With Sam Stovall, Chief Investment Strategist at CFRA Research
The Trump effect on stock market: From hype to snipe and gripe?
Veteran equities analyst and market patterns historian Sam Stovall joins Steve to talk about recent gains in the stock market, the Trump effect on markets, and the volatility and valuation of stocks headed into 2017, among other topics. Steve kicks off the interview by asking Sam to review the market’s reactions to President Trump’s actions both before and after he was inaugurated, a sentiment that may be encapsulated in the phrase “from hype to snipe, then gripe”. Stovall describes the exuberance that followed Trump’s election victory as powered by expectations of deregulation of the financial industry among other sectors and a surge in earnings from industrial and materials companies that would benefit from the infrastructure development that Trump promised. Fast forward to February, less than a month into Trump’s presidency, and amidst the barrage of executive orders, there is a growing sense that perhaps some of the more heavily anticipated programs in Trump’s agenda won’t roll out in his much ballyhooed first 100 days in office, or even the first 200. Stovall avers that the collision between the market’s early pricing in of Trump’s promised deregulation and stimulus and reality may result in a giveback of steep gains made since last November.
Stock market volatility 2016
At Steve’s prompting, the conversation detours to the stock market’s performance in 2016, a year that saw a good deal of volatility between its bearish start and strong finish. Tom recalls that many investors were expecting a recession at the beginning of 2016 led by weak earnings, a collapse in oil prices, and worries about China. After further consideration, many came to the conclusion that the problems were mainly confined to the energy sector, and this analysis enabled a broader market rebound. As far as the volatility is concerned—the market swung 23% as measured by the early lows to its end of year highs—Stovall points out that the market has averaged an annual 27% movement in every year since WWII. While it may have seemed volatile, in historic terms it was actually a bit less volatile than normal. Steve remarks that this data reveals an important lesson about volatility, namely that it does not reliably predict major market downturns. Stovall agrees and amplifies Steve’s point by noting that the stock market posted gains in 85% of the years since WWII. Moreover, most of those up years experienced a negative year-to-date return at some point. Stovall deduces from this data that volatility is simply a part of investing. He makes a final, salient observation that volatility in bull markets rises over time and that the longer a bull run lasts, the more unstable it becomes.
Bull market resilience and exhaustion
In another insight drawn from Stovall’s trove of historical research, he describes a pattern in bull markets of robust recovery to break-even levels following 5-10% pullbacks and 10-20% corrections. Since WWII, 8 out of 10 market declines have returned to break even within 4 months, supporting the case to be made for buying stock during a pullback or correction. Steve wonders whether this particular bull market is nearing an end, based on P/E ratios and its unusually long run, the 2nd longest since WWII. Stovall reckons that bull markets “don’t die of old age; they die of fright” and that what they fear is recession. For this reason, Stovall focuses on broader economic trends, expressed by indicators like the treasury yield, number of housing starts and consumer confidence and supplemented by leading indicators, all of which can shed light on where the economy is heading. According to Stovall, these indicators are not signaling recession in the near future.
Stock market outlook 2017
Steve returns to the topic of PE ratios and what they might or might not say about the stock market outlook for 2017. Using Stovall’s data, Steve comes up with a PE ratio for the S&P of 20. He asks where that situates today’s market in historic terms. Stovall concedes that by GAAP earnings, at 26 times trailing earnings, the market is the second most expensive bull top since WWII, with the tech bubble’s 32 trailing PE ratio being the most expensive. What’s different this time, at least in terms of expectations, is that investors believe there will be a “V-shaped” recovery in earnings—up 11% in 2017 in contrast to being almost completely flat in the past two years.
Bringing us full circle to the beginning of the conversation, this expectation is tethered to an anticipation that Trump will pull off large tax cuts, infrastructure spending, tax reinvestment from overseas, and deregulation. Speaking to his stock market outlook for 2017, Stovall believes that the S&P will nudge forward another 2% from the level, itself already 2.5-3% higher than it was at the start of the year, for a total return of about 6%. Needless to say, this feels like a conservative estimate in the context of a very confident market over the past 3 months. Sam explains that one reason he remains bullish on stocks is because of the low inflation rate. Even if inflation heats up because of Federal Reserve interest rate increases, it will still be low enough to support high PE ratios. In times with double-digit inflation, bull markets had a hard time breaking through a PE ratio of 10. Stovall mentions that he uses his “rule of 20” to crunch the data further and derive a specific target for the S&P this year, a topic that you can learn more about in this video.
