Market Memo: Hope on sale

04-13-2017

Since late December, the markets have shifted from offense to defense. Stocks dependent on reaccelerating growth (“the Trump trade”) have been consolidating their gains, while stocks that do well in a low-growth environment have taken the lead. Financials, for example, are up only 2% year-to-date after rallying hard in late 2016. Two other strong 2016 closers, energy and industrials, are down 6% and up less than 5%, respectively, so far in 2017. Meanwhile, organic growers that don’t need a lot of help from GDP growth are doing well again: health care is up 8% and technology is up double digits. Bonds also have rallied, while bond-proxy equity sectors such as utilities are having a great year.

We see this as a natural progression after both a sharp market run-up and a disappointing political failure—the inability of a GOP White House and Congress to replace the Affordable Care Act (ACA) has rightfully (though we think ultimately erroneously) raised doubts about the Trump pro-growth agenda. So what to do next? Dare we suggest buy cyclicals and financials? Yes, and here’s why:

  • Even though fear indicators aren’t moving higher, which would send a nice contrarian buy signal if they were, hope indicators have moved quite a bit lower. We see this in an S&P 500 Index call option exercisable at 2,400 three months out; its price has collapsed, mostly on declining hope that the S&P can break above 2,400. This suggests market optimism—Hope—has come way down even if outright fear is not way up, likely because of the lack of any real progress on the legislative elements of Trump’s agenda (health care, tax reform, infrastructure spending) even as other elements, especially deregulation, seem to be on track. The result is investor-time horizons have shortened significantly. Back in November, the risk markets were climbing the Wall of Hope on the promise of economic re-acceleration in 2018, driven largely by President Trump’s promised pro-growth policies. They were buying not on what may happen over the next 12 months, but over the next 24 months as the full weight of tax reform, infrastructure spending and regulatory reforms kicked in. Now, markets are back to a much shorter 12-to-18 month view, creating opportunities to buy at relatively attractive levels.
  • Indeed, the market continues to look relatively inexpensive if not outright cheap. Our earnings forecast for the S&P for 2018, which includes some tax cuts but not the entire package Trump has promised, is $140 per share. This represents a 16.7 P/E multiple at current levels, whereas the market historically has traded closer to 18 in low-inflation environments such as we presently have. Eighteen times $140 gives you 2,520.
  • Earnings growth has turned, and we expect this quarter’s season to surprise to the upside. Drivers include the interest-rate bumps we’ve already gotten and relatively strong capital-markets activity (good for the financials); the renewed upturn in the U.S. oil patch on the back of oil price stability in the $50/barrel range (good for energy, industrials and transport stocks); the reversal in dollar strength (down almost 4% in the first quarter); and the overall uptick in confidence among consumers and businesses since the election. The earnings season for sure got off to a solid start with the big three bank earnings released today. More to come, we expect.
  • The market seems to be misunderstanding the impact of the Fed’s early interest rate hikes off of what have been crisis levels. Most studies on the impact of interest-rate hikes presume the starting point is “normal.” However, in the present environment, the starting point is “way below normal.” From the zero level, early hikes improve financial market conditions rather than slow them (i.e., banks begin to make money again and lend more from their bloated reserves; consumers earn more from their savings accounts and have more disposable income). Combined with the Chair Janet Yellen’s innate dovishness, we see the Fed as more in the position of pouring gasoline, not water, on the fires of economic reacceleration.
  • The March nonfarm jobs number was likely an aberration, not a cause for alarm. Unseasonably warm weather in February likely pulled jobs forward from March. Moreover, the survey week in March occurred during the winter storm Stella, which kept many away from work. Our favorite “hard data” jobs indicator, initial jobless claims, continues to indicate that labor-market conditions remain very strong and growth supportive.

Looking forward, we remain modestly overweight equities and would add to this position on any significant pullback—5% or more. We particularly like the aforementioned financials, energy, industrials and transports, and are neutral international markets but view them as cheap and potentially a buy once uncertainty about the French election passes.

Keys to watch: French election, ACA revival
In fact, that election likely poses the biggest risk to our view, largely out of concern that the two extremist candidates, Marine Le Pen on the right and Jean-Luc Melenchon on the left, are probably both under-polling due to the so-called “Trump effect”—i.e., their views are so out of the mainstream that voters are reticent to admit to a pollster that they are going to vote for them. If they make it to the run-off, the markets are likely to experience a bout of volatility since both candidates favor a euro exit—an anti-Europe outcome.

For the record, any volatility that comes from this will be a very buyable dip, at worst. France’s political system is different than ours—they have a parliamentary system where the chief executive of the country is not the president, but rather the prime minister elected by the French Parliament. That election is in in June, and is so gerrymandered that it is impossible, from what we’ve gleaned, for anything other than a centrist or coalition outcome to emerge. So whatever the presidential election result, France is not going anywhere. 

On the plus side, the biggest potential positive catalyst could be revival of ACA reform, a possibility that’s generating a lot of whispers. Republicans undoubtedly are getting an earful from their constituencies during their Easter break and might come back to Washington after the 2-week recess better incented to compromise. This would be big, as it would insure a source of funding for a more dramatic tax reform bill later this year.

So, bottom line, Hope is on sale. Call it an Easter clearance. Happy shopping.