Should I Stay or Should I Go?

By: Tony Genua, Sam Mitter, Jonathan Lo* • October 4, 2017

U.S. equity returns are still healthy despite President Trump’s unhealthy approval rating

The U.S. bull market is still intact and we believe investors should stay the course to participate in anticipated further gains. A rising trend in U.S. stock prices has been underway for the past eight-and-a-half years with the market appreciating 279%1 from its cycle-low, and still, the fundamental backdrop remains favourable. Despite this, investors continue to show hesitancy, as evidenced by a lack of flows into U.S. equities. Whether fearful of political risk, economic longevity, valuation concerns, or quite likely a combination of all three, we offer our thoughts on these topics and why growth opportunities remain.

 

Political Risk

The U.S. equity market has posted double-digit returns year to date1 despite the challenges President Trump has faced in delivering on his campaign promises. To date, there have not been any substantive details nor a firm deadline offered in support of tax reform, deregulation and infrastructure spending. However, this lack of progress on the legislative agenda has yet to materially disrupt the stock market’s advance. Even the precipitous drop in President Trump’s approval rating has not impeded this year’s rising equity market despite the rating itself being perilously close to previous low levels when the stock market has encountered some difficulties. Given Trump’s propensity to post offensive tweets and make off-handed comments, we would not be surprised to see his approval rating sink to levels where the market may be challenged if history is any guide (see Figure 1).

What should be considered when looking at approval ratings is that Trump seems to be upheld by the support he receives from his core loyalist following and by his party, both of which are still quite high. That said, one could expect further progress on pushing forward Trump’s market friendly agenda of lower taxes, deregulation and infrastructure spending. While uncertainty surrounding the timing and the magnitude of the benefits from policy measures will likely remain through the end of this year and possibly into next year, any market correction should be viewed as a buying opportunity.

 

U.S. Economic Growth Supplemented by Synchronized Global Growth

Notwithstanding eight years of economic recovery, the outlook for further growth is as encouraging as it has been since this recovery started in July 2009. U.S. domestic conditions continue to point to further economic gains, coming from the corporate sector as well as from the all-important consumer sector. As can be seen in Figure 2, optimism for small businesses remains elevated and consumer confidence is at levels not seen since the early 2000’s. The fact that consumers have been a driving force in this economic recovery comes as no surprise given the spending support from employment growth, wage gains, low gasoline prices and interest rates. While still early, a preliminary look at holiday sales for 2017 by Deloitte is quite encouraging, as retail sales growth is expected to increase by as much as 4.5% from last year’s level with e-commerce rising by a stellar 18-21% for this upcoming holiday period2.

 

The second most influential economic component after the consumer (accounting for 69% of GDP) is business investment, at 16%. With capital expenditures accounting for the large majority of business investment (75%), the economy should continue to benefit from this positive outlook. Not only is the Energy sector showing a recovery in 2017 expenditures after a precipitous drop in 2016, so too are spending intentions from other sectors, and this should accelerate into next year. According to the most recent NFIB Small Business Survey, the percentage of companies intending to increase capex over next three to six months is the highest it has been in over a decade. Augmenting this spending by small businesses into 2018 could well be an acceleration in capex by large U.S. multinationals, especially should taxes be reduced on repatriation of foreign held cash by these global companies. Even without knowing the timing nor the magnitude of the benefit from tax reform, U.S. based global companies are the beneficiaries of an international economic environment that has not seen such a synchronized recovery in many years, as exhibited in Figure 3. This alone should not only allow for healthy top- and bottom-line growth, but also help to ensure capex spending remains at healthy levels.
Since the economic backdrop is favourable, the U.S. corporate profit picture should remain encouraging to equity investors. Like the solid second quarter results, corporate profits reported for the third quarter are likely to continue to strengthen. Figure 4 illustrates a healthy earnings growth rate and that the earnings correlation with the stock market supports a rising price trend.

Market Valuation: Elevated but Reasonable Relative to Interest Rates

Much has been published on how expensive the U.S. stock is based upon the P/E ratio. And indeed, the P/E ratio on an absolute basis is quite high relative to its historical experience. In looking at today’s P/E of 19x estimated earnings for 2017, current valuation is at levels comparable to those last seen in the early 2000’s and late 1990’s. In fact, those were the only recent time periods when the P/E ratio was higher, as can be seen on the left side of Figure 5. If we were to exclude the early 2000’s experience, since earnings were depressed from recessionary conditions, it leaves only the last three years of the 1990’s when the market had a higher valuation on this measure.


It is worthwhile to note, however, the relationship between the P/E ratio and the level of interest rates. What can be observed from the exhibit is that with today’s P/E of 19x, the market’s valuation level is just slightly above where it was 10-15 years ago in the last economic expansion. And yet interest rates, as measured by the U.S. 10-Year Treasury, were twice as high (4-5% vs. 2.25% current level) during the last expansion as observed on the right side of the graphic. When viewed against the interest rate environment, whether the level over a decade ago or the late 1990’s (circled in Figure 5), the valuation of the market is not excessive, as measured by the P/E ratio. 

 

 

Since interest rate levels are generally reflective of the rate of inflation, it is worthwhile to note the relationship between the P/E ratio and the inflation rate. It is not surprising that high P/E ratios are associated with low levels of inflation, with the highest ratios at inflation rates between 0-2% and 2-4%. What we now see in the current economic environment is a lack of inflation being well contained in the range associated with the highest P/E levels historically.

 

Conclusion

If one is looking for reasons why the S&P 500's current bull market should soon come to an end, you do not need to look far – geopolitical tension with North Korea, catastrophic weather with Hurricanes Harvey and Irma, valuation concerns and importantly, the tightening of monetary policy, to name a few. Time is also a troubling factor, with the current bull market extending over eight years in duration. History would suggest that a correction is long overdue.

While an investor's initial reaction may be to get out of this rally before a correction occurs, the end of bull markets have been painful to miss, generally concluding with strong returns. In the 12 most recent bull markets dating back to 1937, the 12-month period preceding the peak have accounted for approximately one-fifth of the returns during the entire market cycle, on average, gaining 25%.

 

 

Despite concerns over an abundance of issues all significant enough to trigger a material correction, the S&P 500 has continued to show remarkable resiliency. We believe there is further room to run as we approach Q3 earnings season, given the depressed U.S. dollar providing a tailwind for foreign trade and energy prices stabilizing. Moreover, with each passing month we should be getting closer to legislation being passed to enact lower taxes and infrastructure spending measures.

We believe well-executing companies should continue to outperform before this bull market officially comes to an end, providing an opportunity for active managers, like ourselves, to take advantage of these opportunities and strong-performing stock markets to add value for our clients before the tide turns.

For more information, please speak with your AGF relationship manager.

* Does not make investment recommendations.

1 Bloomberg, as of September 30, 2017

2 Deloitte, September 20, 2017

The commentaries contained herein are provided as a general source of information based on information available as of October 3, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and / or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein.
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Published Date: October 4, 2017