Last week, our entire research and portfolio management team got together, as we do each quarter, to discuss our investment philosophy and process. We were focused on developing the behaviors of successful investment teams. One of the most important behaviors has to do with intellectual curiosity. Because investment markets are always changing and the available investment strategies continue to evolve, it is imperative that the group remains open to looking at information in a new way.
Because our investment decisions are made in groups, we discussed the challenge of ensuring that investment ideas take into consideration both positive and negative perspectives. In order to do this better, we agreed that discussions regarding a change in strategy should incorporate a devil’s advocate—someone who would take an opposing view to that of the majority of the group and present the alternative.
Recently, stocks have strung together a number of new record highs across many market indices, so I thought it might be appropriate to take the opposing view to those new highs and discuss what could go wrong with the current optimistic outlook.
We believe stock prices have been moving higher for three reasons. First, corporate earnings reported for the fourth quarter of 2016 have been very good. In fact, (using the S&P 500 Index of stocks) when compared to the fourth quarter of 2015, they are nearly 24% higher. Much of this has to do with the recovery in the energy sector. At the end of 2015, the sector lost $8.20—much worse than the $.98 profit made during the last quarter of 2016. Results in other sectors, like health care (up 17.8% year-over-year), technology (up 14.8%), and consumer staples (up 8.7%), were also very good.
Because we suffered a multi-year decline in earnings, this improvement has been pushing prices higher as investors believe this is the beginning of an up-trend in faster earnings growth. The estimate for S&P 500 Index earnings in 2017 is near $131, more than 20% higher than 2016. (Because all companies in the S&P 500 Index have not reported Q4 2016 earnings, we are including actual operating earnings for companies that have reported through 2.17.17, and estimates for those that have not yet reported. Source: spindices.com.)
The second reason for higher stock prices has to do with the potential for new fiscal policy. The Republican victory in November has led to discussion about lower taxes for corporations and individuals, which could boost business and consumer spending. It also suggests that we will see a reduction in regulation, especially in sectors like energy and financial services, two industries that have seen a reduction in capital returns due to regulation. As long as Congress and the administration are talking about making progress, markets will continue to view these potential policy changes positively.
Finally, the improvement in the U.S. economy’s performance has lifted stock investors’ attitudes. While stocks don’t track the economy closely over short periods of time, in the long run, economic growth and stock price advancement are highly correlated. Over the last six months, the economy (real gross domestic product) grew at a 2.67% annualized rate, while for the last year it grew at only 1.90%. This acceleration in the growth rate has buoyed stock investors’ perceptions of future prospects for the economy.
These positive feelings are aided by the rhetoric from the Federal Reserve, which began raising interest rates in December of 2015, because it believed that the economy’s performance, and inflation would be headed higher. The Fed raised them again in December of 2016 because it felt that higher inflation, reflecting better growth, warranted another move away from the easy stance it has taken for several years.
Playing the devil’s advocate role, let’s poke some holes in stock investors’ optimistic outlook for both prices and the economy this year. In order to do this, we must understand that fiscal and monetary policy changes take some time to affect things like the growth rate of the economy and inflation. This lag effect can vary based on the type of policy we are talking about.
While there are many things that led to improvement in last year’s economic performance, we’ll focus on three. These include a reduction in energy prices, a reduction in interest rates and wage growth.
During the first quarter of 2016, oil prices declined to nearly $25 per barrel, a drop from more than $100 in mid-2014. This decline in oil prices provided a stimulus to the economy in the form of lower gas prices, which increased consumer spending and lowered energy costs for businesses, which in turn can add to profitability. Now we have a 100% increase in energy prices, with the current cost of a barrel of oil exceeding $50. Those positive effects of declining energy prices could reverse themselves as we move through 2017.
The rate of inflation has risen as a result of the increase in energy prices and better economic growth. This has given the Federal Reserve the confidence to further increase interest rates. As a result, we have less stimulus coming from monetary policy in the U.S., and this should serve to reduce the economic growth rate in the future. As bond investors begin to worry about future Fed hikes, they have sold off intermediate bonds; rates now stand more than 1% higher than mid-summer of last year. Higher interest rates serve to raise the cost of borrowing and reduce corporate profitability. So, while last year saw a precipitous decline in interest rates in the first half of the year, we have since seen rates rise, which could reduce economic growth and earnings.
Finally, wage growth has been accelerating as the labor market tightens. A low unemployment rate makes workers scarce and raises wages. While this benefits consumers in the short run by providing them with additional disposable income, longer term it hurts corporate profitability. Companies have benefitted from slow wage growth until last year. Eventually, companies begin to reduce employment to maintain profits if revenue growth doesn’t pick up.
While there is a lot of optimism among stock investors, it’s possible that the forces which led to better economic growth a year ago have reversed themselves and could begin detracting from growth this year. The question will be whether or not the new fiscal policies are enough to offset the negative effects of higher interest rates, energy prices and wages. As always, the devil is in the details.