Stocks rose sharply in January, but gave most of it back in February, and then a bit more in March. For the first quarter of 2018 the S&P 500 showed a small loss.
While real GDP growth came in at 2.3% in 2017, it would appear that the impact of fiscal stimulus and deregulation will increase that rate to 3-4% in 2018. Likewise, S&P 500 operating earnings, which were flat for three years, accelerated roughly 10.8% in 2017 to $132 and are on course to reach $148-150 in 2018. Why then, are the markets not marching to new highs?
One factor is that markets hate uncertainty. In the past several weeks both domestic and foreign markets have been shaken by several events—including rising inflation, currency volatility, trade tensions, White House staff turnover, the Mueller investigation, the potential impact of the November U.S. midterm elections, and the end of quantitative easing. That said, despite these uncertainties, the economic fundamentals remain sound with rising consumer spending, growing corporate profits, a recovering CapEx, solid employment, faster money velocity, a more normal monetary policy, and historically high consumer and business confidence. These are simply not the signs of an economy which is about to roll over. In fact, if we look at the leading indicators, the current expansion may be one of the longest on record, and should continue.
We have written in the past about the two main influences on equity prices—corporate profits and interest rates. Arguably, corporate profits have never been better and will continue to rise. We must conclude, therefore, that rising interest rates have upset the market the most. The fear is that a rapidly expanding economy will stoke inflation, force the Federal Reserve to preemptively raise interest rates, eventually resulting in a recession. In actuality, all inflation numbers are presently hovering around the Federal Reserve’s 2% target, and, historically, inflation has rarely been a problem for the equity markets until rates reach 4%.
Perhaps another cause of upset is the return of market volatility after several years of barely any movement at all. This factor is further complicated by the historical track record of midterm election years—generally flat-to-down until the 4thquarter, with an average correction in the S&P 500 of 18% (2002 saw a correction of 34%). The good news is that these corrections have turned out to be buying opportunities, with strong fourth quarter performances. Even better news is that the S&P 500 has not declined in the twelve months following a midterm election since 1946, with an average gain since 1950 of 15.3%.
We suspect the next few months may be volatile, and that it will be prudent to maintain some cash reserves. We do not believe, however, that the economic expansion or the bull market in equities is over, and we expect we may see higher stock prices by the year’s end.
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The 2018 midterm election is generating a record-breaking level of enthusiasm that could make this a November to remember. Over 36 million voters cast their ballots prior to Election Day, an 80% increase over the roughly 20 million who cast ballots prior to 2014’s midterm election. This upsurge is an important factor since pre-election polls have built-in assumptions in regard to how many people actually vote. In other words, larger-than-expected turnouts can have significant consequences on outcomes. In addition, a flurry in new registrations, early voting and absentee voting among young people aged 18 to 29 years of age could favor the Democratic Party in hotly contested races in states such as Arizona, Florida, Georgia, Illinois, Nevada and Texas. November’s elections also include a number of noteworthy propositions that could yield economic consequences for individuals, companies and for the economy. For example there are propositions on this year’s ballot in Colorado regarding oil drilling, in Nebraska regarding the Keystone pipeline and in California regarding kidney dialysis payments. If the Democratic mayor of Tallahassee, Andrew Gillum, should win the Florida gubernatorial race it could result in a massive corporate tax increase that could negatively impact the state’s strong entrepreneurial culture.
It has been our opinion that the midterm elections would be both a hurdle and a potential pivot point for the equity market. Since the best of the midterm election year’s performance tends to be in the fourth quarter this would follow precedent. But also, the months of November through January are traditionally the best three-month period of the calendar year. However, this November’s election could have more profound implications. We are finding that many agree with us since a CNBC poll showed that 79% of those surveyed believe the Democratic Party will retake control of the House of Representatives. The poll also indicated that 48% of respondents believe GOP control of both houses of Congress is good for the US economy, 31% believe a GOP Senate and Democratic House is good for the economy, but only 10% believed Democratic control of both houses would be good for the economy. When asked which legislative outcome would be best for the stock market 52% said GOP control of both houses, 38% said a Democratic House and GOP-run Senate and zero percent said a Democratic Party win of both houses. In sum, this week’s elections could move the markets.
