Stock markets have gone absolutely ballistic since just before the early-November election, with the Dow Jones Industrials up 25 of the past 32 trading days, for a gain of more than 10% along the way.
The bulls believe this winning streak can continue in the New Year. Their evidence includes:
• The recent pick-up in economic data.
• A rebound in S&P 500 earnings last quarter.
• Plus prospects for less business regulation, lower taxes and greater fiscal stimulus under President-elect Trump.
Never mind the fact that Trump doesn’t even take office for another four weeks.
Meanwhile, the bears believe stocks have rallied too far too fast on nothing more than inflated expectations, and they have hard evidence of their own, including:
- High stock market valuation.
- Slow corporate sales and profit growth.
- And suspicion that there will be no quick-fix for what ails the U.S. economy.
Both the bull and the bear camp make valid points. What’s more, if you take a look at stock market cycles, you’ll see the first year of a president’s term often brings rough sledding for the stock market and the economy.
|“Both the bull and the bear camp make valid points.”|
Pundits like to compare Trump’s election to the start of the Reagan Revolution in the early 1980s. But don’t forget stocks peaked in April 1981 – just three months into Reagan’s first term – and the Dow dropped 25% before bottoming in August 1982.
For me, the outlook for stocks in 2017 depends on two factors that are closely intertwined: Prices and Earnings.
Investors have great expectations for profit growth in 2017, because they’ve already pushed stock prices much higher in anticipation.
VALUATION A CONCERN
Now at 2,260 as I pen this, the S&P 500 is trading at 21 times trailing earnings per share over the past 12-months. That’s in the top 20% in terms of valuation over the past ten-plus years!
Granted, valuation alone is not a good tool for timing the twists and turns of the stock market. But the starting valuation matters a great deal for the returns you can expect from stocks going forward.
When the market valuation is in the top 20%, as it is today, you can expect stocks to return just over 5% over the next 12-months.
That’s quite a bit below the 7.3% average annual return for any year since 2005.
And keep a watchful eye on the market’s trailing P/E in 2017, because if it creeps into the danger zone – top 10% of valuation – then the average return for stocks drops to minus 8.4% in the following year!
For stocks to not get even more overvalued, profits need to come through in 2017. That may prove to be a tall order because S&P 500 earnings have gone nowhere for the past three years, although profits did turn up last quarter.
PROFIT GROWTH NEEDS TO ACCELERATE
S&P 500 earnings jumped 2% year-over-year in the third quarter, and that was the very first time profits grew, on a year-over-year basis, since early 2015.
Profits are expected to accelerate to a 3% growth rate in the current fourth-quarter. But even if that’s the case, it puts full-year 2016 earnings for the S&P 500 at about $118 per share, according to Merrill Lynch. That’s about the same level of corporate profits earned in each of the past three years!
Next year, analysts expect S&P 500 profits to grow 11.4%. That’s a tall order since it represents a quantum leap from flat earnings for the past three years straight!
For stocks to trend significantly higher in 2017, there’s not much room for P/E ratios to expand without getting into the danger-zone, where stock market returns typically go negative.
Analysts have great expectations for profit growth in the New Year, and the results better come through or it could be another volatile year for stocks.
Director of Research