EQUITY MARKET OUTLOOK
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EQUITY MARKET OUTLOOK
Martin Sirera, CFA©
Senior Director of Equity Portfolio Management
The Trump Rally – Hope and Change
Since our last Equity Market Outlook, much has changed. Last November’s US
Presidential election result that was surprising to most observers has brought
about much speculation as to the future direction of not only the U.S. but also,
given other populist surges in other locales, the world overall. The question is –
how much have things really changed? After a two-term presidential
administration which was originally brought into office on a mantra of hope and
change, obviously, the answer is a lot. The next most important question is –
how will this change manifest itself for investors over the foreseeable future?
• US Equity markets rallied on the election news, and even right before it,
reversing a slide as investor optimism about changes in economic policy
takes hold.
Our Risk Management Tenets
9 We believe in extensive asset
class diversification
• Risk continues to be high despite the fact that certain measures of short-
9 We actively manage tactical
asset allocation policy
• Corporate fundamentals are finally turning around and showing some signs
99 Our stock selection process
emphasizes intrinsic value, innovation, and durable competitive advatages
99 We believe excess returns are
achievable due to market inefficiencies that persit over time
term volatility have been trending downwards.
of emerging growth.
•
Quantitative Easing is still a major consideration effecting both asset prices
and underlying fundamentals around the world.
•
European Central Bank (ECB) buying of non-financial corporate bonds
(announced in March 2016) stimulated yield-seeking behavior, accelerating
the flow of funds into low-quality assets.
In this quarter's Equity Market Outlook, we review the major possible effects
from the presidential election and new administration as well as the emergence
of growth opportunities around the world.
9 We seek to build diversified
portolios of stocks with attractive valuations, quality balance sheets and aboveaverage earnings growth
The Era of Big Government is… changed
Over the last decade and a half, the direction of public policy in the US has been
a more robust federal government engaging in more energetic fashion with all
participants in the economy. From massive expenditures on a variety of public
well-being initiatives, to massive expenditures on foreign entanglements and
99 We closely monitor valuation
interventions, from massive amounts of new regulations to massive
measures to limit downside risk
interference in markets (e.g., mandates), and from massive spending increases
to massive tax increases, the burden placed on private sector production in the
9 We carefully control portfolio
US has grown steadily, and massively. Perhaps the clearest and most distinct
average capitalization and
change brought about by the election of Donald Trump as President (coupled
beta
with the ability to work with Republican majorities in both houses of Congress)
'
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FEBRUARY 15, 2017
EQUITY MARKET OUTLOOK
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is the immediate cessation of this steady build-up of
burdens, at least as far as regulations, mandates, and
current taxes are concerned.
All by itself, this change appears to have resulted in an
immediate mark-up in expectations for near-term
fundamental (revenue and profit) growth. Expectations
were already improving from the flat growth in
revenues and declines in earnings evident over most of
the last year and a half and the Trump presidency has
stimulated that optimism.
The initial post-election run-up in stock prices through
the Christmas holidays repriced the upside potential in
economic and earnings growth. Since that time,
domestic equity markets have ebbed and flowed within
a narrow range and have not advanced significantly. It
appears the stock market has adopted a more “show
me” approach toward both the probability of all the
hoped for reforms actually materializing as well as the
ultimate impact of the new policies.
Low Quality Rally Continued After Election
As we reviewed in this space last November, investors
have an elevated appetite for risk at present. This is
evident when looking into the underlying characteristics
of the types of stocks that have performed best in the
last year. In general terms, lower quality stocks have
been outperforming higher quality ones. Our
assessment is that this is largely driven by the massive
amounts of liquidity still being pumped into global
markets by central banks, primarily the European
Central Bank, the Bank of Japan and the Bank of
England. Partly, this is a function of the old definition of
inflation: “too much money chasing too few stocks.”
This preference for lower quality persisted in the postelection run-up in stock prices however there are at
least preliminary signs of a shift back to quality in the
first month of 2017.
The best performing sectors since the election have
been the lowest quality sectors, in terms of trends in
expectations about future growth of underlying
fundamentals. Excluding the Energy sector (with its
substantial retrenchment in earnings over the last two
years and expected huge bounce back in earnings
growth this year), on average the sectors outperforming
the S&P500 since the election have seen their 2017 EPS
estimates reduced by 8% so far this year; while the
sectors which have underperformed the S&P500 since
the election have seen their 2017 EPS estimates cut by
only 4%. Furthermore, trends in fundamental growth in
the 3rd and 4th quarters of 2016 were running inverse to
stock performance. In general, companies with weaker
fundamental growth in those quarters saw better
performance in their stocks than the rest.
However, the differences among the growth
characteristics of the best and worst performing sectors
is narrowing compared to the middle part of 2016.
Especially as the market has progressed through the
latter part of January, an investor preference for quality
(i.e., companies with more attractive earnings growth
and less leveraged balance sheets) is showing signs of
emergence.
The pattern of equity investors preferring lower quality
companies’ stocks has been mirrored in the credit
markets lately with significantly higher performance
coming from the lower quality segments of the bond
markets, driving yield spreads on junk bonds to levels
which normally signal overvaluation. Junk bond credit
spreads in the aggregate have reached levels near the
bottom of very long-term ranges (with the exception of
crisis periods). As of 1/31/17, junk bond risk premiums,
as measured by the Barclay’s High Yield Corporate Bond
OAS (option adjusted spread, referring to call options)
on average were 3.88% higher than 10-year U.S.