Grid Lock, Blue Sweep or Red Repeat
CNBC’s poll confirms the consensus view that election results are likely to shift the control of the House to the Democratic Party. Most investors believe this is already discounted by current stock prices. Nevertheless, if the Democratic Party wins the House of Representatives by a large margin we think the recent lows will be tested and this will be followed by six months or more of a range-bound market between the October lows and the September/October highs. Fundamentals will drive stock prices in the subsequent six months and investors will wait for better than expected earnings to drive stocks higher.
Legislative gridlock is usually viewed favorably by investors, but the US Constitution requires that all bills regarding taxation must originate in the House of Representatives. The House Budget Committee has the power to spend, collect revenue, and borrow money for the US government and the House Ways and Means Committee is the chief tax-writing body. A Democratic-run House would likely shift the chairmanship of the Budget Committee from Republican Steve Womack of Arkansas to Democrat John Yarmouth of Kentucky and the House Ways and Means Committee chairmanship would shift from Republican Kevin Brady of Texas to Democrat Richard Neal of Massachusetts. In our opinion, it would take at least six months to see how House Democrats use their legislative advantage and whether Democratic leaders act upon their threats of fiscal policy changes and attempts to impeach President Trump. Either way, it could bring Washington DC to an uncomfortable standstill. What would weigh heaviest on the equity market would be if Democrats try to rewrite or repeal the Tax Cuts and Jobs Act of 2017. Although a repeal of tax reform is unlikely to pass the Senate, it could still make investors defensive.
Democrats are not apt to gain control of both houses of Congress, but if they do, we believe stocks have downside risk to the October lows or more. Our reasons are again financial since the possibility of the Tax Cuts and Jobs Act of 2017 being repealed increases. Also, under this scenario, the 2017 tax cuts could be replaced by tax hikes in 2019. Recent gains in real personal disposable income, due to lower tax rates, low inflation and modest wage gains have been one of the bright spots of 2018. It would be unfortunate if these income gains were reversed.
If the Republicans were to retain control of both houses or possibly gain seats in both bodies, we would expect stocks to rally. In the longer run, our 12-month SPX target of 3150 could prove to be conservative. Along with millions of Americans, we will be monitoring election results, but it is possible that many elections will be too close to call by Tuesday evening. If so, it could be a long nervous week for investors.
The Economy is Just Fine
October’s total nonfarm payroll increased by 250,000 jobs and the unemployment rate was unchanged at 3.7%. This was a solid report despite the fact that Hurricane Michael created havoc in the Florida panhandle at mid-month. The establishment and household surveys showed total employment increased 1.7% YOY and 1.77% YOY, respectively. This was just below the long-term average for the establishment series, but well above the long-term average for the volatile household survey. In sum, it was a good report. See page 3. But the best news was found in wages. October’s average hourly earnings for production & non-supervisory employees rose 3.2% YOY, the highest since April 2009. Average weekly earnings rose to 3.4% YOY for all private industry employees, which was the highest since August 2007. In short, wages are experiencing the best momentum seen in this economic cycle. See page 4. Other positive signs for households are found in the misery index — the sum of inflation and the unemployment rate – which was 6.1% in October and well below the long-term average of 9.3%. Note that October’s 6.1% is well below the 7.4% seen before the 2014 midterm election. The Conference Board’s Employment Trends Index was 110.72 in October. This was down slightly from August’s record 111.27 but still pointing to good momentum in the job market. See page 5.
According to Thomson Reuters IBES, third quarter earnings for the SPX are expected to grow 27.5% YOY, or 24.1% excluding the energy sector. This 27.5% estimate is up from the 21.6% reported on October 1. Third quarter revenues are forecasted to increase 8.4% YOY, or 7.3% YOY excluding the energy sector. This 8.4% estimate is up from the 7.4% YOY revenue increase forecasted on October 1. In sum, SPX earnings continue to exceed expectations in the third quarter and are a source of underlying support for the US equity market. See page 7.
Good News Bad New Crude Oil
Crude oil prices are falling and much of this is due to reports that US crude production hit a record 11 million barrels per day in August. The US is also the world leader in dry natural gas production. A shale revolution has helped push US crude production to record highs, rivaling top producer Russia and outpacing Saudi Arabia. We believe these lower oil prices are positive for the inflation outlook, consumers and the Fed since it reduces pressure on the Fed to raise interest rates. See page 8.
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I, Gail Dudack, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific views contained in this report.
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting
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