Steve Pomeranz: I’d like to welcome back one of my favorite guests, his name is Sam Stovall. He was formally Chief Equity Strategist of S&P Capital IQ and I have spoken to him numerous times in that position, but that is changed. Now he is Chief Investment Strategist of CFRA Research, which is basically the company that S&P sold their business to, right? Sam Stovall, welcome to the show, by the way.
Sam Stovall: Thanks, Steve, good to talk to you again. Yes, after 166 years, S&P decided to get out of the equity research business, and we sold our research department to CFRA Research. So, it’s the same people, doing the same thing; we’re just wearing a different uniform.
Steve Pomeranz: Okay. I guess there’s enough money just in licensing the S&P 500 name these days, right? Why have all the hassles?
Sam Stovall: Well, oh sure. The S&P just decided it wanted to focus on its core businesses, being index, ratings, and data. We just no longer fit into that mix.
Steve Pomeranz: Okay, all right, well, times change, things move on, so do we all after a while. Let’s talk about your current outlook. You’ve had 20, nearly…I’m reading from your report…nearly 20 executive orders since inauguration day; this was written on February 2nd. And there seems to be some confusion, and maybe some building animosity creeping into the mix here. What you wrote here, is that it looks like investor sentiment may morph from hype to snipe, then gripe. Tell us about that.
Sam Stovall: Well, I think that we pretty much saw that right after Donald Trump was elected president that the market took off because of the expected easing of regulations on the financial sector, combined with the expectations for earnings improvements in industrials, as well as some of the other more cyclical areas of the market, materials, in particular, because of the projection that we would see an increase in the spending toward infrastructure. Then, finally, because that growth would probably lead the Fed to be more aggressive in raising rates in 2017, therefore makes smaller cap stocks all the more attractive because of their lack of international exposure. So, we have that very nice pop up into the middle December where we traded sideways for a little while, and then popped again just most recently. However, we have a lot of people in Washington, on Main Street, on Wall Street, who really are questioning how much of this is going to get done.
The Republicans were talking about the first 100 days, now they’re talking about the first 200 days. And, so, I think that there’s an awful lot of expectation that is built into this most recent move, and, as a result, we might end up digesting some of these gains in short order.
Steve Pomeranz: Well, let’s talk about that in a minute, but let’s look at 2016 very quickly. I mean it was a pretty volatile year, last January of 2016 and February, I think the S&P 500 was down maybe something around 11%, and it ended the year, with dividends included, up a little over 12%. That’s a 23% spread in one year. Were you surprised at the final tally in the end of 2016?
Sam Stovall: Yes, I was. Certainly, at the beginning of the year, the expectation was the that US—and maybe even the rest of the world—was headed for recession because we’ve had 13 times, since World War II, that the S&P 500 fell into an earnings’ recession.
Steve Pomeranz: Mm-hmm (affirmative).
Sam Stovall: And we had an economic recession occur 11 of those 13 times. So, a pretty good likelihood there, for that very sharp selloff, the earnings decline, oil prices dropping below $30 a barrel. Worries about China were really pointing to a recession. But, then, most investors decided, “You know what? The problem really has to do more with energy.” Take out energy, and it would have helped earnings in ’15 and ’16. Now in 2017, energy is expected to be a tailwind. But, you know what is interesting, Steve? Is that if you look back every year, to World War II, there is a 27% difference between the high and the low of that, of every year on average. So, I guess people shouldn’t be too surprised when they see a 20+% differential between the high and the low because that ends up being fairly normal.