Treasury Bond yields. For reference, at the beginning of
2016, that spread was 6.74%; and at the depths of the
Financial Crisis / Great Recession, when default risk was
at its highest, the High Yield OAS peaked at 19.71%.
A Return to Quality Accompanying a Return to Growth
That a return to quality seems to be emerging in early
2017 is a good sign for active investment management,
which generally suffered in 2016 as indiscriminant
buyers ignored fundamental growth distinctions. The
core philosophy underlying COAM’s equity portfolio
management process is that fundamentals ultimately
drive stock prices. When a market environment persists
in which the companies with the worst trends in
underlying fundamental growth are rewarded with
investor dollars and superior stock returns, that philoso-
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FEBRUARY 15, 2017 EQUITY MARKET OUTLOOK
2
phy is challenged. Notwithstanding this challenge our
belief holds true – companies that exhibit consistent
growth of core earnings, strong balance sheets and
reasonably priced stocks will be the best ones to own in
the long run. They also are the stocks that attract the
most intense investor interest in times of stress.
In late 2015 and for the better part of 2016, recessionary
conditions dogged several sectors of the domestic and
global economies. Manufacturing, in part driven by
severe cutbacks in energy sector investment spending,
was contracting. Top line corporate revenue growth has
been negative on a trailing 12-month basis for five
straight quarters (Dec 15 through Dec 16; considering
estimates for Dec 16). However, the pace of that
contraction has abated and growth appears to be
perking back up (Figure 1). This was already taking place
before the election. Since the election, a number of
developments have taken place which could add a
compounding factor to that growth.
Most importantly, the early actions by the new
administration exhibit a desire to reduce the burden of
government on private sector activities. Reductions in
regulations, mandates, and taxes will all serve to
increase the future profitability of corporate activities
and investments. This is a key component in the
Administration's strategy to accelerate growth in the
U.S. from the anemic rates of the last decade. Stronger
growth is necessary to increase standards of living and
encourage capital investment. As these developments
begin to take effect, a virtuous cycle can emerge in
which a growth-friendly feed-back loop encourages
entrepreneurial behavior and stimulates growth further.
Figure 1 - Quarterly EPS and Sales Growth
Valuations Still Reflect Extreme Optimism
Equity valuations today reflect a high level of optimism
about future growth. Relative to history, price-toearnings multiples, price-to-sales multiples, and many
other barometers are all in the high end of the range of
experience. The market has been more overvalued than
it is today, most notably in 1999 and 2000, but not very
often.
In addition to being an expression of sentiment,
valuations are also driven by the central bank liquidity
issue, as global liquidity flows have driven capital into
U.S. equities. Current valuation levels are a warning sign
to investors and leave little room for either negative
surprises or further multiple expansion. The
environment for growth is improving and high
valuations may yet prove validated by accelerating
earnings expectations. Investors should remain mindful
of high valuations, however, and remain agile in asset
allocation considerations. Much rides on the execution
and delivery of President Trump’s ambitious growth
agenda.
Conclusion
Given the improved outlook for economic growth,
earnings growth and better economic and regulatory
policies, we have become more constructive on the U.S.
equity outlook and have eliminated the modest
underweight to equities in balanced accounts that
prevailed for much of the last year, moving to neutral v.
long-term strategic targets. Within equity portfolios, we
continue to emphasize U.S. over International stocks
and mid- and small-cap over large cap. We remain wary
of a number of risks including high valuation levels. In
addition, the rapid increase of sovereign debt in the
developed world over the last decade will continue to
present challenges to growth and to fiscal flexibility for
overly-indebted governments. While we remain wary of
growth prospects in Europe, Japan and China, we see
value in emerging market equities that have completed
a currency adjustment and which are also less
dependent on China; and consequently we are
selectively adding modest exposure to emerging
markets equities.
Source: Factset
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FEBRUARY 15, 2017 EQUITY MARKET OUTLOOK
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As always, should you have any questions about this piece or your portfolio, please do not hesitate to contact your
Portfolio Manager or Trust Officer.
Unless otherwise noted, all performance and return data sourced from Bloomberg, LP, February 15, 2017.
Disclosures
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Any opinions and recommendations expressed herein do not take into account an investor’s financial circumstances, investment objectives, or
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investments that reference a particular derivative index or benchmark.
Past performance is not indicative of future results. The securities described herein may be complex, may involve significant risk and volatility,
may involve the complete loss of principal, and may only be appropriate for highly sophisticated investors who are capable of
understanding and assuming the risks involved. The securities discussed may fluctuate in price or value and could be adversely affected by
changes in interest rates, exchange rates, or other factors. Asset allocation and diversification do not assure or guarantee better
performance, and cannot eliminate the risk of investment losses.
Investors must make their own decisions regarding any securities or financial instruments mentioned or discussed herein, and must not
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inaccuracies or errors in, or for any omissions from, the information contained herein.
Fixed Income securities are subject to availability and market fluctuations. These securities may be worth less than the original cost
upon redemption. Corporate bonds generally provide higher yields than U.S. treasuries while incurring higher risks. Certain high yield/
high-risk bonds carry particular market risks and may experience greater volatility in market value than investment-grade corporate bonds.
Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and
fixedprincipal value. Interest from certain municipal bonds may be subject to state and/or local taxes and in some circumstances, the
alternative minimum tax. Unlike U.S. Treasuries, municipal bonds are subject to credit risk. Quality varies widely depending on the specific
issuer.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
This is only an opinion and not a prediction or p omise of events to come.
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FEBRUARY 15, 2017 EQUITY MARKET OUTLOOK
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