For many investors it may seem difficult to believe since it has been so long ago, but the equity markets do go through negative returning periods. The average intra-year decline for the S&P 500 Index since 1980 is 14% and the last double digit decline was in February 2016, nearly two years ago. So what in the world is going on that has stocks in what seems an uninterrupted climb?
The below 'monthly' chart shows the S&P 500 Total Return Index since the beginning of 2016. Over the course of the two years, 2016 and 2017, the S&P 500 Index has experienced only three negative returning months (red bars) with no down months in 2017. The last bar on the chart represents the January 2018 return and the start of this year has been decidedly bullish.
If one is to believe individual investor asset allocation responses reported by the American Association of Individual Investors, individual investors are nearly all-in on their equity exposure. The bottom half of the below chart shows equity allocation at 72% as of December which is near the 77% high reading. Also, cash allocation is at 13% and near the low reading of 11%. If interest rates are moving higher, thus bond prices declining, an underweight in bonds seems to make sense.
The next chart shows AAII's individual investor bullish sentiment moved higher this week to 54.1%. This move higher followed a decline in sentiment last week. Also continuing higher is the 8-period moving average. As I noted in a post on sentiment on January 11, the contrarian sentiment reading is the most actionable at market bottoms versus market tops.
Not only are consumers expressing positive sentiment, businesses are as well. As seen in the below chart, the NFIB Small Business Optimism Index (green line) has seen a steady improvement since the financial crisis with a big jump in the NFIB Optimism Index in December of 2016. The December 2016 reading was one of the top readings for the index since its inception. In fact, 2017 was a record year for the Optimism Index since it was created 45-years ago. The monthly average for the Index during 2017 equaled 104.8 and the prior record year was in 2004 when the index averaged 104.6. In NFIB's report on the December 2017 Index reading, it was noted,
"2017 was the most remarkable year in the 45-year history of the NFIB Optimism Index,” said NFIB President and CEO Juanita Duggan. “With a massive tax cut this year, accompanied by significant regulatory relief, we expect very strong growth, millions more jobs, and higher pay for Americans."
Historically, high NFIB Optimism readings have been associated with strong equity market returns in the 12-months following high index level readings. As seen in the below chart, the 1-year equity market return of 18.3% following the high December 2016 reading (orange line) was the highest returning 12-month period compared to the other four completed one year periods. The red line represents the S&P 500 Index's return since December 2017.
I could show a number of additional sentiment and confidence measures and nearly all of them are extremely positive. Sentiment is important in supporting equity market returns, but the strong equity market returns seem to be built on improving fundamentals as well. This improving fundamental picture is being partially supported by the anticipated benefits from the recent passage of the Tax Cuts and Jobs Act. These tax reform measures are not simply one time stimulus boosts, like sending out one time checks. This reform incorporates structural changes in the tax code that will have benefits over a multi-year period.
A lower corporate tax rate means companies will have additional cash they can reinvest in their businesses, both in capital expenditures and in their employees through higher pay. Also, the lower tax rate provides a tailwind for earnings and this is beginning to be reflected in analysts' forward earnings estimates. As seen in the below chart, the forward earnings growth estimate for the S&P 500 Index was 10% in November and in just six weeks, the 12-month forward earnings growth estimate is now 13%. This is a 30% improvement in the earnings growth rate and is an important reason why stock prices are moving higher, i.e., adjusting to a higher earnings level. The market correlation to earnings is .94 or nearly 1.0. As is said often, stock prices tend to follow earnings.
Finally, it takes cash to buy stocks and cash levels seem high if one reviews the Federal Reserve's Flow of Funds z.1 report. The below chart shows household deposit levels along with deposits as a percentage of GDP.
What seems to be occurring with stocks then, is an adjustment in valuation in anticipation of higher corporate earnings growth. Equities in the U.S. have certainly done well; however, those investors that bought and held in 2000 and 2007 have been invested in a sideways trending market. Not until 2013 did the S&P 500 Index break out of this 13 year trading range. From 2000 to January 2018, stock returns have been unexciting, i.e., returning an annualized 3.42%.
Scott Grannis, former Chief Economist at Western Asset Management, recently wrote a blog post, Putting Bonds and Stocks into Perspective, where he included the below chart and noted US equity market capitalization as a percentage of global equity capitalization is lower today than in 2004.
I would say the equity markets in the U.S. seem priced for perfection; however, stocks usually do not correct simply based on valuation. The economic and fundamental underpinnings seem strong and are expected to remain so in the coming year. In a non-recessionary environment, stocks can continue to perform well. Is a pullback, and a double digit one at that probable? Yes. However, I believe the pullback will be a normal market function and not caused by say an economic recession. Business and consumer sentiment levels are decidedly positive and for justifiable reasons.
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