Orlando's Outlook: Powerful start to the new year

01-10-2018

Bottom line The S&P 500 surged 2.8% in the first week of 2018, marking a new record high each day and representing the best start to a new year since 2006. In fact, this powerful start, which was the stock market’s eighth best since 1950, suggests that full-year performance could rival 2017’s impressive gains.

Early ‘January Barometer’ predicts that 2018 will be a strong year The early “January Barometer” says that historically, as the first five trading days of January go, so goes the full year. Since 1950, Jeffrey and Yale Hirsch at the Stock Trader’s Almanac report that 69% of the time (47 out of 68 observations), the direction of the year—up or down—was the same as that of the first five trading days of January. But specifically when the first five trading days of the year are positive—as they were this year—the stock market finished the year in positive territory 84% of the time (36 out of 43 instances). Is this just a coincidence? No, because investors typically begin the new year making their annual retirement and college-savings contributions and their changes in asset allocation, thus reflecting either their bullish or bearish sentiment.

Strong start to 2018 Over the first five trading days of calendar 2018, the S&P enjoyed a price-only gain of 2.77%, starting from 2,673.61 on Dec. 29, 2017, and closing at 2,747.71 on Jan. 8, 2018. By including dividends, the total return over this period improves slightly to a gain of 2.80%, the S&P’s eighth-best start to a new year since 1950. By historical comparison over the past 68 years, according to the Stock Trader’s Almanac, the S&P in each year’s first week has posted a median gain of 0.55% and an average gain of 0.23%, so this year’s powerful first-week return of 2.8% is well above average.

No down years In fact, looking at the 68-year history of the early “January Barometer” (but excluding this year), whenever the first week’s returns were 2% or higher (which happened 16 times out of 68 years, or roughly the top quartile of observations), there was not a single down full year. The average full-year return was 18.8% and the mean return was 19.0%, within a broad range of 1.4% to 38.1%.

But it’s fundamentals that really matter A mediocre year in 2016 (up only 2.9% into early November) was salvaged in November and December by Donald Trump’s surprising presidential victory and the stock market’s strong 7.8% post-election rally into year-end. That was followed by a 21.8% total return in 2017, as investors responded well to a more market-friendly set of fiscal policies under President Trump, including tax reform and deregulation. Adding on this year’s early gain of 2.8%, and stocks have soared by nearly 35% from Nov. 4, 2016, to the present.

We are currently estimating $155 in corporate profits for the S&P for 2018, up 19% from our $130 estimate for 2017. Stocks are trading at 17.7 times our 2018 estimate, and we expect that the price/earnings (P/E) ratio will grind higher over the course of the year, to our target of 20 times, due to relatively benign levels of both inflation and interest rates. That translates to a full-year target price of 3,100, which is roughly 16% higher on a price-only basis over the course of the year.

Why does our target price offer a potentially lower trajectory (up only 16%) than the more robust historical returns (up 19%) implied by the early January Barometer? Despite Trump’s positive fiscal policy changes to date, we are very wary of two developments that could materially increase market volatility midyear:

  • The Federal Reserve’s monetary policy and leadership transition Will Chairman-designate Jay Powell maintain the same dovish bias on interest-rate hikes and balance-sheet shrinkage as outgoing Chair Janet Yellen?
  • Midterm elections in November Despite much stronger economic and corporate profit growth under Trump, his poll numbers are miserable, and the threat of a wave election in Congress is real. 

Stay tuned We will return with January Barometer, Part II, in early February, after we have investment returns for the entire month of January, to see what potential full-year market implications we can draw, and to identify what the top-performing industry sectors may be for the full year.

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