“Stocks are bought on expectations, not facts.” – Gerald Loeb
Review
Wow! What a year 2016 turned out to be. The United Kingdom shook up Europe with a vote in favor of Brexit; the Chicago Cubs won the World Series in spectacular fashion; and the US Presidential election featured cyber leaks, twists, tweets, turns, and the surprising victory by Donald Trump. While the magnitude and pace of major headline events captured our attention, the stock market rewarded patient investors with a year of solid returns.
The Dow Jones Industrial Average (DJIA) posted its best annual performance since 2013. The rally in 2016 extended a bull market that has tripled in value from the low established in March 2009. During the last two weeks of the year, the DJIA came within 13 points of reaching the 20,000 point milestone. Stocks shook off several scares highlighted by the concern over a possible recession at the beginning of 2016. The first week of the year featured a brutal week of selling with the S&P 500 declining over 5% in value. Also, there were worries about an economic slowdown in China and a brief sharp selloff from Britain’s historic vote to leave the European Union.
The majority of the gains in the stock market took place in the second half of the year. A rebound in corporate earnings and an acceleration in economic growth helped boost market sentiment and push broad averages higher. The pivotal point for the stock market was election night. The after-hours equity futures market dropped sharply as the surprise US presidential results were digested late on November 8th. However, a conciliatory tone from the new President-elect Donald Trump at about 3:00AM on November 9th was credited with helping to stem the market’s decline. Subsequently, the stock market on November 9th opened with muted losses, then turned up quickly and moved steadily higher through year end. Investors anticipate more business-friendly policies such as lower tax rates, reduced regulations, and increased government spending. Now the hard part comes for the new Administration to see what kind of reforms can be passed and implemented.
The stock market finished 2016 at an above average valuation. However, there is a different valuation picture depending on whether historical earnings are used or future expected earnings are considered. At year end, the companies in the S&P 500 were trading at an average price-to-earnings (P/E) multiple of 24 times their past 12 months of earnings, which is above the historical average of 16 times. On the other hand, the S&P 500 was trading at a P/E multiple of 19 times anticipated earnings in 2017. Therefore, the market appears much more overvalued looking in the rear-view mirror than it does looking through the windshield of stock market analysts.
Outlook
The stock market is always forward looking, so we believe it is prudent to place more emphasis on the forward market P/E valuation. Anticipated earnings factor into analyst expectations in regards to potential tax and regulatory reduction, and government spending. Therefore, an improved economic climate could help justify the current valuations. But, if it takes Congress longer than anticipated to implement the new Administration’s economic policies, the market could react negatively in the short-term. While recognizing both perspectives, we maintain a positive outlook for equities in 2017.
We anticipate the Federal Reserve will raise interest rates two to three times in 2017. As the economy likely enters a stronger growth phase over the next year, the Federal Reserve will feel the pressure to raise interest rates to stave off inflation. Therefore, we maintain a cautious approach towards fixed income investments. We are deliberately shortening the duration of the fixed income portion of client accounts.
We continue to prefer to purchase high-quality companies that pay dividends, especially those with an ability to grow earnings and raise their dividends consistently. Additionally, we maintain a fully diversified portfolio over almost all sectors of the economy.
Sincerely,
Marietta Wealth Management, LLC