January 2018

In 2017, stock prices across the globe added more than

$9 trillion of market value. The S&P 500 finished 2017 at 2673, up 19.4%.

The S&P Global Broad Market Index gained 22%. U.S. 10 year Treasuries finished at 2.41% while

they began the year at 2.44%. Stocks rallied on earning increases, low interest

rates and an historic tax bill lowering rates for individuals and corporations.

Corporate tax rates go down from as much as 35%, one of the highest in the world, to 21%,

more in line with global competitors. Top rates for individuals go down from 39.6% to 37% and as low as 10% for low income earners. According to FactSet, the S&P 500 index calendar year

earnings growth was 9.6%, the highest annual growth since 2011. All eleven sectors are projected to report year-over-year growth in earnings; led by the Energy, Materials, and Information Technology.

Even as the Fed announced an unwinding of their expansive QE policy, stocks continued to rally.

With new leadership in place for 2018, Jay Powell, the recently appointed Fed Chairman is expected to raise the funds rate by 0.25% at least three times this year. The 5 year U.S. Treasury note at 2.44% increased in yield by 0.70% in 2017 which outpaced the 10-year note

yield now 2.44% by a considerable margin. The so-called flattening of the 2-10 yield curve,

currently +51 basis points, is closely monitored by market participants as an early indicator of future recession. Five of the last six times the 2-year treasury yield now at 1.93%, exceeded the 10 year yield the economy subsequently entered a recession. Foreign stock markets outperformed U.S. stocks as their earnings recovered and the dollar lost 14% versus the Euro, its worse year since 2003.

Emerging market stocks outpaced their developed country brethren in 2017. Despite negative headlines from North Korea, natural disasters at home and Russian collusion inquiries stocks rarely dipped more than 2%. Gold was up 13.6%.

Where do we go in 2018?

We remain in bull markets here and abroad.

Inflation, interest rates and future earnings are the keys to

further market appreciation. Fed policy is expected to hold steady.

Investors typically value stocks at 18.1x earnings when the

Consumer Price Index (CPI) stays between 0 and 2%.

Valuations normally drop as consumer prices rise beyond this level.

Central bank's in Europe, Japan and the U.S.  target 2% inflation

which they have struggled to achieve since the Great Recession in 2008.

With a +2-4% average CPI we have historically seen the 17.7 P/E multiple,

moving down to 14.7 P/E with a +4-6% CPI range.

The salient point is that unless we have much higher inflation the market

P/E multiple should hold in the current range barring a recession.

Bond investments appear to be more vulnerable than stocks in a rising inflation and rising GDP scenario. Earnings will continue to climb as GDP pushes above 3% and inflation gradually exceeds the 2%. We remain in a synchronistic global recovery despite concerns about trade wars.

The U.S. has taken a more aggressive foreign policy stance toward Israel, Iran and North Korea. ISIS has been defeated in Iraq. Saudi Arabia has a new leader challenging the old order. The EU will soon taper their QE monetary expansion following the U.S. Japan continues her QE policy at full tilt

as Adenomas is working in the land of the rising sun.

U.S. GDP and wage growth will be spurred by lower taxes, less regulation and increased capital spending, which increases productivity.

Lower unemployment levels have yet to push up wage inflation but as we dip below 4% this may change. After the tax reform bill was signed, many corporations  announced employee bonuses and wage hikes. Repatriation of $2-4$ trillion in overseas cash will lead to more capital spending, buybacks and higher dividends. 

Due to an accounting system that only Washington D.C. could create this repatriated cash counts as an addition to our deficit, as measured by the Congressional Budget Office. In fact, the cash coming back to our shores is a net boost to tax revenues as well as banks, consumers and investors.

Lower tax rates on U.S. corporations also brings jobs and profits home helping our trade deficits.

 Given the stronger economy our Fed will have a timely opportunity to pare down their $4 trillion balance sheet. Some forecasters believe earnings for the S&P 500 index will rise

into the $152.00-$157.00 zone in 2018 and over $161.00 in 2019.

Calendar 2018 estimates are now $146.59 according to FactSet before tax reform additions.

At 2730 on the index, we derive a 17.95 forward P/E multiple and a 5.55% earnings yield on a $152.00 estimate. While the multiple is at the high end of the historic range, prices are not excessive. Bonds appear less attractive than stocks and are likely to underperform again this year. We do not foresee a recession or an inflation spike in 2018. We do see better global GDP growth, rising wages, higher earnings plus, stronger employment. In sum, the table is set for climbing stock prices not withstanding higher interest rates. Money on the margin is more likely to flow into equities, out of cash and bonds.

We wish you all a happy, healthy and prosperous 2018!

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