How Long Can This Go On? Policy Expectations Lift the Market Higher and Higher

02.15.2017 - Carin L. Pai, CFA

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Less than a month into his presidency, Donald Trump is already making some of the sweeping changes he promised to bring to Washington DC, providing a lift for stock prices across a variety of market sectors and industries.

Two of his pro-growth policies in particular—deregulation and tax reform—are spawning high expectations for continued growth in the equities market. 

We see both opportunities and risks in this new environment.

Pros: Companies could benefit from tax reform and regulatory relief

In general, four types of companies have seen the most impressive price appreciation since the November elections:

  • Companies that are focused on the domestic market, both in terms of manufacturing and distribution, and are therefore likely to benefit from Trump’s ‘America First’ policy.
  • Firms that pay relatively high effective tax rates or have significant offshore cash reserves, which they could bring back into the US at a special one-time repatriation tax rate of 10%.
  • Companies that could benefit from less government regulation, especially financial firms.
  • Industrial, materials and energy companies that could benefit from regulatory relief and fiscal stimulus programs. Trump has already lifted restrictions on the proposed Keystone XL and Dakota Access oil pipelines and he continues to voice support for infrastructure spending.

Cons: Valuations appear full, sources of cheap financing are plentiful

In our view, there are several factors that could offset some of the benefits mentioned above. Much of the market’s newfound optimism appears to be predicated on the hope that the President’s pro-growth policies will encourage individuals and corporations to loosen their purse strings and start spending more freely, creating a virtuous cycle of business expansion and economic growth. So these factors are important to consider:

  • Most large corporations already pay effective tax rates that are well below the 35% statutory rate. So tax reform may not result in the corporate windfall investors are anticipating.
  • With interest rates near zero, US companies already have plenty of cheap financing that they could have used for capital improvements if they were a priority.
  • Rising interest rates could trigger market volatility if the Fed tightens more aggressively than expected.
  • A stronger US dollar could eat away at earnings for companies with a strong international presence. The average S&P 500 company generates more than 40% of its sales outside the US, according to Standard and Poor’s.
How Long Can the Market’s Surge Continue? Policy and Earnings Are Key

Is the market’s momentum sustainable? The answer depends largely on whether or not President Trump can deliver on his campaign platform, as well as the continued strength of corporate earnings (CHART).

In 2015 and 2016, stock prices appreciated despite the fact that earnings fell for six consecutive quarters. The Fed’s accommodative monetary policies provided businesses with cheap financing, which investors perceived as a “safety net” for stock prices. But in 2017, that safety net could be removed if the Fed raises rates as expected.

Still, P/E multiples in some areas of the market have approached the top of their historic range.

A Market Correction May Be Possible within the Next Several Months

The bottom line is that we think a market correction is possible within the next several months if presidential policies fall short of expectations, or if corporate earnings lose their momentum. We never want to chase performance by investing when valuations appear full or when sectors are rallying based on investor sentiment. But a brief pullback in the market could provide us with an opportunity to increase our exposure to certain holdings at valuations we consider more reasonable.

When the Pendulum Swings, Discipline Matters

It is also worth pointing out that our investment philosophy emphasizes growth at a reasonable price, whether the market is rallying or retreating. In the first half of 2016, for example, fears of a global recession and deflation pushed investors into “safe haven” sectors known for income and capital preservation, driving valuations to levels that were difficult to justify given our expectations for slow and steady economic growth. Our discipline was rewarded when the economy strengthened and markets re-adjusted during the second half of the year.

While we are always on the lookout for new investment opportunities, including stocks that might benefit from the current economic cycle, we prefer longer-term investment themes that appear less sensitive to the economy’s ups and downs. Today, those high-conviction themes include cloud-based technologies, innovation in the healthcare industry and consumption patterns driven by millennials.  

CHART: Earnings Are Expected to Improve in 2017

 Source: FactSet as of 2/10/17.

This communication is intended solely to provide general information. The information and opinions stated are as of February 16, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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