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CANEY CREEK REPORT - Happy Days

| January 29, 2018
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The US equity market, expressed as the Standard & Poor’s 500 Index, has had a pretty good year in January.  The index has already returned 7.5% through January 26 for this year.  Foreign markets have also been fantastic.  The Vanguard Emerging Markets Index Fund has returned 10.6%.  And, the Total World Index Fund has returned 7.4%.  Bonds have done poorly.  The Total Bond Index has returned -1.0% during the same time.

The S&P is already up toward the top of the trading range that we anticipated for the year as investors try to capture the benefits of reduced corporate taxes here, as well as the “synchronized” growth in global economies.  There is a lot of positive leverage for earnings from these things.  Estimates for operating margins for the companies in the S&P have recently increased from about 10% to 12.5%.  This is almost double what they were 20 years ago.  

I am guessing that we have probably been too conservative in our outlook for earnings after tax reform.  Forecasts for S&P 500 earnings for 2019 have moved up to $165 per unit.  On those numbers, the index is selling at a price/earnings multiple of just under 18X.  That is not excessive with interest rates where they are.  So, it would not surprise me that the index overshoots the top of our forecast by a little.  But, we still believe there will be some rough patches to get through this year.  

First, in the short run, Sentiment points to a severely “overbought” market.  Investor Intelligence reports some 65% Bulls and only 12% Bears.  It is hard to see where a lot of new money can come from to push stocks higher.

Second, Monetary factors are changing.  Short term rates are rising relative to long rates.  And, the Federal Reserve is looking to raise short term rates a further 0.75 - 1.0% in 2018.  A two-year US Treasury now yields about 0.5% more than the dividend yield of the S&P 500.  Bond yields will continue to rise giving more competition to stocks. 

Why would bond yields rise further?  Inflation.

The dollar has been, and remains weak versus other currencies.  Costs of foreign goods are therefore going up.  We are importing inflation.  Materials costs such as copper, oil, even gold are hitting new highs for this cycle. 

We are in a close to “full employment” economy.  Labor costs are rising at about 3%, and you can expect that level to accelerate.  It is likely that the federal minimum wage will increase this year to $10, from the $7.25 that it has been since 2009.

Rising inflation will translate into rising bond yields (lower bond Prices).  That eventually puts a top on stock valuations. 

Our biggest near term concern is the universal Bullishness.  By summer, the midterm elections will dominate the news.  Recent election results have not been encouraging for the current pro-business administration.  The market could become wary of a serious change in power in the fall.  That is not in the stock market.

I would be careful about adding new money to stocks today.  Average in slowly over coming months.  It certainly has been a great ride.  And, fundamentals remain good.  But, I would keep a close mental stop loss under your equity portfolio. 

  A note from WSC and WAMI . . .

Robert C. Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant.  Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Chappel Hill, Texas.  He now lends his expertise and knowledge of the markets to our company and customers.  We hope you find it interesting and insightful. 

 

Woodland Securities Corporation, Member FINRA and SIPC

Woodlands Asset Management, Inc.

10655 Six Pines Drive, Suite 100

The Woodlands TX 77380

281-367-2483

 

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