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The bull case: Part II

Saturday, February 18, 2017 11:03
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RYAN  By Guest Blogger Ryan Lewenza

In my last post I examined the bear case for the equity markets. I cited high valuations, age of current bull market, and the inevitable end of accommodative central bank policies. This provoked a sense of validation or “I told you so” sentiment from some of the bearish blog dog readers. Well buckle up you doomers and believers in the coming zombie apocalypse, as I’m going to present our bull case for further equity gains in 2017. I can already envision the Darth Vadar (or Kylo Ren for you youngsters) rage I’m likely to encounter in the comments section of this pathetic blog (Garth’s words). There goes my Saturday!

In developing my market outlook I always start with the economy. As Bill Clinton’s campaign strategist James Carville famously said “It’s the economy, stupid!” I see the US and global economy picking up this year. I’m expecting the US economy to grow around 2.5% this year, up from a lackluster 1.6% in 2016. I see the consumer continuing to do most of the heavy lifting, but see the potential for a boost from business investment and government spending if President Trump is able to pass some of his pro-growth policies.

Most of the economic data I track shows a clear acceleration in recent months. US Q3/16 GDP came in at 3.5% Q/Q annualized, which is the strongest quarterly growth rate in two years. The US economy did slow in the fourth quarter to 1.9%, but the trend in economic data remains clearly to the upside. This includes continued strength in the labour market, housing, auto sales, industrial production etc.

One economic indicator I track closely is the US Citigroup Economic Surprise Index, which measures how economic data is coming in relative to economist’s expectations. It’s recovered nicely in recent months (capturing data is coming in above expectations) and is at a level not seen since 2014.

Finally, I focus a lot on manufacturing data as the manufacturing sector is highly cyclical capturing the ebb and flow of the economy. I analyze manufacturing data across all the major countries and regions, and as illustrated below, manufacturing globally is in an upswing with the global manufacturing index at the highest level since February 2014.

In summary, I see the odds of a US recession as remote for this year (Bloomberg estimates it at 15%) and in fact, I see the US and global economy re-accelerating following a soft patch last year.

Global Manufacturing Is Rebounding

Source: Bloomberg, Turner Investments

A stronger economy should bode well for higher corporate profits this year, which is the main thrust of our bullish outlook for 2017. Stocks rise through either an increase in valuations (e.g., P/E rises from 10 to 12x), or through an increase in corporate profits. Much of the gains over the last few years have been by an increase in equity valuations. For example, the P/E ratio for the S&P 500 has increased from roughly 17x in 2014 to a lofty 21x currently. I believe the equity markets will transition from a valuation driven market to an earnings driven market this year. And the recent results are showing this.

The S&P 500 experienced an earnings recession in 2015 and first half of 2016, posting a number of consecutive quarters of Y/Y earnings decline. However, this trend reversed in Q3/16, with S&P 500 earnings hitting an “inflection point”. Based on Bloomberg data, Q3/16 earnings rose 2.3% Y/Y with the current quarter tracking at an impressive 8.6% Y/Y.

Given our expectations for stronger US and global growth, I see earnings continuing to improve this year, thus driving US and Canadian stock prices to new all-time highs. Currently, analysts are forecasting S&P 500 earnings to rise 19% to $130/share in 2017. I think this is overly optimistic and see earnings growing by high single digits, helping to realize my year-end price target of 2,400 for the S&P 500.

Critically, this forecast does not embed the potential for President Trump and Congress to lower the US corporate tax rate. The US corporate tax rate is currently 35%, and is one of the highest of any developed nation. President Trump is proposing to lower the corporate tax rate from 35% to just 15%, while House Republicans are pushing for a cut to 25%. Regardless of the final rate reduction, a cut to corporate tax rates of even 10% would equate to over $13/share in S&P 500 earnings according to Thomson Reuters. If this gets passed this would be huge for corporate America and could provide more fuel to the equity markets, possibly resulting in the S&P 500 surpassing my 2,400 price target for this year.

S&P 500 Earnings Are Rebounding

Source: Bloomberg, Turner Investments

Finally, I believe strongly in combining fundamentals with our technical readings of the markets in determining our outlook and strategy. And in my opinion the technicals are demonstrably bullish for the equity markets at present. Looking at the chart below you can see that the S&P 500 remains in well-defined long-term upward channel. Note the trend of “higher highs” and “higher lows” which is the definition of an uptrend.

Additionally, the S&P 500, and most other global equity markets are trading above their rising 200-day moving averages, which again defines an uptrend. And finally, market breadth, which measures the number of stocks advancing versus the number stocks declining, is very strong with the NYSE Advance/Decline line continuing to make new highs. This is very bullish and is confirmation of a healthy bull market.

I could go on and on, citing numerous charts and indicators that show a healthy bull market. But you have other things to do other than reading this pathetic blog on this Saturday. Suffice to say, given our positive assessment of the economic, fundamental and technical readings of the economy and stock market we’re sticking with our bullish outlook. As referenced in my last blog post, “when the facts change, I change my mind.” We’ll adjust accordingly when the weight of evidence tells us to do so. Until then, stay long and prosper!

The S&P 500 Is In A Long-term Uptrend

Source: Stockcharts, Turner Investments
Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.


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