The Making of a Rally
Doug Walters
A big move up in equities again this week has some commentators wondering if the asset class has run too far. Expectations for fiscal stimulus are high, but a rising distaste for bonds is also adding to the demand for stocks.
Market Review
Contributed by Doug Walters
A Steady Tailwind
U.S. equities charged forward this week, with the S&P 500 up an impressive 3.1%. Much has been said about the expectations for higher fiscal stimulus with the new administration, and this goes a long way toward explaining the post-election rally. However, the shrinking attractiveness of bonds has also played a part in the move.
- The rise in U.S. equities to fresh all-time highs has pushed valuations up. With stocks incrementally more expensive, we might expect to see the rally waver.
- However, as we discussed last week, with interest rates and bond yields expected to rise, demand for bonds has waned. This dynamic is not expected to end any time soon, and could provide a continued tailwind for equities, in spite of valuation.
A Poor Indication
The S&P 500 is currently trading on a trailing 12-month adjusted price-to-earnings (PE) ratio of 18.9x. This is above the historical average, indicating that valuation is rich. We regularly hear market commentators using this as fuel for selling equities. However, history shows this to be a poor indicator.
- For example, the PE ratio of the S&P 500 was 18.9x back in 2003. In the subsequent four years, U.S equities, climbed over 50% and the PE ratio actually fell. Stocks were rising, but earnings were rising faster.
- The moral is that stocks are only expensive at 18.9x if earnings are not expected to grow enough to justify this price. At the moment, the market is giving the economy the benefit of the doubt.
- Time will tell if the move in equities has been justified, but the above example shows that it can be dangerous to try and time the market. Rather, investors should build the right portfolio for their risk tolerance, and be willing to ride the market’s natural ups and downs.
| Indices & Price Returns | Week (%) | Year (%) |
|---|---|---|
| S&P 500 | 3.1 | 10.5 |
| S&P 400 (Mid Cap) | 4.2 | 21.0 |
| Russell 2000 (Small Cap) | 5.6 | 22.2 |
| MSCI EAFE (Developed International) | 2.7 | -2.4 |
| MSCI Emerging Markets | 3.1 | 10.7 |
| S&P GSCI (Commodities) | 0.2 | 24.2 |
| Gold | -1.6 | 8.8 |
| MSCI U.S. REIT Index | 3.9 | 3.6 |
| Barclays Int Govt Credit | -0.1 | 0.1 |
| Barclays US TIPS | -0.1 | 2.8 |
Economic Commentary
The United States government is expected to forgive $108 billion of student debt within the next few years. Although this may seem like a large number, it is only 8% of the total amount of U.S. student debt outstanding which has steadily increased to $1.28 trillion. Student debt in the United States is larger than all other consumer debt types with the exception of home mortgages. About 40 million Americans have student loans, of whom 8 million are in default.
To help alleviate the burden on college graduates, the Federal Government has offered two different ways of servicing the debt:
Traditional Repayment Plan
This plan entails fixed payments every month over a set time period (e.g. 10 years) in which the debt is fully paid.
Income Driven Repayment Plan
For this option, monthly payments, based on % of income, are made over a fixed time period (e.g. 20 years), after which the remainder of the loan balance is forgiven by the government. The most generous Income Driven Repayment plan caps a borrower’s monthly payment at 10% of their discretionary income (defined as adjusted gross income above 150% of the poverty line).
While these programs can help graduates manage their accumulated debt, it is likely that easy money from the government has helped contribute to the dramatic rise in college tuition over the past few decades.
When choosing between the two above plans, a new graduate will have to decide between paying off their debt in less time, which would minimize the interest payments, or making monthly payments more affordable, albeit over more time. Our wealth management specialists at Strategic are well-equipped to help you weigh these two options.
Week Ahead
Contributed by Max Berkovich
Data Overload
Wednesday morning Retail Sales, Industrial Production, Producer Price Index and Mortgage Application data will be released, but this data may not matter this time.
Rate Date
Wednesday at 2 P.M. the Federal Reserve Bank will announce their rate decision.
- The above listed economic reports may not play any role in the Federal Reserves’ decision.
- The market has already adjusted rates higher, putting the Central Bank in a catch up position.
- The Fed could surprise the market by moving the rate higher by ½ of 1% instead of the expected ¼ of 1%, but we doubt the Fed wants to surprise the market this late in the year.
Strategy Updates
Contributed by Max Berkovich
STRATEGIC Asset Allocation
A Trip Abroad
While small capitalization stocks continue their hot run, it was a relief to see developed and emerging international indices make up some ground this week, topping domestic large capitalization.
More Interest in Interest
Bonds bounced back this week. The sell-off in bonds caused interest rates to drop precipitously and may have now incited some bottom fishing.
- A 2.40% yield on a 10 Year U.S. Treasury is finally surpassing the dividend yield of the S&P 500.
- Municipal bonds witnessed the heaviest of selling during the recent interest rate move and have reached before tax yields that are on par with the U.S. Treasury. These yields have even made the debt appealing to non-taxable investors. This is particularly evident on the longer end of the yield curve.
Action and Reaction
- The capital growth portion of the portfolios continues to run a little higher than long-term targets, as U.S. markets continue to make new highs.
- This week’s relative catch-up action in international markets and REITs have narrowed some of the performance gaps between different asset classes.
- We hesitate to rebalance and bring our capital growth allocation down when fixed income asset classes are facing a headwind of raising rates. However, we may choose to increase our cash equivalent portion of the portfolios until better values arise.
Strategic Growth
Members Only
The Health Care sector seems to have been kept out of the party this week. The Financial sector continues to be the belle of the ball, but this week technology perked up as well. In earnings news…
- Costco Wholesale Corp. (COST) reported a mostly in-line quarter. Sales grew by 3% to $27.47 Billion from a year ago. What caught investors’ attention was a 90.3% renewal rate of membership. The membership fee adds up to $630 Million of revenue annually. One analyst predicts that a 90% renewal rate allows the company to increase their annual fee. We also note that the company grew its online sales by 8% year over year.
STRATEGIC EQUITY INCOME
Paying Dividends
Banks continue to drive the Financial sector higher, while Health Care continues lag. High dividend paying sectors had a reprieve, catching some interest again this week. Speaking of dividends…
- Strategic’s focus for this strategy is on dividend growing companies, not the highest dividend payers, so we acknowledge a few bumps in pay out the past two weeks.
- General Electric Co. (GE) increased its quarterly payout by a penny to $0.96 per share annually.
- Ventas Inc. (VTR) a Health Care REIT increased its annual payout by 6.2% to $3.10 for a yield just shy of 5%.
- Last week WEC Energy Group, Inc. (WEC) also raised their dividend by 5% to a $2.08 annual level. The company is committed to reaching a payout level close to its utility peers.
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