January Investment Comments


The S&P 500 has continued its run, returning more than 17% year-to-date through November.  The steady rise this year, with only modest turbulence, has increased the number of market observers highlighting an “overheated” market where investors have become complacent.  Not to completely dismiss these concerns, but a fact-based analysis helps to put the current situation in perspective.  Returns in 2017 have generally been driven by valid reasons, including global economic growth, rising corporate profits, and the likelihood of tax reform.  The most recent report from the Labor Department showed nonfarm payrolls in November rose a solid 228,000, the 86th consecutive month of expansion.  Steady hiring has brought the unemployment rate to 4.1%, a 17-year low.

This positive backdrop is expected to produce 10.2% earnings growth for the S&P 500 in 2017.  Consensus estimates put Q4 growth at 10.6%, which would mark the third time in the past four quarters we experienced a double-digit increase.  Looking ahead to 2018, earnings for the S&P 500 are expected to rise approximately 11%, to $146.  If tax reform passes, estimates suggest it would add approximately another $10 to composite earnings.  This would bring the forward P/E multiple to 17x, higher than the 5-year average of 15.8x but far from levels divorced from rationality.

Speaking of which, the substantial increase in the value of bitcoin has received extensive media coverage and captured the imagination of many.  Coinbase, which allows one to buy, store, and sell bitcoin, recently became the most-downloaded iPhone app in Apple’s U.S. app store.  The digital currency is up more than 1,500% in 2017 and approximately 85% in recent weeks.  Jokingly, one commentator highlighted that in bitcoin terms the S&P 500 is in the midst of a crash.  Certainly, moves like we have seen in bitcoin prompt one to think of other manias that have ended poorlythough opining with any certainty at this juncture is likely a fool’s errand.

The function of a currency is to serve as a store of value and a means of exchange.  How good bitcoin is at either of these is up for debate.  Determining the intrinsic value of bitcoin is all but impossible as it generates no underlying cash flow.  This puts the digital currency in a similar category as art or other collectibles, meaning buying bitcoin today is done in the anticipation one could sell at a higher price to someone else later.  This could work out well or poorly.  As Warren Buffett’s teacher, Benjamin Graham wrote decades ago, “The speculative public is incorrigible.  In financial terms it cannot count beyond three.  It will buy anything at any price, if there seems to be some ‘action’ in progress.”  There is definitely some “action in progress” in bitcoin right now.  Sentiment will drive prices, and who is to say where that stops?  After all, Paul Newman’s Rolex Daytona watch recently sold at auction for $17.8 million and Leonardo da Vinci’s “Salvator Mundi” sold for $450.3 million.

A more valid relative comparison to the S&P 500 than bitcoin is the level of interest rates.  The current forward earnings yield (E/P ratio) for the S&P 500 is 5.5% versus the 10-year Treasury yielding about 2.4%.  To us, this is a comparison that continues to favor stocks.  However, this relationship is dynamic and worth watching carefully.

Many have pointed to the impact global central banks have had on lowering interest rates.  The Fed’s quantitative easing program increased the size of its balance sheet to $4.5 trillion through the purchase of Treasuries and mortgage-backed securities.  The European Central Bank has been buying €60 billion of bonds per month, and the Bank of Japan has also been acquiring government bonds to keep its 10-year yield near 0%.  These actions have pushed interest rates lower across the globe.  According to JPMorgan, there is now more than $10 trillion in global government bonds with yields below zero.

However, central banks have begun to withdraw their support.  In response to solid economic performance and substantial improvement in the labor market, the Fed started the process of reducing its balance sheet in October.  To be sure, the Fed’s unwinding of quantitative easing will be slow, but combined with rate hikes, it is clearly reversing direction.  The European Central Bank has also announced it will cut back its bond purchases to €30 billion starting in January 2018 and signaled its quantitative easing program could end as soon as September 2018.  Central banks pulling back stimulus on this scale is uncharted territory and introduces risks.

This raises the question, “what impact have global central banks had in pushing down interest rates, and what happens when central banks remove their support?”  This question does not have an easy answer, but a rough estimate comes from looking at the historical relationship between nominal GDP growth and the yield on 10-year Treasuries, which have typically mirrored one another.  Nominal GDP growth has been around 4%.  In alignment with historical norms, increasing the yield on the 10-year Treasury to match nominal GDP growth would change the comparison to an earnings yield of 5.5% for the S&P 500 versus a hypothetical treasury yield of 4.0%.  This is less favorable for stocks than our prior comparison, but wouldn’t necessarily threaten stock prices.

Though the President has yet to score a major legislative victory, less regulation is one campaign promise that is coming true.  Financial commentator Gary Shilling recently pointed out in a Bloomberg article that the Competitive Enterprise Institute last year found regulation cost American businesses $1.9 trillion, much greater than the $344 billion in corporate taxes.  New regulation under the current administration is at its slowest pace since the 1970s.  Through June, the federal government had made 1,731 preliminary, proposed or final rules, down 40% from the 2011 peak under President Obama.  Furthermore, many actions taken under President Trump are reversals of earlier rules made under the Obama Administration.  Though the merits of such deregulation are the subject of intense debate, in the near term this is a trend that is clearly positive for stocks and one that is likely to continue in 2018.

James M. Skubik, CFA