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Portfolio > ETFs > Broad Market

Has the 2016 Stock Market Rally Stolen Next Year's Expected Gains?

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Since Donald Trump won the presidential election in November, the Dow Jones Industrial Average has gained 22% and is trading near record highs. That’s larger than the 15% gain in the stock market year to date, with the Dow now trading just under 20,000.

The market appears to have already discounted the potential bullish effects of Trump’s plans to slash corporate taxes, spend about $1 trillion on an infrastructure and reduce regulation – all of which could potentially increase earnings – while it ignores the potential bearish impact of a stronger dollar and Trump’s plans to levy tariffs on imports from China and Mexico, who could retaliate against the U.S.

“The market is anticipating almost everything to go right under Trump,” says Sam Stovall, chief investment strategist at CFRA. “But history is not on our side.” According to Stovall, during the first two years of every Republican presidency since Teddy Roosevelt’s, the economy fell into recession, and the current recovery is already among the longest since World War II, almost eight years old.

But past is not always prologue. The Stock Trader’s Almanac, for example, says that the market’s performance during the first five days of a year determines its direction for the entire year. If that were true, the stock market would be ending lower this year rather than up double-digit percentages and near record highs because the Dow fell more than 6% in the first trading days of 2016 — its worst start of the year ever.

Impact of Policy Changes

Past performance could also be even less relevant next year because of the many uncertainties introduced by geopolitical developments, including Trump’s election, against the backdrop of an unusually long economic expansion. “Brexit and the U.S. President-elect Donald Trump make a complicated late-cycle outlook even less predictable,” according to Russell Investments 2017 Global Market Outlook. “2017 offers few certainties and plenty of potential risks.”

“Policy uncertainty introduces a degree of instability to our 2017 forecast that has been absent in recent years,” write Goldman Sachs strategists in their 2017 outlook. They note, for example, that although policies on tax reform, repatriation of foreign earnings, fiscal stimulus and the reduction of regulations are all expected to be introduced, none of the details about these plans are known, and they won’t be known until at least March.

While the market awaits those details, Goldman strategists expect the stock market will focus more on hope than fear, as it has since the election, pushing the S&P 500 index up to 2,400 before settling back to 2,300 by year-end 2017.

Merrill Lynch also has a year-end target of 2,300 for the S&P 500, while CFRA, which recently acquired the equity and fund research business of S&P, is forecasting 2,335. In fact BMO, Citigroup, Credit Suisse, Morgan Stanley, Schwab and the Wells Fargo Investment Institute are all forecasting that the S&P 500 will end 2017 between 2,300 and 2,350. These forecasts suggests little change from current levels.

Earnings and P/Es Still Key

Supporting the stock market, according to strategists, are continued growth in the U.S. economy – GDP estimates, adjusted for inflation, range from 2% to 3% – as well as market hopes for enactment of Trump’s stimulus and tax cut policies. But in the long run, stock prices will follow earnings, says David Kelly, chief global strategist at J.P. Morgan Asset Management.

The earnings recession that had hung over U.S. stocks ended in the third quarter of 2016, setting the stage for higher earnings in the fourth quarter of this year and throughout 2017. Strategists forecast earnings growth in the mid-single digits to low double digits for 2017.

“The ultimate question for equity investors will be whether this growth [in earnings] will be on top of current elevated P/E ratios or whether earnings will simply “grow into” lower valuations,” writes David Lafferty, chief market strategist at Natixis Global Asset Management in his outlook. “The former … could result in very strong U.S. equity returns. Alas, we’re bigger believers in the latter: that elevated P/Es already discount much of the future earnings improvement.”

P/Es are also expected to come under some pressure from rising inflation and rising bond yields, due in part to Fed rate hikes. Those pressures will likely lead to fear pervading the U.S. stock market during the second half of the year, Goldman strategists write.

Favoring Cyclicals

Given these expectations for moderate growth and rising rates, coupled with Trump’s plans to spend more on infrastructure and defense, repeal or reform the Affordable Care Act and Dodd-Frank, and cut corporate taxes, including those on repatriated overseas profits, strategists are favoring cyclical stocks over defensive shares as well as financials, industrials, technology and selective health care shares. Stovall notes that cyclical stocks historically perform better between November and April.

Goldman also favors S&P 500 stocks currently paying the highest effective corporate tax rate because they will have the most to gain from tax reform.

Goldman is also more bullish on U.S. companies serving a primarily domestic market rather than those relying on exports because the U.S. dollar is now trading near 14-year highs. Stovall recommends increased exposure to foreign stocks, including developed and emerging market stocks, because of relatively lower valuations compared to U.S. stocks.

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