By David Nelson, CFA
Coming into 2017 I doubt many including yours truly thought the Dow would end the year close to 25,000. The good news wasn’t restricted to just the America’s as most of the developed world delivered strong returns as well. Even emerging markets after a near decade long slump knocked it out of the park taking the crown for 2017. Of course when you take a longer term view, the picture isn’t as inviting. Even after a monster run (EEM) iShares Emerging Markets ETF has only just captured the highs pre the financial crisis.
Back here in the states the political news cycle was the driving force behind sector and sometimes individual stock performance. As Goldman’s David Kostin points out in a recent research note 2017 took on something of a Goldilocks market environment. Nothing seemed to stop investors from buying into every dip. The biggest enemy for portfolio managers in 2017 was cash.
Sector Performance
Right out of the gate the usual suspects Tech and Healthcare took the lead. Hard to have a bull market without Technology finishing at or near the top and 2017 was no different. Of course, therein lies the danger. In a market cap weighted index you can easily find yourself invested in just a handful of companies as some of the Tech giants continue to grow. Apple (AAPL) is closest and likely the first company to achieve a $1 Trillion market cap.
After a miserable start energy stocks we’re down close to (-17%) by August. Crawling out of the gutter the sector jumped almost 20% in just a few months finishing the year close to the flat line. By September estimates started to dramatically improve, first in the refiners like Valero (VLO) and Marathon (MPC) and later integrated and explorers.
Tax Overhaul
The recent passing of the tax overhaul is of course a political as well as a financial discussion. There are valid pros and cons on both sides of this very important debate. In this post I’m going to focus on the financial and what it means for markets and stocks.
Obviously bringing down the corporate tax rate from 35% to 21% does wonders for the bottom line not to mention repatriation which could initially bring back $400 Billion in corporate cash being held off shore. Estimates for S&P earnings have been rising for months as the odds the bill making its way to the President’s desk improved. Several companies post the bill have recently announced wage hikes and others like AT&T announcing bonuses. Fed Ex (FDX) a very cyclical company has come out and dramatically raised guidance pointing to the tax package as the reason.
To be fair some of these announcements sound politicized. AT&T (T) is currently dependent on justice and the FTC hoping to push through their purchase of Time Warner (TWC). What could be better than offering a little good will in the form of bonuses to 200,000 employees?
The question I’m asked most often by those in the media is what CEOs will do with all this repatriated cash. In the past they’ve taken the easy way out using stock buybacks to artificially boost the bottom line. Remember, buybacks do nothing for the growth of earnings. It only boosts earnings per share as the number of shares outstanding decline.
Some like former GE CEO Jeff Immelt took that route for years. Financial engineering gimmicks like this did nothing for the health of GE and as a result shareholders have endured a miserable 17 years. Jeff is gone today and I suspect other CEOs who continue down this path will be shown the exit if they don’t start to grow revenue.
There are always exceptions like Apple (AAPL) whose off-shore cash holdings are so large there’s no way they could deploy the capital.
Look, buybacks will always be with us and one of the tools CEOs will use. However, I think we are entering a period where it is no longer a tool being used exclusive to all others. I’ll repeat what I’ve posted often. The next leg of the bull market isn’t going to come on the heels of financial engineering. I believe we’re at the beginning of a CAPEX cycle and CEOs that take that route will set the stage for future growth.
Estimates Rising
High end estimates for the S&P are coming in at about $150 for 2018 which implies 15% growth year on year. In a perfect world that might translate into 15% returns next year. If only it were that simple. U.S. markets have undergone a high degree of multiple expansion in the last several years and IMHO we’re at the end of that cycle.
At best, multiples and valuations will stay the same or start to contract especially in the face of a Federal Reserve on a path to normalization. The Fed seems committed to raising rates if for no other reason than to reload. They need options for the next economic downturn and currently have few.
15% growth in earnings might get us to an 8-10% return next year. Unfortunately, in the real world market predictions are just that, predictions with a fair amount of speculation. It’s what we can’t see or forecast that always gives us the most problems.
Market Concerns for 2018
There’s never any shortage of things to worry about for stock investors. We’ve already talked about the Fed whose normalization efforts could put upper pressure on the yield curve.
Rising rates, if going up for the right reasons i.e. an improving economy needn’t be a concern but at some point they will prove competitive drawing capital away from equities.
China – #1 with a bullet
China, without question is my biggest concern as we start the New Year. The geo-political issues especially as they relate to North Korea are well documented and not likely resolved anytime soon. However, the bigger threat may in fact be trade.
China showed their hand months ago with trade sanctions on South Korea in response to the deployment of our THAAD Missile Defense system. Devastating to South Korea as China represents 25% of their Exports. Recently, President Xi offered an olive branch to South Korean President Moon Jae-in inviting him to the country for talks. Never the less it’s clear Xi who appears to be making constitutional moves to cement his power beyond a 10 year mandate is willing to use each and every weapon in his arsenal including trade sanctions to achieve a political and economic goal.
The passing of the Tax Cuts and Jobs Act didn’t go unnoticed in Beijing. Just yesterday, China announced they would exempt foreign companies from paying tax on their earnings in a bid to hold on to business and cash likely to leave the country. The United States is getting competitive and that’s become a concern.
Add the tensions rising over North Korea and getting caught red handed violating UN sanctions, it’s pretty clear President Xi is going to push the envelope as far as he can.
Stocks don’t live in a vacuum. Trade sanctions from either side can hit markets much harder than any terrorist attack because it actually hits revenue and earnings.
Despite the usual wall of worry it’s hard not to go into 2018 with a smile on our face. But like every year we reset the scoreboard and its back to the blocking and tackling of portfolio and risk management.
