The year 2017 was one for the U.S. stock market record books. According to The Wall Street Journal, The Dow Jones Industrial Average made 71 record-high closings, the most since the tech frenzy of the late 1990s. The S&P 500 Index® and NASDAQ also stood near record highs at year end. Thomas Dillman, President of Mutual of America Capital Management LLC, provides a close look at the various reasons behind the strong showing in the markets, as well as the generally unified global economic growth that prevailed in 2017.
One of the more interesting statistics is that 2017 was the first time in which the S&P 500® posted positive total returns for every month of the year, part of a string of 14 consecutive months of increases. Also during 2017 there were no days in which the S&P 500® finished with a 2% or greater move, and very few with even a 1% move. In fact, the best performance day was a 1.38% advance. Such outcomes were not anticipated by any economists or strategists.
Globally, the same held true for most markets. All developed markets posted positive results, with all but two in double digits. In the U.S., the S&P 500 Index advanced more than 20% on a total return basis. The Japan Nikkei Index advanced about 20%. European markets generally finished up in the high single-digits to mid-teens in percentage terms. In U.S. dollar terms, foreign results were even better, given the weaker dollar versus last year. At the same time, most emerging markets also posted strong gains.
The sources of these spectacular results are threefold, in our opinion. First, 2017 was a year of truly synchronized global economic growth. Second, global monetary policy remained accommodative because, despite the scaling back of quantitative easing by the U.S. Federal Reserve, Europe and Japan continued to pump money into the global financial system. And third, markets were buoyed by high expectations for aggressive fiscal policy initiatives by the Trump administration, including tax cuts and infrastructure spending.
Synchronized Global Economic Growth
With regard to the global economy, we have previously commented on the steady acceleration in economic statistics during 2017. The U.S. produced two back-to-back quarters of 3.0%-plus Gross Domestic Product growth and is likely to see the fourth quarter come close to, if not match, those results. Both the ISM Manufacturing and ISM Non-Manufacturing surveys of purchasing managers stand near cycle and historical highs. The most important underlying components of these surveys—namely, orders, prices and deliveries—were among the strongest. Retail sales at the end of the year registered a 6% year-over-year run-rate following six straight monthly advances. Beyond the U.S., in an ascending trend, Japan posted seven positive GDP quarters in a row, while Europe has slowly expanded over the past three years and is currently growing at a rate approaching 2.0%. China, while expected to slow over the long term, continued to grow at a mid-to-high 6% range over the past few years. Combined on a weighted basis, global growth showed modest but consistent improvement for the past couple of years, as indicated by optimistic forecasts by such organizations as the International Monetary Fund.
Global Monetary Policy Accommodative
All major global monetary authorities are at various stages in their quantitative easing cycles. The U.S. stopped buying new bonds two years ago, then began to gradually raise the Federal Funds rate. More recently, it allowed its balance sheet to begin slowly shrinking by not reinvesting the proceeds of maturing bonds. The Bank of England has pursued a parallel course. The European Central Bank began its withdrawal from quantitative easing by beginning to let its maturing bonds roll off without reinvestment, but at a very gradual pace. Given recent good news on the economy, it is expected to begin to raise interest rates sometime in 2018. The Bank of Japan will probably maintain its bond buying program until it becomes more confident in the sustainability of modest inflation. Plenty of liquidity remains in the global financial system and if economic conditions begin to deteriorate, central banks should be able to reinitiate some form of rate reduction/quantitative easing program. Of course, there are skeptics who fear that central banks will tighten monetary conditions too quickly and curtail expansion prematurely. The strength of the global economy and the deliberately slow pace at which the banks are moving suggests that won't happen anytime soon. The major concern is how current policy may have to be modified to respond to the economic effects of the recently passed Tax Cuts and Job Act in the U.S.
