March 31, 2017

The post-election stock market rally continued in the first quarter with the S&P 500 adding 6% on top of the 5% fourth quarter post-election advance.  As of the end of the first quarter, the S&P was up 11% since November 8th.  However, there was a notable shift in leadership during the quarter.  The so-called “Trump stocks” (cyclical reflation beneficiaries like financials, energy, materials and industrials) that led the initial advance took a breather and gave way to some of the secular growers within healthcare, technology and consumer discretionary.  The lagging performance of the “Trump stocks” seemed to coincide with a pullback in the dollar and bond yields, a sign that investors’ enthusiasm for the timing, if not the substance, of the Trump administration’s pro-growth agenda, and in particular tax reform, started to wane a bit.

In our last quarterly review, we had warned that investors seemed to be placing a lot of faith in the successful passage and timely implementation of the new administration’s agenda.  However, following the failure of Congressional Republicans to unify to pass their own health care reform legislation, investors are left to question their ability to push through similarly complicated tax reform.  Considering the down payment that healthcare reform was expected to make on the federal budget deficit, it now becomes monumentally more difficult to pass meaningful tax reform that is revenue neutral (a key requirement of passage under budget reconciliation) without including controversial proposals such as the border-adjustment tax (BAT).  The BAT was expected to produce roughly one trillion dollars in new tax revenue but seems to lack the necessary support in the Senate given its potential adverse effects on import prices, consumption, and profits for certain companies such as retailers that are heavily dependent upon foreign goods.  Thus, it seems more likely that President Trump and Congressional Republicans may be forced to settle for a scaled back package of tax cuts that come with an expiration date.  While still positive, this outcome is certainly not as desirable as more comprehensive tax reform that would truly affect behavior and drive new investment.

At the same time that doubts are emerging about policy makers’ ability to fulfill investors’ hopes for improving growth to justify the post-election rally in share prices, we see a growing discrepancy between sentiment-based indicators of economic growth, which continue to show strength, and data reflecting actual economic activity, which have remained soft.  This dichotomy between the so-called “soft” data and “hard” data presents a risk for investors that near-term growth may prove disappointing.  We currently expect first quarter real Gross Domestic Product to show growth of just 1%, a step down from last quarter’s 2.1% and the post-recession average of about 2.0%.  While it is possible we could see an inventory-fueled bounce in the second quarter, we expect full year 2017 real GDP growth to once again be about 2.0%.

Of course, these disconnects are nothing new to this market.  Active managers broadly have struggled with the market’s divergence between asset prices and fundamentals. The last five years the market advanced mostly on multiple expansion; and we believe that the next five years will have to be driven by earnings growth.  The S&P 500 forward P/E is around 17.5x – the highest it has been since 2002, and well ahead of its long term average.  Median multiples are at record levels.  It is difficult to make the case that multiples can continue to climb from here.  If not multiple expansion, then asset prices will likely move higher on earnings growth.  Earnings growth is a far more discriminating criteria than what we have been used to, particularly in an environment with increasing volatility and dispersion.

Low market volatility with little dispersion is the result of central bank liquidity and zero percent short-term interest rates.  The market climbed higher despite modest year over year sales and earnings growth.  The resulting multiple expansion was broad based and indiscriminate, yet lower quality securities benefited the most.  This multiple expansion also drove a significant amount of assets to passive investing and as a result, we may be in the midst of a passive bubble.  Active managers in general aren’t able to benefit from indiscriminate market advances – reducing the effectiveness of processes that exploit market inefficiencies. The divergence between asset prices and fundamentals has grown each year (along with flows towards passive indices) as investors became increasingly confident that central bankers wouldn’t let the market falter.  The market has been discounting Fed policy (and more recently Trump’s pro-growth agenda), but clearly not fundamentals.  Because of this disconnect and subsequent multiple expansion, valuation metrics on most measures suggest that the market is fully, if not overly valued.  As seen on the chart below, median ratios on price to sales, market cap to GDP, and enterprise value to EBITDA are in record territory.  The only metric that justifies the market multiple today is the relative attractiveness of equities to fixed income, given the artificially low bond yields.

Source: FactSet, FRED. Data as of 3/31/17.

As the Federal Reserve removes the extraordinary accommodation with the ending of their Quantitative Easing program and increases (normalizes) interest rates, volatility is likely to return to historical norms, creating more dispersion, and ultimately an environment of winners and losers based on higher quality, more predictable fundamentals.  In other words, the market will likely return to an environment of rewarding and punishing stocks more idiosyncratically, which should be a relative benefit for our Clients.  We continue to have high conviction in our Clients’ holdings, as these high-quality growth stocks offer a compelling combination of above-average profit growth at attractive valuations.  We remain confident that these holdings should perform better during challenging markets and offer the prospect of superior long-term risk-adjusted returns.