Steve Pomeranz: You know, that’s a wonderful lesson for us all to understand that…the way I put it is…the cost of getting higher, the potential for higher rates of return in the stock market, is this volatility. And this volatility—you said 27% from high to low—that’s a lot of volatility. But, historically, when you look back at it, it’s just that. It’s volatility; it doesn’t necessarily mean that the end of the world is nigh because you happen to be hitting the low part of what is a normal trading range. Any comments on that?
Sam Stovall: Absolutely. Taking that one step further, about 85% of all years have been up since World War II.
Steve Pomeranz: Okay.
Sam Stovall: And, when you then say “okay”, well, of those 85% of years, what’s interesting is that we have seen the market post a negative year-to-date return at some point in time, during most of those occasions. And, about 70% of the time, it happens in the first quarter alone. So, I think people have to realize that volatility is just part of investing, and the older that a bull market gets, the increase in volatility we traditionally see. I like to say that, “Bull markets are like humans; the older they get the more unstable they become.”
Steve Pomeranz: Speak for yourself there, Sam, please.
Sam Stovall: All right.
Steve Pomeranz: Yeah, so, you know, I think Warren Buffett would say that …when he would look at a stock, and he would look at the price range of XYZ stock—pick one, I don’t know, just make one up out of the air here, let’s say General Electric stock—you look at the high for the year is at 35, you look at the low for the year is 23. So, the question really was, “Who’s buying … Who are those people buying at 23?” Generally speaking, you know, obviously, most people are going, “Well, I don’t want to buy at 23, because it’s … something, you know, has happened, which has caused this price to go down. Maybe it’s just the market, but maybe they had an earnings miss or something like that. But this range is a natural range, so why not be the buyer at 23? Rather than the buyer at 35 if you possibly can.
Sam Stovall: Oh, you’re bringing up an excellent point. Just to show you I have no social life, I went back to World War II and counted up all of the times that we had market declines that I call pullbacks which are 5 to 10% declines, corrections, which are 10 to 20% declines, and then bear markets. The amazing thing is the speed with which the market gets back to break even. We have had 56 times in bull markets that we went through a decline of 5 to 10% and then got back to break even.
Steve Pomeranz: Wow.
Sam Stovall: Well, we got back to break even an average of only two months. We then had 21 times that we fell 10 to 20%; we got back to break even in four months. So more than eight out of every ten declines, we ended up getting back to break even in an average of four months or fewer. So what I recommend investors do is, “Put some money to work, at every 5% decline threshold” because, over the long term, you’ll end up being a marvelous market timer by buying rather than bailing.
Steve Pomeranz: Wow, that’s fantastic. You know, how do you measure where a bull market starts? For example, the 2008 great recession caused the stock market to go down 40 to 50%, we’ll say. And it did a double-dip, that was like in September or so of ’08. And then in ’09, it did a double-dip in March, and it hit again. A lot of people saying that was the bottom of the bear market, and then the bull market started from that point. But I’ve also read reports that said that, really, the bull market didn’t start until 2013 because that period between that very deep low in ’09, in 2013, that was kind of just like the market correcting itself and repairing, but really the economy didn’t really get going until 2013. The idea here, Sam, is that when you’re measuring how long a bull market we’ve been in, it really depends on where you start, so I’m curious to know where you start things.
Sam Stovall: I basically start them at low points. For me, the definition of a bull market is a 20% advance off of a prior low. Or maybe I should start with the bear market. A bear market is a 20% decline off of the prior high. And then your bull market is a 20% advance off of that low. That also lasts for at least six months, the reason being that in November of 2008, we hit a bottom, and then we rallied by more than 20%. So you would think, “Oh, we’re now in a new bull market,” only to then hit an even lower low in March of 2009. So, because it occurred in such a concentrated period of time, to me that was not the ultimate low in November of 2008. But, again, there is no universally observed definition for bull markets and bear markets. Some people even call a bear market simply a matter of the market not making a new high over an extended period of time. Even though prices really haven’t declined, just because they have not gone up precipitously, some call that a bear market.
Steve Pomeranz: So, when we hear these reports that the bull market is low in the tooth, you know, and it’s the longest bull market in history or in such-and-such a time, do you think that we should hear that with a cynical ear?
