Market Memo: Firmly in the 'buy the dips' mode

02-13-2017

This rally that has taken the market to new highs is starting to feel overextended. We wouldn’t be surprised to see a 3-5% pullback soon. But our fundamental bullish view hasn’t changed. As noted before, we think the investor’s mindset did a 180 with last fall’s election, shifting overnight from a Wall of Worry to a Wall of Hope. As such, we have set a 12-to-18 month price target of 2,500 on the S&P 500 and would view pullbacks as opportunities to add to stocks for five key reasons:

No. 1: Animal spirits are flowing again. The Trump revolution has changed market psychology. With a pro-business cheerleader in office, confidence indicators throughout the economy are picking up. Markets are looking through 2017 to much higher nominal GDP growth (we think 5.5%) in 2018, and with this, higher earnings (we are at $140 on the S&P for 2018).

No. 2: President Trump is pushing long-term structural reform, not one-off fiscal stimulus. This is a key point that most of the analytical establishment doesn’t seem to understand. While it debates/discusses the impact of temporary measures, the White House is looking to permanently raise the low productivity growth rate of the economy and lift trend GDP growth back to previous, higher levels than former President Obama’s team thought possible. Key structural reforms that could raise potential GDP include: corporate tax reform (not just a cut); infrastructure investment to eliminate economic bottlenecks (not just FDR-style make-work); deregulation to eliminate costly rules with little economic benefit. It’s unlikely this all will be in place this year, but we think it’s looking good for 2018, and as a result, have bumped our real GDP forecast for next year by 100 basis points to 3%.

No. 3: Early interest-rate hikes will help, not hurt, the economy. Although the market worries at times about Fed rate hikes, we are in the unusual situation of seeing rates rise effectively off zero. Early moves off these unprecedented lows will help baby-boomer consumers living off their savings (their incomes will rise) and banks trying to earn a margin (their net interest spreads will expand, creating more income and bigger base off which to lend). Said differently, we are just now exiting the era of “financial repression” and are nowhere near what might normally be called “monetary tightening.” 

No. 4: Oil’s recovery is a bonus. OPEC delivered a major gift to the U.S. with its recent quota deal, which is actually being implemented based on recent data. This gives some room to U.S. producers who are rapidly stepping up production even while the downside on prices is supported. Energy is a key driver of the U.S. economy, and along with a friendlier regulatory backdrop, this is very good news.

No. 5: Rising corporate capital expenditures (capex) represent another bonus. Corporate capex almost flat-lined under former President Obama’s “you didn’t build it’’ admonition. With tax reform promising better after-tax cash flows and the immediate expensing of capex, we expect a significant business investment cycle to finally get underway.

To be sure, there are risks—there always are. Topping our list is the possibility Trump ends up spending too much political capital on less important issues such as immigration, leaving him without enough to push through corporate tax reform. Other concerns include a Fed that panics and starts to hike too quickly, choking off growth; a dollar that moves up sharply instead of grinding higher, undermining profits and exports; and an acceleration in China’s capital outflows, raising the potential for a major global credit event.

Our base case is the above risks are worth monitoring but, at this juncture, more likely to be nuisances, nothing worse. For now, we continue to favor stocks over bonds in our stock-bond portfolio model, with an emphasis on cyclical, energy and financial names that stand to benefit from reaccelerating growth, deregulation and corporate tax reform. We think international stocks also deserve a look. They are trading at an historic discount to the U.S. and should eventually share in the Trump reflation as it helps lift world growth. Continued strength in the dollar is constructive, too. And if we do get a market hiccup at some point in the coming weeks, remember that we have reentered the third stage of this secular-bull market. So use pullbacks to add to equity overweight positions. We are firmly in “buy the dips” mode until further notice.