With the S&P 500’s forward P/E ratio at approximately 17.5x, stocks continue to trade at an elevated multiple relative to the 25-year average of just under 16.0x. Per usual, the current environment includes reasons for both optimism and pessimism. On the positive side for markets, earnings are growing, the Trump administration continues to offer the possibility of tax reform, deregulation, and infrastructure spending, all of which would be viewed as positive for growth, and interest rates remain low. Those more skeptical toward stocks point to elevated corporate profit margins, expectations for higher interest rates, and uncertainty in whether the new administration will be able to enact their pro-growth policies.
For the first quarter, earnings for the S&P 500 are expected to grow 9.2%. This would mark the highest earnings growth for the index since Q4 2011. Sectors expected to drive earnings growth in the quarter are energy, technology, and financials. Sales, a number many view as a cleaner read into the health of the economy than earnings, are expected to increase 7.1% versus a year ago. Furthermore, analysts, who often make downward revisions to expected numbers ahead of results, have actually made a greater number of positive than negative revisions to revenue forecasts in March. This is the first time that has happened since 2014. The trajectory of company fundamentals appears headed in a positive direction.
Though expectations are for solid Q1 earnings growth, doubt has crept into the market and stocks have moved sideways since mid-February following the post-election surge. Market sentiment always oscillates, but the frequency with which those swings occur seems to have increased of late. The recent choppiness seems to be a tug of war between those believing in a future with improved growth and one where secular stagnation remains the status quo.
The market’s recent lack of direction is almost certainly a byproduct of the environment of increased uncertainty. President Trump hasn’t cultivated a reputation for predictability and his comments, such as those included in his recent interview with the Wall Street Journal, have kept the market on its toes. Recently, the administration has seemingly adjusted its position on NATO, China’s currency policy, the Export-Import Bank, the status of Janet Yellen as Federal Reserve chair, the desirability of a low interest-rate policy, and the prioritization of health-care reform versus tax reform. Layer on top of this the geopolitical uncertainty related to North Korea and Syria, and frequent sentiment changes in the market are understandable.
Viewed as the largest potential beneficiaries, small cap stocks are a reasonable gauge for confidence in the new administration’s ability to enact tax reform and prop up growth. Between Election Day and the end of 2016, the Russell 2000, a benchmark for U.S. small cap stocks, rose an impressive 13.6%. This was well ahead of the S&P 500, which was up 4.3% over the same timeframe. In 2017 the fortunes of the two indices have reversed, with the Russell 2000 down slightly year-to-date while the S&P 500 is up approximately 4.5%.
Bond yields and inflation expectations are also indicative of skepticism regarding future growth prospects. The 5-year implied inflation rate from Treasury Inflation-Protected Securities (TIPS) is currently at approximately 1.75%, down from recent highs of around 2.00% in January. Yields on 10-year Treasuries, correlated with GDP growth, have also contracted and have been down for five consecutive weeks to around 2.20% versus 2.60% in mid-March.
To the extent the market’s day-to-day shifts in sentiment are reflective of the collective belief/skepticism in the Trump administration’s ability to enact pro-growth change, a wait-and-see stance seems prudent. Given the progress to date (or lack thereof), some skepticism around the implementation of pro-growth policies is understandable. However, it shouldn’t come as a huge surprise that some of the potential changes the market was initially positive on might take time to put into place, even with Republicans in charge of both branches of Congress. Wagering on rapid change coming out of Washington has generally been a losing bet.
In the interim, eyes will be on the upcoming earnings results. Solid Q1 earnings accompanied by positive management commentary could help swing sentiment in the positive direction and break the sideways trend we have seen since February. As always, there are risks, but steady growth in what remains a low rate environment should continue to support stocks.
James M. Skubik, CFA