Investment Committee & IA Department News – 4th Quarter 2017

Late Cycle “Reflation” and What it Means

Last quarter we speculated as to whether or not corporate earnings would play catch up or if the gap between the price of the S&P 500 and the Earnings Per Share (EPS) growth for the S&P 500 would continue to widen. Well, given the continued resilience of the stock market, the gap has slightly widened, despite continued outpacing of expectations on the earnings front. If we view the illustration to the right, we’ll notice the fairly large spread between the current level of the S&P 500 on a price basis (shown on the vertical axis) and forward 12-month EPS for the S&P 500 (shown on the horizontal access).

Despite the visibly widening gap, which currently gives the S&P 500 a Price to Earnings (PE) multiple of roughly 18 times next year’s earnings, the S&P 500 is on pace for its 13th quarter in a row of earnings outperforming estimates. As recently as 9/30/17, the 3rd quarter 2017 earnings growth estimates were 3.0% and after 55% of companies having reported earnings so far, the earnings growth rate sits at 4.7% 2. In fact, 76% of the companies that have reported have given positive EPS surprises and 67% have issued positive revenue surprises, both strong, from historical perspective 3. Many may see the tight correlation between earnings growth of the S&P 500 and the price of S&P 500 (in fact, it’s .92 going back to 1990, according to Bespoke Investment Group) and assume the gap has to tighten. We would agree that it does in time. However, the catalyst(s) that help force the hand, need to be in place. At the moment, few of the main ones, such as rapidly rising interest rates and inflation, seem to be exerting pressure.

This brings us to the late market cycle reflation conversation around which the market has recently gained increasing enthusiasm. Specifically, we’re seeing the following factors, real growth as GDP recently surprised on the upside at an annualized 3% rate, firming inflation, normalizing monetary policy with gradual rate increases, and the efforts to bring forth expansionary fiscal policy combined with the strength of corporate earnings helping drive and support current stock prices. However, if rates rise more than expected through a meaningful uptick in inflation and/or a less accommodative monetary policy, that could be problematic for helping justify historically higher equity valuations. If we remain in this lower for longer interest rate environment supported by tame inflation, equity market valuations can be supported and even drift higher. However, the interest rate aspect of the equity market risk doesn’t even address the structural economic headwinds on growth relating to labor supply and productivity growth, which will ultimately relate to pressure on corporate earnings. Given some of these systemic challenges our nation is faced with, it’s hard to imagine economic growth meaningfully above current levels, which is why this late cycle reflation theme will likely need a meaningful catalyst, such as corporate tax reform, to help not only support current valuations, but to help ignite further earnings growth.

1 Source: FactSet Research Systems, Inc., Earnings Insight Report for October 27, 2017
2 Source: FactSet Research Systems, Inc., Earnings Insight Report for October 27, 2017

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