Sam Stovall: Maybe not a cynical ear, but, I think that most statements should be responded to with, “Yeah but …” On March 9th of this year, we go celebrate the 8th anniversary of this bull market according to my measurement. That is the second longest bull market since World War II in my opinion. Is that a reason for concern? No, because my feeling is that bull markets don’t die of old age; they die of fright, and what are they most afraid of? They’re most afraid of recession. So, the indicators that I look at, the yield curve, the year over year change in housing starts and consumer confidence, and then finally leading economic indicators, none of them is pointing to a potential recession anytime soon.
Steve Pomeranz: My guest is Sam Stovall, formally the Chief Equity Strategist of S&P Capital IQ. S&P sold its business to CFRA Research, where he is now Chief Investment Strategist.
So, you’re talking about, you don’t see any indicators for recession, that’s fine. So, therefore, the economy is healthy, the market, therefore, is reflecting a healthy economy. But everybody worries that stock prices are so high relative to earnings, the so-called PE ratio. I did some of the math, based on your numbers. Your estimate for the S&P earnings versus the current value of the S&P 500, when you do the math there, it’s showing that the current PE ratio of the S&P 500 is 20 times earnings. Give us a sense of where that is with historic context.
Sam Stovall: Well, right now, if you actually look at the price-to-earning ratio on the S&P using, as reported, or GAAP earnings—GAAP means generally accepted accounting principles—I say it’s like Prego spaghetti sauce, ‘cause everything is in there. Right now, if this bull market ended today, it would be the second most expensive bull market top since World War II, second only to the year 32 times that the market traded at when the tech bubble burst. Today, we’re trading at about 26 times trailing results. Yeah, you could say, looking backward, this market is very expensive. But I think that investors are saying, “you know what?”— I want to sound a little like Yogi Berra, who once supposedly said,—”History ain’t what it used to be.” And they’re looking forward, and what they see is a V-shaped recovery in operating earnings or earning for continuing operations, rather than seeing flat earning last year in 2016 and a negative -1% earnings in 2015. They’re looking at an 11% gain in earnings for all of 2017. And with the prospect of a Trump tax cut, infrastructure spending plan, tax reinvestment from overseas, repatriation, that is … You know, all of that could then be adding more octane, if you will, to the earnings’ growth that is expected. Wall Street looks forward, and, right now, they are looking forward to a V-shaped recovery in earnings.
Steve Pomeranz: Well, all that said and done, your target number for 2017 on the S&P 500 is 2,335. The market as we’re talking today stands just around 2,300, so there are only 35 points to go. On a $2,300 number, we’re talking about less than 2%. Is that what you guys think we’re gonna see this year? About a 2% rate of return? And does that include dividends?
Sam Stovall: The full year rate of return right now is expected at about 4% because remember we ended up starting the year at about 2.5, 3% lower than where we are today.
Steve Pomeranz: Okay, all right.
Sam Stovall: Add 2% and yeah, you’re talking about maybe a 6% total return.
Steve Pomeranz: Okay.
Sam Stovall: So I call myself a bull, but with a lowercase ‘b’. Now you might be wondering, “Well how do I get there?” I use something called the rule of 20, that basically says, “Look to PE ratios in conjunction with inflation.” Because the reason that we have seen bull markets top out at a PE of 10 or even 9.5 in the past, was because of inflation in the mid-teens.
Steve Pomeranz: Yeah.
Sam Stovall: Today, inflation is around 2.1% on a year over year basis with core CPI, yet we expect it to rise to 2.4% as the Fed increases interest rates. So, with $131 in earnings expected for the S&P 500, 2.4% CPI, that comes up with about 2,335 on the S&P 500, when using my rule of 20.
Steve Pomeranz: Wow. Well, my guest Sam Stovall, Chief Equity Strategist for CFRA research, and also the author of … I’m gonna name this segment, “Watch out for Hype, to Snipe, and then Gripe.” So, doesn’t sound like you’re griping too much. Sam, thank you so much for joining us.
Sam Stovall: Steve, as always, it’s a pleasure to talk to you.