Bob’s View: Moving beyond 1st quarter gains
Stocks are off to a strong start for 2017 with the broader markets climbing 6% during the first quarter. Earnings are forecast to rise 10% for the first quarter, compared to the first quarter of last year. That increase in earnings is significant because it would be the highest growth since the end of 2011.
Solid employment gains should continue to support consumption and the housing markets. Job growth in the United States has averaged an impressive 220,000 jobs per month for the last three years as the economy gets closer to full employment.
Strong corporate profits will also contribute to growth.
Macroeconomic Advisers has forecast that the U.S. economy will grow 2.3% in 2017, slightly above the 2% growth of 2016 and the three-year average growth of 2.1%.
Most economists agree that two factors are holding back the U.S. economy.
- First is the continued decline in work force participation rates, currently at 63% of the working age population. Economic growth is dependent on an increasing work force.
- Second, economists are at a loss to explain why productivity growth – output per hour worked – continues to be flat. Productivity growth largely explains the economic miracle of the ‘90s and is the only way to increase aggregate net worth.
Longer term, the U.S. needs to find more workers and figure out how to make them more productive.
Yes, it is mostly about interest rates and earnings. Earnings are doing their part, with forecasts for the entire year indicating a 10%-12% increase in profits.
Interest rates have held remarkably steady despite recent increases in the short-term rate by the Federal Reserve.
Recently, the government reported that U.S. inflation, as measured by the Personal Consumption Expenditure Index, was up 2.1% over the last 12 months – finally exceeding the Fed’s inflation target of 2%. Core inflation over the same period averaged only 1.8%. Forecasts suggests that unless oil prices climb significantly, inflation should remain below the Fed’s target for the foreseeable future.
The Federal Reserve recently said that it intends to begin unwinding its $4 trillion bond portfolio later this year. That has the potential to disrupt the bond market, but because inflation forecasts remain below the Fed’s target and because the unwinding of the Fed’s portfolio will take years, the current forecast calls for interest rates to rise just gradually over the next few years.
Stocks are expensive, as measured by the forward price-earnings ratio. The average for forward 12-month earnings is 15 – and we’re almost at 19 times forward earnings. The market has priced in much of the proposed policies of the Trump administration, including lower taxes, less regulation and higher infrastructure spending.
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The difficulties experienced in the proposed legislation to modify the Affordable Care Act may lead to near-term disappointment if future legislative efforts meet similar results.
Fortunately for U.S. stocks, global growth appears to be accelerating just in time to support higher valuations. The European economy, having suffered several recessions the last few years, appears headed for growth as the financial problems of southern European countries diminish.
China also looks to have turned the corner. China continues to be restrained by significant problems in its banking industry, but recent reports indicate that the Chinese economy is no longer decelerating. That will help many countries in the emerging world, which depend on selling raw materials to China.
In assigning degrees of probability for the outcome of various events, economists talk about fat-tail risk. Right-tail risk is the chance that things could get better than you realize. Left-tail risk is just the opposite – the potential for things to be worse than you think.
Both left-tail and right-tail risks have recently gone up. It is unusual that this is occurring and underscores the uncertainty in the current market environment.
As this bull market – the second-longest in U.S. history – ages, and with rich valuations for stocks, it becomes important for investors to maintain a balanced portfolio of stocks and bonds and to expect an increase in volatility as we enter the latter stages of the current business cycle.
Bob Landaas is president of Landaas & Company.
(initially posted April 7, 2017)
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