High Expectations for Economic Expansion
There is no doubt that the Act will add fuel to the economic expansion. Analysts have already penciled in an additional $10 to $18 in S&P 500® earnings per share over the next two years. It appears that most Americans will see at least a modest increase in their paychecks. A number of corporations have already announced across-the-board wage increases and special bonuses. In addition, one key expectation is that corporations will use some of the proceeds from the tax cut and repatriation of foreign earnings to expand capital spending, which has been a missing component in this expansion. These expectations are backed up by surveys of corporate leaders. Unlike share buybacks, dividends or acquisitions, which are financial transactions whose proceeds tend to feed back into financial assets, capital spending injects money and liquidity into the real economy where it has a multiplier effect. As an example, when Company A buys a machine from Company B and produces goods more efficiently and cheaply, it permits wage increases and/or lower consumer prices. In the meantime, Company B must hire workers to fulfill new demand, thus raising incomes which in turn are used by workers to buy food, furniture, or cars.
There are skeptics who raise the question of why companies would ramp up capital spending now when there has been more than enough cash to do so during most of this expansion. Instead, most cash went toward share repurchases, dividends and acquisitions, generally non-productive uses of capital except for the latter—if they work. Companies invest in projects if they determine that the returns on capital invested exceed the costs of that capital. Given the historically low interest rates that have prevailed over the past 10 years, the cost of debt capital has been extremely low, and therefore one would think there would be many viable investment alternatives for corporations to pursue. But corporations often took on debt for share repurchases instead, suggesting that such reduction in share count and thus higher earnings per share and returns on book value were deemed higher (and less risky) than capital projects. The question now is whether the tax law changes the calculus to incentivize capital spending as opposed to directly or indirectly returning capital to shareholders. Of course, the answer will be case specific, but the combination of reducing the amount of interest expense that can be used for tax purposes, the five-year provision allowing full expensing of capital purchases, and the lower taxes on profits derived from such capital projects, would seem to provide plenty of motivation for at least some corporations to change their capital allocation policies.
A Closer Look at Valuation
Increasing economic growth drives corporate sales and earnings, which in turn drive stock prices. Rising earnings drive rising earnings expectations, both in terms of magnitude and sustainability. These two components of expectations are important because they help to explain the relative contributions of actual earnings and the price/earnings (P/E) ratio to stock price changes. If earnings expectations rise and are then realized or exceeded, stock prices should advance by the same amount assuming the P/E multiple does not change. But P/E multiples do change and account for a wide range of differences between how much earnings affect relative stock price changes. P/E ratios depend on how much future growth markets are willing to incorporate into current stock prices. The more confidence investors have in the sustainability of earnings growth the more they are willing to pay per dollar of earnings (i.e., the P/E ratio). Conversely, if earnings growth is viewed as the result of a one-time event, such as a change in tax law, the P/E ratio is not likely to rise much, if at all. And if the markets begin to suspect that earnings are about to roll over and decline, the P/E ratio and, thus, stock prices will fall faster than actual earnings decline.
This admittedly arcane discussion of valuation is important to understanding what we believe is going on in the market today. The most strident complaint is that the markets are too expensive because the P/E ratio, even based on tax-cut adjusted corporate earnings, is currently 18.5 times versus a long-term historical average of 15.0 times. Based on the reasoning above, it would seem that the step-up in earnings from the recently passed tax cut has been fully taken into account by the markets. However, we believe the price per dollar of those earnings (P/E ratio) is not excessive for several reasons. First, the historical average is just that, an average over time that encompasses both up and down markets. Given the strengthening global economy and increase in sales and earnings over the past couple of years, it does not seem outlandish to pay more than average for those kinds of results. Furthermore, the current strength seems to have momentum that could persist, especially with the assist of large tax cuts for corporations and increased paychecks for most consumers.
The point is that investors are incorporating incremental growth effects expected to come from a pick-up in corporate capital spending due to tax cuts. More growth, higher earnings, and higher stock prices for a longer period of time are why we don't believe stock valuations are too elevated and why we believe the current bull market rally has longer to run.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.