Market Memo: Reiterating bull call—stay overweight stocks and buy dips

02-22-2018

We added to equities in our PRISM® stock-bond portfolio model during the worst of the recent dip and may add some more if there’s another move down. The reason is simple: we are in the midst of a very positive fundamental economic and earnings backdrop, with still tame inflationary forces and valuations that are too low, not too high. So let the bears growl—we think their case is misguided and based on outdated rules of thumb that simply aren’t applicable in today’s world. We are as wedded as ever to our 3,100 target on the S&P 500 for year-end and longer-term target of 3,500, and here are our five main reasons why: 

  1. We expect above-consensus growth this year and next—our forecasts are for 3.4% and 3% real GDP growth, respectively—abetted by soaring business confidence with the election of President Trump and a Republican Congress, almost immediate and continuing regulatory relief, and of course, tax reform. The short-term stimulus due to tax cuts for 90% of individual taxpayers is a plus for near-term growth, but it is the longer-term stimulus due to its supply-side impact that we think is key to keeping this secular bull going. Led by a permanent 20%+ increase in the after-tax returns on investments resulting from the corporate tax cut, the tax bill provides a much-needed punch at a critical time in the economic cycle when labor is increasingly scarce. This should result in a long-overdue productivity boost that can extend the cycle without feeding excessive inflation. This is important because to the extent we get faster growth, rising federal budget deficits everyone is now worried about are unlikely to come to pass.
  2. Six weeks into the year, earnings forecasts are following an unusual pattern—they are rising, not falling. Consensus is now above our previously optimistic S&P 2018 earnings forecast of $155. We are now at $175 for 2019. Key drivers of the earnings uplift: a natural rebound from the 2016 earnings recession; accelerating nominal GDP; a weaker U.S. dollar; rising energy prices; and now, the tax bill. Ultimately, stock prices follow earnings so this backdrop is extremely bullish.
  3. Deflationary pressures have not gone away, regardless of the recent backup in 10-year yields that has some investors spooked. “Those bond people know something we don’t!”  I would first point out bond markets have predicted 10 of the last two recessions. That said, while we do expect rising wage inflation in the coming months, particularly once the wage hikes associated with the corporate tax cuts start getting booked, we think markets are mistakenly assuming wage inflation will equal broader price inflation, and take down bonds. We disagree. Deflationary pressures are present throughout the economy: Amazon is disrupting retail and now drug distribution; Uber is disrupting consumer transport services; Facebook is disrupting the advertising industry; and everywhere, CEOs are engaged in using technology to drive down costs, i.e., robots and iPads are replacing workers at a rapid clip. At Federated, our team of 120 analysts and portfolio managers are speaking with companies every day about their businesses. With the exception of companies in cyclical businesses now getting overdue price increases after three to four years of declines, companies everywhere are cutting prices, not raising them. So while some modest uptick in inflation, perhaps close to or a little above the Fed’s long-term 2% target is likely, we simply do not see a dramatic pickup the next two to three years.
  4. Rate pressures reflect supply-and-demand forces, not inflation. In our “Surprise, surprise” piece of early January, we laid out our case for a steepening yield curve and a move in the 10-year yield to 3% or possibly a little higher. We are still of this view. However, we think this move is being driven primarily by potential Fed acceleration in quantitative tapering in light of better economic growth and stepped-up Treasury issuance to fund (short-term) the tax bill deficits. We still think 3%, not 4%, will be the norm because other pressures on bond yields, especially inflation, are not present. We expect the Fed’s policy to largely be guided by core PCE numbers, not wage increases. Institutionally, given the Fed’s historic experience from 1937 when it hiked too early and extended the Great Depression, the central bank remains of the view that being behind the curve coming out of a deflation is better than being ahead of it. Assuming inflation rises to 2%, a fed funds target rate between 2% and 2.5% probably works, and would be consistent with the January meeting minutes. With supply and demand forces pushing the 10-year to 3-3.25%, that gives a healthy slope to the curve without an excessive discount rate on stocks.
  5. Worries that valuations are too high are based on faulty assumptions. When we first declared a secular bull market in 2010, the chorus of the bears was that the Shiller P/E, which looks at earnings over the past 10 years, was too high; this number at the time was vastly inflated because there were two economic/earnings recessions in the trailing 10-year number. Most of last year, the talk was of the “too high” market multiple against trailing 2016 earnings, which encompassed an earnings recession of 2015/16. The new reason that valuations are “too high” is that bond yields are going to 5%, requiring a lower discount rate on stocks.  Once again, we just don’t see it. With a positive fundamentals backdrop, minimal risk of a 2007-08 event and modestly higher bond yields, we expect multiples to expand, not contract. In all previous secular bulls, P/Es followed this pattern. The Roaring ’20s bull peaked at 30, the Nikkei 1980’s bull peaked at 70, and the tech bubble bull of the 1990s’ peaked at 30.  We are not forecasting 30 anytime soon, but we do think a multiple of 20 is in sight by this time next year.

Might there be a rebound in volatility in March? Sure. That’s when wage increases associated with the corporate tax cut (about 25% of tax cut-related announcements have been wage increases) will begin to show up, causing skittish longs to become nervous that the (temporarily) outsized wage increases could lead to more aggressive Fed action. If bond yields gap higher again on these concerns, toward our 3.25% upper target, this could trigger another round of selling from risk-parity funds and/or others. If this were to spark another, probably final correction during this transition phase to higher growth, we almost certainly would add to equities in our stock-bond model and are keeping some powder dry for this possibility. The bottom line: stay the course–this secular bull has more room to run. Stay overweight stocks and buy whatever dips may come.