The economy is strong. The US has enjoyed two quarters in a row of 3% or better growth, even with the disruption caused by the hurricanes. Earnings for the S&P 500 for 2017 will increase at a double digit rate for the first time since 2011. A further double digit gain is forecast for 2018, even without tax “reform.” The S&P 500 has returned over 15% year-to-date and some 25% since the Presidential election. The University of Michigan Consumer Confidence survey is at an almost record positive 100. And, small business optimism is at a similar high. Capital spending plans are improving daily.
Say what you will about the administration, regulatory reform and a more business friendly tone are freeing the economy of the shackles that have been holding it back. In particular, the EPA and Consumer Finance Protection Bureau are no longer intimidating folks with unnecessary and overreaching rulings.
If the tax “reform” passes, earnings will be an additional 5% greater next year. The S&P 500 could earn $150 per S&P share in 2018. So, on that basis, with the S&P at 2600, it is selling at a forward price/earnings multiple of 17.5x. That is certainly not unreasonable with interest rates where they are. The even larger benefit from the “reforms” is the repatriation of hundreds of billions of dollars of cash held overseas on the balance sheets of our best international companies. Apple has $216 billion, Microsoft has $109 billion, Cisco has $60 billion, Johnson and Johnson has $41 billion, and so on. This will be the cherry on the top of the sundae for corporate America and economic growth!
The hard question for investors is how much of this is already in the market? The Investors Intelligence Survey is a good reflection of market sentiment. These researchers read hundreds of market letters determining which of the investment “professionals” are bullish (optimistic), or bearish (pessimistic). Currently, the numbers are overwhelmingly bullish. In fact, the difference in the percentage of letter writers that are bullish vs bears is close to 50%. That is the highest in the last 30 years. In a market that has not had even a 3% pullback in the last year, that presents a problem. Who is left to buy? Over the next few months, a pullback of 3-7% is likely to correct this “overbought” condition. My guess is that this occurs in January and February, or sooner if the tax “reform” actually passes this year.
Whether the correction is contained in those parameters on a longer term basis depends more on monetary conditions. The new Federal Reserve chairman will likely continue the gradual tightening program begun under Dr. Yellen. That means another short-term rate increase in December, and, at least three more next year as planned. Higher inflation hasn’t showed up yet. But, it is coming.
An old saying is that “bull markets have a copper top.” That means that when basic commodities like copper start to see dramatic increases in price, the underlying rates of inflation begin to reflect it, as do wages. The Federal Reserve has always reacted to this by raising rates, slowing money supply growth, etc. Eventually this leads to a flat yield curve, and an economic slowdown, and an end to the bull market. Copper prices have risen from $2.20 per pound to $3.10 in the last twelve months.
This Bull market is getting long in the tooth. A “normal” correction is likely near term. A larger selloff is not likely until monetary tightening starts to bite. That might be 12-18 months from now.
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 Chappell 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.