Market Memo: Buy—don't sell—in May


We remain bullish on stocks and, as you may recall, added further to our equity overweight in our PRISM stock-bond portfolio model late last month. That overweight went to large-cap value stocks, which have underperformed this year as the market rotated back toward growth names. We view this as a healthy “rotational correction” that should end soon, with financials, energy and industrial stocks set to resume leadership as the market moves toward our long-standing 2,500 forecast for the S&P 500. Here are our 4 key catalysts: 

  • Political risk is skewing towards the upside. The French election was the most dangerous vote the market had to get through in 2017, and with its market-friendly result, European break-up risks are temporarily subsiding. On the U.S. side, expectations for positive policy changes out of the Trump administration are the most sober they have been since the election, skewing the risks for the market higher, not lower. The Comey story is noise, little more, in our view. Meanwhile, Republicans are moving forward on health-care reform, which they are highly incented to do, and once accomplished, expectations for significant corporate tax reform should rise as the former is an important source of funding for the latter. While both health-care and tax reform at this point are likely to bleed into the back half of the year, signs of progress on both fronts should begin to emerge in the coming weeks. This would provide a positive backdrop for the markets, particularly cyclicals and financials that stand to benefit the most from the Trump reflation policies.
  • Reaccelerating earnings should fuel additional investment and economic growth. The nearly completed Q1 earnings season has been an almost unqualified success, with year-over-year growth coming in at 14%, well ahead of expectations. We expect this positive momentum to continue into Q2 and the second half, and then to accelerate again in 2018 as tax-reform measures become effective. We continue to expect earnings on the S&P 500 to trend toward our 3-year target of $150.
  • The bond market is not backing up as quickly as investors have expected. We think this good news is likely to continue. For sure, better growth globally and slightly higher global inflation will keep upward pressure on yields. But a key lesson of the first four months of the year has been that other global forces remain at work holding long-term yields below where most economic models expect them to be: nervous central bankers, anxious to avoid a repeat of the famous 1937 experience of premature rate hikes coming out of a deep recession; nervous investors, still cautious on equities and desiring cash income following double 40% losses during the 15-year bear run from 1999 to 2013; global competition that’s holding back wage inflation; and developed-world demographics that are relentlessly driving a large component of the global investor base toward less risky assets. While we see the 10-year yield eventually getting above 4%, maybe even to 5%, before this long upcycle is over, this is going to happen much more gradually than markets seem to expect. This slow, gradual bond bear market gives investors in bonds and bond-like equities time to offset price deterioration with interest/coupon income, and is generally equity friendly.
  • Healthy rotation out of cyclicals into big tech stocks is nothing more than that. For example, while tech is up 18% year-to-date and financials are up only 2%, both sectors since Nov. 1 are up 20%. We view the dynamics of rotational markets as a relatively healthy form of a “correction” within a market that remains buoyant, with an upward bias as idle cash is gradually moved off the sidelines. Rather than the absolute pullback in the averages that most investors are expecting, we think the next move will be higher still, driven by the well-rested cyclicals, financials and energy names that have been catching their breaths. 

In sum, we believe the next leg up will be driven by continued signs that the global economy is picking up, political risk is on the decline, corporate earnings and investment are accelerating, the bond market is unexpectedly behaving and the all-important energy sector is healing. While many market observers are fretting that stock volatility is unusually low, presaging a market correction, we would not be surprised to see the VIX press lower, not higher. In fact, the much feared and heavily forecasted stock market correction that many are calling for may have already occurred.