2017 4th Quarter Letter
US equity markets achieved notable gains in 2017 as investors grew confident in the strength of economies worldwide. Robert Bender and Associates’ equity composite significantly outperformed the equity markets in 2017, as our companies have produced outstanding cash flow and earnings. Over the past year, stocks appreciated on the back of a sustained rise in corporate earnings, rather than multiple expansion. This is a key difference between the current market cycle and other periods of market strength. Stocks also responded to reduced regulations and lower tax policy for corporations. While economic growth is accelerating worldwide, we feel central banks will continue to be wary of deflation, and interest rates should remain low throughout 2018.
For the first time since the expansion began, world economies are experiencing simultaneous economic growth. The US, Europe, and Asian economies have moved beyond being solely driven by monetary conditions and are being led by companies producing consistent earnings and cash flow. Those who still feel the current expansion is being driven primarily with easy money have stopped paying attention. The Fed ended their quantitative easing program in 2014, and raised short-term interest rates in 2015. Rather than fall back into recession as many sceptics predicted, the economy has continued to grow and create new jobs.
For long-term investors, the central determinant of stock prices is growth in earnings per share. While the economic backdrop and direction of interest rates are key factors, stocks are ultimately priced as a multiple of earnings. From 2014-2016, the S&P 500 averaged annual earnings per share of approximately $118. As economic growth has accelerated and regulatory burdens on companies have decreased, estimates for S&P earnings have risen over the past year. Investors now expect S&P 500 earnings of approximately $132 for 2017, an increase of 12% over 2016. The three-month earnings revision ratio, which indicates the number of companies revising earnings higher vs. lower, currently stands at 1.31. This is the highest reading in 6 years. With the combination of recent tax-cuts and a further move towards deregulation, many investors are starting to feel the S&P 500 could earn $150 or more in the coming year.
Many of our holdings should benefit from the changes in tax policy as they maintain large cash balances overseas. This could particularly benefit health care and technology companies as they are among the largest holders of overseas cash. Historically, companies have used repatriated cash primarily on stock buybacks and dividend increases. This time, several companies have responded to tax policy changes by announcing higher wages, increased hiring, and accelerated capital investment. As 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 and corporate profits. Compliance with government rules and laws are a greater encumbrance on small companies, and regulation hinders small business formation, growth, and job creation.
Considering the return of corporate earnings growth, it is natural stocks have moved higher over the past year. Several of our technology stocks were among the market leaders in 2017, as investors rewarded companies with the strongest growth prospects. The current market environment is very different than the dot-com craze as it is earnings driven rather than multiple driven. This has enabled stock prices to rise without seeing their valuations become excessive. For example: If a stock rises 30% in a given year, yet also sees a 30% rise in earnings per share, the price/earnings ratio of the company remains the same. This dynamic has played out for several of our companies in 2017.
While the Fed has begun to tighten short-term interest rates, the market now seems comfortable higher interest rates will accompany a higher rate of GDP growth. Even though short-term rates are rising, they remain at extremely 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. The level of liquidity in the banking system in the form of net-free reserves and the steady growth of M2 money stock should provide a solid foundation of liquidity for the economy for the next several quarters.
Based on earnings expectations for 2018 of $145.00, the S&P 500 market multiple is valued at approximately 18.4.x earnings. Robert Bender & Associates’ PEG ratio, which measures the price-earnings ratio of a company relative to its growth rate, now stands at 1.58x for 2018. The number of new highs on the New York Stock Exchange reached 471 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 in 2018 as earnings growth keeps pace with the stock market.