Large Cap Commentary – November 2017
As we wind down 2017, the statements for our clients are looking pretty good, as the S&P 500 Index is up around 20%. Not a bad year, especially considering we are moving into the ninth year of recovery both for the stock market and the U.S. economy.
With that as a backdrop it should come as no surprise that the stock market is a less compelling buy than it has been in the recent past. In fact, using a concept called the Rule of 20, for the first time in nine years the market looks slightly overvalued (see chart below). The Rule of 20 is a way of looking at stock market valuation (determining the appropriate price-earnings ratio for the market). The Rule of 20 states, in a normal market, the 12-month forward price-earnings ratio (P/E) of the S&P 500® Index should closely mirror the number 20 minus the yield on the 10-year Treasury Bond. When the forward P/E of the market is less than the Rule of 20, the market is considered to be undervalued. Conversely, when the forward P/E is greater than the Rule of 20, the market is considered to be overvalued. Looking at the chart, the value of the market is currently greater than the Rule of 20, indicating the market is a bit overvalued.
While it is true that the market has not been in a straight line path upward since bottoming in March, 2009, it is fair to argue from that point to today that there was value that deserved to be recognized in stocks. In other words, the price-earnings ratio (or P/E) of the market was depressed. Relative to bonds, that were paying very low rates of interest, investors should have been paying more for stocks. That gap, depicted in the graph, closed over the intervening years in a good way to bring us today’s valuation level.
So, where we stand today is a slightly overvalued market and a 20% return for 2017. What does that portend for the future? At Argent, we would be surprised to see another 20% return year for 2018. Instead, we would expect a more normal rate of return for the market, around 5 – 10%, perhaps leaning on the lower side given the valuation headwinds.
Despite the high valuation of the current market, there are a couple of positive offsets to consider as we look into 2018. The first is tax policy. If Congress and the President lower the corporate tax rate, that change will have a material effect on earnings, especially for more domestic businesses. The second consideration is the state of economies outside of the U.S. According to the International Monetary Fund (IMF), global GDP growth for 2018 should rise to 3.8%. In fact, the IMF stated that recent growth has been more broad-based than at any point since the beginning of this decade. This global expansion has been referred to as “synchronized global GDP growth.”
So, we have the potential for earnings growth through a change in the tax code, and the tailwind, for the first time in a decade, of synchronized global GDP growth. Given the continued low level of inflation in the U.S. and the very strong employment picture here, we think we are set up for a positive 2018, even in the face of less compelling valuations for the market as a whole.
We have four successful equity strategies – Large Cap, Mid Cap, Small Cap and Dividend Select. If you have questions on any of these, or know others who might have an interest in our mailings, please call us.
Senior Portfolio Manager
Past performance is no guarantee of future results. Views expressed herein represent the opinion of the portfolio manager as of the date above and are subject to change. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. You should not assume that investments in any securities within these sectors were or will be profitable. A list of stocks recommended by Argent in the past year is available upon request.