outperforming in 2015, the health care sector spent most of 2016 consolidating the gains of the prior year. The health care sector also came under pressure during the election season as the issues of reimbursement and drug pricing were raised. Despite these challenges, we continue to feel it is appropriate to overweight the health care sector in our portfolios as the product flow of these companies should continue to produce strong relative earnings and cash flow in the coming years. Recent changes in the way the FDA reviews new drug candidates could lead to a more consistent flow of products to the market with high earnings potential.
Based on earnings expectations for 2017 of $133.00, 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 1.22x for 2017. While the stock market has moved higher since the election, the number of new highs on the New York Stock Exchange reached 225 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.