“If the question is when markets will recover, a first-pass answer is never,” is a post-election quote from Nobel prize winning economist Paul Krugman after Donald Trump won the 2016 election. Since then, the S&P 500 is up 23% with 19% of that coming last year. I cite that quote because it’s an excellent example of how personal biases, ignorance of actual data and a negative view of markets were being promoted in financial media heading into 2017. In fact, last year is an excellent example of how many market participants gave in to preconceived notions about market outcomes and then were caught completely offsides from the actual results. And now, with the S&P sitting just a breath away from its all-time highs, investors are faced with difficult decisions on how to manage their gains and how to invest new money. It’s at critical junctures like this where investing becomes as much an exercise of mental fortitude as it is a test of economic knowledge. This is why it’s so important to assess, not just overall market valuation and future growth rates, but also the psychological reasons that cause investing at this stage to be so uncomfortable.
Starting in 2016 and through 2017, the “late cycle” narrative was being used by many pundits throughout financial media to describe an economy and market that were at the end of their prosperous times. The “late cycle” concept is rooted in NBER data which shows that on average since World War II, recessions occur about every six years. This 6-year average completely ignores the changes that have taken place in the American economy which I discussed previously and explained why cycles have lengthened as the economy has become services / consumption based. While the calendar recession timeline is an easy explanation, it’s a very weak analysis that has now become ingrained in investors’ thought processes. The reality is that recessions are started by some type of shock to the economy like a real estate crash, stock market crash or an inflationary spike as was seen after the oil embargo of 1973. The point here is that it’s incorrect to allow the calendar to dictate the timing of recessions and even worse to base investment strategies around it. From a behavioral finance perspective, when a concept like 6-year recession timing takes precedence over the actual economic data being presented, this is called conservatism bias. Conservatism biases lead investors to overestimate unlikely events (recessions) and to underestimate the likely events (continued economic expansion). This bias also causes investors to ignore new data like rising corporate profits, strong business activity data and a newly elected pro-business administration for the mental ease and comfort of assuming a recession is due.
We can see this bias showing itself in the 2017 predictions by this panel of experts in Barron’s:
We see that even with economic data showing growth into 2017 and a new administration promising pro-business policy changes, the average predicted return was 6.3% which then falls to just 5.4% if we back out the one bullish strategist from Prudential.
Analyzing the predictions of the panel shows that all but one of them were expecting multiples to contract which is a typical sign of late cycle / early recession market behavior. All the panelists above had the same data to work off of, but only one took the view of a bull market return. It’s also interesting to note that one of the lowest estimates was from Goldman Sachs and they revised their target upward in midyear to 2400 but were still citing “late-cycle dynamics” as a reason for slowing sales and earnings going forward. And now, with Q3 earnings season behind us, we see that a majority of firms have actually raised sales and earnings estimates for Q4 and 2018. According to Factset, 2018 is projected to have the best earnings growth since 2011. This earnings growth is a direct result of accelerating global economic growth and is not indicative of “late cycle” market behavior.
Looking at the economic data at the end of 2016, we see that it was showing growth. National ISM surveys and regional Federal Reserve Bank manufacturing data were all showing activity picking up headed into 2017.
Table: ISM data
(All chart data is the headline activity index taken from its respective Federal Reserve Bank research database.)
Then there was labor market data which was also showing significant strength in terms of a record high level of job openings and a persistently low level of unemployment claims data.
(data from DOL and BLS)
Essentially, at the end of 2016, the economic data was pointing towards further expansion, but most financial pundits were talking about the “late cycle” narrative simply because of the length of the expansion. Looking at the economic data and the pro-business rhetoric coming from Washington, an unbiased analysis showed that the stage had been set for 2017 to be a strong year for stocks, and it turned out to be exactly that. All one had to do to take advantage was to keep an open mind and stay focused on the data which is why my target for 2017 was 2700. Published on Twitter :
So, what’s in store for 2018? I’m looking for a sustained economic expansion throughout the year. I’m expecting ISM surveys to fluctuate around the mid 50’s and for unemployment claims to drift down to and through the 200,000 level as the labor market continues to tighten. We have a very unique situation in the US economy for 2018 as it’s already on a strong and sustainable path while the government is preparing significant stimulus in the form of a massive infrastructure rebuilding plan. Given the already tight labor market and rising commodity prices, there is a good possibility of getting a pick-up in inflation which could bring out a more aggressive Fed. Even with a more hawkish Fed, I still see equities performing well as economic growth and strong corporate earnings will be the dominating factors.
In terms of market valuation, I like to compare this market to the bull run of 1997 – 2000, a.k.a the original tech bubble. However, what separates today from then is that companies are actually making money. In 1997 – 2000 the S&P traded with an average 25 multiple on low quality and in some cases non-existent earnings.
Today, we have high quality and growing earnings. Coupling current earnings estimates with tax reform benefits and the pro-business agenda of the Trump administration, I see the S&P climbing to 3,350 in 2018. And with that, I wish everyone a happy New Year!!