Market Memo: Correction, such as it was, is over as market is set to move higher

09-29-2017

On the wall of my Pittsburgh office hangs a copy of a Barron’s feature article on Federated from August 2014, “A Bull’s Advice, Get Ready for S&P 2500.” The S&P 500 at that time seemed stuck in a tight range between 1,900 and 2,000, having melted through our previous bull market target of 1,650 the year before. While initial reaction to the 2,500 call among clients was, “Wow, that’s kind of optimistic,” slowly but surely the underlying positive fundamentals of the economy and market drove us there.

That’s how bull markets work. Up the Wall of Worry—a wall that remains very much intact today. Indeed, as the equity market has been hovering around all-time highs since late August, our equity team and virtually everyone else has been expecting a late summer or early fall 3% to 5% correction. And while a correction of this magnitude is always, always, I repeat always possible, we think the balance of risks near-term are leaning heavily in favor of another big up-move toward the 3,000 target we initiated last June.

In fact, we will go so far as to say the correction happened beneath our collective noses and we missed it. In recognition of this, Federated’s macro PRISM® committee this week added again to equities, (specifically, small-cap value stocks), raising our overall equity allocation in our stock-bond model portfolio to 92% of maximum. Here’s a brief summary behind our thinking:

  • Earnings should be constructive. With a seasonally tough period almost passed without a major pullback and the third-quarter reporting season upon us, the market’s focus is shifting back to earnings. They should be good—not just for this quarter but for 2018, as well. The current consensus of S&P earnings next year is $140.
  • The economy is supportive. While some of the data may be spotty because of the one-off effects from Hurricanes Harvey and Irma, it’s highly unlikely the near-term economic news will derail the market. In fact, we think the news is likely to be good given underlying trends. But to the extent there is a blip, the markets are likely to give the news a “hall pass” given the short-term disruption caused by the hurricanes.
  • Republicans need a win and tax reform should be it. We assume that with their backs to the wall, Republicans will unify behind tax reform and pass legislation. Most of the market is in wait-and-see mode on this, but we expect a positive outcome to be gradually priced in through the fourth quarter as important milestones and side agreements are announced, such as last week’s agreement to incorporate $1.5 trillion of revenue into the tax-budget forecast using dynamic scoring that seeks to reflect faster economic growth that results from tax cuts.
  • The Fed is going to remain highly accommodative. This month’s policy meeting and this week’s comments by Fed Chair Janet Yellen made clear the central bank is going to move glacially on balance-sheet reduction and remain very measured in raising the target funds rate. This is supportive of the market and particularly financial stocks. We expect the yield curve to steepen as the unwinding of quantitative easing starts next month, and the prospect for further rate increases to diminish following a likely quarter-point hike in December.

All of this comes against a backdrop for a market that, for all the talk about it continuing to set new highs, is really up only 2-3% over the last four months, with sell-offs occurring among its various sectors—industrials, energy, consumer discretionary, and most recently, technology. So in a way, we’ve had a rolling correction. We also think that concerns about the market being expensive should soon abate. Most of the “it’s overvalued” talk is centered around trailing earnings, which were in a recession from mid-2015 through 2016. The last of the earnings-recession quarters are now dropping off, and as we approach year-end 2017, investors will be comparing a level of 2,500 against a trailing earnings number closer to $130, or a 19 P/E. Better, they will be looking now to 2018, which Federated’s relatively conservative forecast puts at $140, with a P/E under 18. This is not cheap, but nowhere near dangerously expensive given where bond yields are likely to remain through “the long cycle (See “Market Memo: Summer storms won’t derail the long cycle”) All told, it seems the near-term risks to the market through year-end are a move higher, not lower. So put away your worry beads and start thinking of the next important big level on the S&P 500: 3,000. We could be there sooner than we all think.

Stephen Auth
Stephen Auth, CFA
Chief Investment Officer, Equities, overseeing all of Federated's equity and asset allocation products globally