Market Trends Report (1/23/2017): Focus on Equities

In Charts & Data, Economics, Investing, Market Trend Report by Global View Team

U.S. Equity investors have been favoring Small Cap and Mid Caps since the Presidential election. We expect that trend to continue as fiscal policies will favor domestic producers in 2017. This trend has a ton of momentum and investors will want to be aware of how to invest in these sectors.

Expectations

We ignore the media and use independent data to analyze trends. Our data analysis includes multi-faceted quantitative measures geared toward measuring where money is truly moving. Knowing where investors are putting their money is a clear sign of where strength truly lies. Here is what the markets are telling us:

  • Expectations for GDP growth are rising
  • Inflation expectations are rising
  • Interest rates are rising
  • Expectations for higher take-home pay for U.S. workers
  • Expectations for higher after-tax corporate profits are rising
  • Asset class rotation is underway (this is known as the Reflation Trade as investors are rotating from bonds to U.S. equities)
  • U.S Dollar is strengthening
  • Equities are in a period of consolidation

As covered previously, consumer and investor sentiment remains high. This bodes well for the economy in general. However, equity markets were overbought after the election and have been consolidating for weeks. As long as there are no negative surprises, it is likely there is another leg up in the equity rally. Here are the leaders since the election that investors will want to consider being overweight:

Rising Interest Rates

The bond market is pricing out deflation or any recession fears (see chart). Although inflation has not yet been priced in, there are indications in the gold market, industrial metals like steel and soft commodities like agriculture, as prices rise. These are very sensitive to actual supply and demand, so we will need to see a follow-through on these trends before committing to these asset classes in a meaningful way.

Janet Yellen was clear this week that she is planning to continue raising interest rates. However, her moderate stance seems to remain as she cited “a few” rate hikes per year through 2019. While she referenced that inflation is meeting Fed expectations, she does not want to kill the economic momentum. Referencing inflation in a speech at Stanford, Yellen remarked, “a natural question is whether monetary policy has fallen behind the curve. The short answer, I believe is ‘no’.”

Yellen also pointed out that the economy is near full employment. However, there is plenty of room for wages to rise, especially across the lower-pay half of jobs. Said Yellen, “Even if the labor market is not overheated currently, one might worry that overheating could rapidly emerge as labor market conditions strengthen further, causing inflation to surge. I consider this unlikely for several reasons…”

Rising rates also impact asset allocations into equities as currency strength from relative monetary policy is impactful. Assets in rising currencies not only receive appreciation from the security, but the currency held in. For assets held in foreign currencies that could negatively impact total return. As such, any allocations outside of the U.S are currently currency-hedged as the U.S Dollar continues to strengthen via other G-7 currencies (see chart).

Tax Reform Supports Valuations

In our October 2016 quarterly letter, we noted how valuations were becoming very stretched. Like most, we weren’t sure what policy would bring in 2017 because we weren’t sure who would win the Presidential election.

As we pointed out in our annual letter this month, if tax policy can create growth in the economy and add revenue to corporate balance sheets, then valuations very well could be supported. In addition, economic growth would be likely to stimulate further advance in equity shares as earnings once again started to grow after the recent earnings recession that lasted six quarters.

The potential for corporate tax reform on index valuations (see chart) across the U.S Equity spectrum is very interesting. As market cap weighted, earnings weighted and dividend weighted multiples fall, this could boost the S&P 500 by nearly 10% if corporate tax rates fall to 20% and 16% if corporate tax rates fall to 15%. That would put the S&P 500 at year-end between 2,500 – 2,650. Small-Cap 600 & Mid-Cap 400 could be even higher. So, for now, indicators are leading assets back on the U.S. Equity train.

Why SmallCap and MidCap Equities

The strong dollar makes it more expensive for people in other countries to buy goods made in the U.S. This is generally seen as a drag on the earnings of multinationals. Most of those companies reside in the S&P 500 which are the large caps.

Interestingly, with repatriation of offshore profits as a likely part of tax-reform, those companies could see new money on their balance sheets coming back from offshore. That could stimulate profits in the short-term. More importantly, it could stimulate the economy domestically as dividends, share repurchases and business investment occur. Domestic economic stimulation is typically very good for small and mid-size companies.

Among sectors that could do well under a Trump Administration are regional banks, industrial companies and domestic energy. Many of those companies are of medium size. A great deal of the companies that service and supply the medium size companies are smaller. So, while some large caps might tread water, the medium and smaller companies should continue to do very well.

People should keep in mind that when small and mid-size companies do well, the economy typically does very well. Employment and wages both rise and that has a positive knock on effect. Preventing bubbles is the key down the road and at least in theory that’s what the Fed is there for.

The Markets Now

Since mid-December the equity markets are in a period of consolidation which is very normal when prices rise rapidly. It’s a way for investors to take a breather and look for confirmation on their forward-looking actions. The inauguration should be the point from which investors will assess the policies coming from Washington D.C. to see if President Trump and Congress will pass the policies that put them in the White House.

Global View remains cautiously bullish until any real risks present themselves materially. Everything else is simply conjecture. We continue to overweight the sectors noted at the top of our Market Trends Quickview Report seen below. As seen in that report, the money market option remains near the middle of our rankings. That means there are plenty of places to put money to work in a good risk-adjusted way.

Contact us with any questions or to discuss how our approach to tactical asset allocation can help you control risk and take part in opportunity.