2017 was a great year for the markets and the overall economy. Looking forward to what we may expect in 2018, the data so far seems to suggest there is still room for the economy (and markets) to continue their expansion. Some of the things we are watching are:
- Since congress passed the tax bill, 85 (and counting) US companies have announced new bonuses for their employees or that they are increasing their employees’ benefits
- The New York Fed’s underlying inflation gauge stands at 2.95%, and the unemployment remains at 4.1%
- The number or workers voluntarily resigning is at a level last seen in the Spring of 2001 (historically, when we see the number of workers who voluntarily resign climbing, it’s been indicative of a good market)
- We continue to see improvement in Consumer Confidence and in Household Net Worth
- The Small Business Optimism Index and the ISM Purchasing Managers Index both also continue to climb
All these indicators typically indicate equities will do well.
Additionally, the news abroad is good. The Chinese Purchasing Managers Index is in expansionary territory, the ECB is beginning to cut back its Quantitative Easing, and the Unemployment Rate in Germany and Japan are at cycle lows, etc. A synchronous global expansion (like what we are now experiencing) could pave the way to increased economic growth and higher markets.
On the negative side, we have trouble finding much to hold on to. However, one thing we are watching is the valuation of US equities. As we shared last month, the S&P 500 is well above its historical average. But high valuations do not mean bear markets. Looking at historical data, we found that between January 1976 and December of 1979, the PE Ratio of the S&P 500 fell 47% and the price return of the S&P 500 was 7.6%. In addition to the price return, the S&P 500 paid a healthy stream of dividends. The cumulative dividend yield between January 1976 and December 1979 was another 19.9%, giving a total return of approximately 27.5% (about 6.3% / year).
While these were not the market’s highest returning years, compared to the 10-year Treasury, currently at 2.48%, it still looks attractive. Then between February 1994 and Feb 1995 the PE ratio of the S&P 500 Fell 25%, and the total return of the S&P 500 was about 0.9% during that period. The importance of this observation is that Valuations can come back to more normal levels in two ways: equities lose value or earnings accelerate. We have witnessed both in the history of our markets.
Because many market indicators suggest equities will continue to rise (and because we are not able to identify a lot of negatives), we continue to maintain our relatively underweight position in fixed income and our relatively overweight position in equities. We will be sensitive to economic data and earnings estimates. If they begin to weaken or slow down, that may be an early indicator of how the equity markets will get back to more historical valuations. For the markets to continue their pace, we’ll need to see an acceleration in earnings, and it will likely be accompanied by an acceleration in economic growth.
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Economic Data Sourced from Thomson Datastream.