How Far Can This Market Rally Go?
Dear Valued Clients and Friends,
We know what is on the mind of investors this week: How much longer can this market rally last? We address this quite head-on this week along with all sorts of must-read information about the economy, global conditions, emerging markets, and earnings. These are the times when investors are least interested and engaged (because after all, everything is going so well) – and yet – these are the times investors should be most engaged (because, after all, everything is going so well). So, with all that said, let’s get into it…
Trees don’t grow to the sky, but markets go higher than people seem to think.
People ask a lot how far this market rally can go, and we get it. The market has moved a lot since the election, and a lot of people believe it shouldn’t be. I thought a report I read this week from a strategist I only occasionally come across helped explain this quite well: There is, simply put, both a secular tailwind for this market, and a cyclical one. The secular trend is simple: Corporate earnings are accelerated, and that always pushes markets higher. If earnings were not accelerating, we would not see markets going higher. But regardless of who is President, when earnings are growing, market prices generally go higher. However, that does not tell the whole story. In a cyclical sense, we see the post-election anticipations adding extra accelerant to the market rally. Those anticipations include tax reform, infrastructure spending, ACA repeal, deregulation, and more. These political issues add optimism to the market, which is already in high gear due to an improved earnings environment.
This is what a reflation trade looks like?
Why do we believe that interest rates going higher and stock prices advancing in anticipation of pro-growth policies has the feeling of a broad reflationary environment? Commodity prices. Take note of how commodity prices have advanced just since election day…
The more things change, the more they really change.
Wal-mart is the third largest employer in the world (behind the U.S. government and the Chinese government), employing about 2.3 million people worldwide. It seems fair to say that one of Wal-mart’s biggest competitors – really their biggest competitor – is the E-commerce giant, Amazon.com. Their total payroll? 100,000 people. Amazon has less than 5% the number of employees that Wal-mart has. Is this a sign of the new economic reality, that significant societal functions can and will be performed with a fraction of the human headcount previously used? These types of things require an investor’s attention…
If only we could figure out what is going wrong?
Europe is 7% of the world’s population, represents 25% of the world’s GDP, and yet makes 50% of the world’s welfare payments. One could argue that perhaps their transfer payments system is, ummm, unsustainable…
In theory, there is no difference between theory and practice. In practice, there is…
One of the issues that should give investors tremendous pause about the border adjustment tax being thrown around is the confidence certain policymakers have that the dollar will increase in direct proportion to the higher cost of the imports, thereby negating its impact. We are always very cautious when we hear about the theories behind something a currency “should” do. The fact of the matter is that the border adjustment tax is real world stuff, with real world prices, buyers, sellers, consumers, and impacted parties. The academic theories about it are “supposed” to work out. They are, well, theories. When it comes to 2017 tax reform, markets will most embrace that which the general public would also most embrace – pro-growth simplicity!
Dividend growth for your peace of mind, and your pocketbook.
Our monumental studies of the realities of behavioral finance has taught us that investors have a hierarchy of needs when it comes to their financial peace of mind. We know how important cash flow and income is to investors, and we know how important assets and balance sheet wealth are. We also know that most investors want to believe their income needs can be met in the present and the future, without having to forfeit the possibility of asset values growing. Scratching this combination of itches is, you guessed it, dividend growing equities – who possess the upside appreciation of the underlying stocks, all the while providing a growing cash flow for the income aspiration of their owners.
Trump + the Fed = Emerging Markets Dream?
If there was one thing most conventional Wall Street bulls and bears alike agreed on in recent months it was that the combination of Trumpian protectionism and Federal Reserve monetary tightening would be disastrous for emerging markets. Emerging markets responded in kind in November and much of December, and the common resurfaced questions of “why do we own emerging markets?” came back around. But, alas, in January and February emerging markets have outperformed even the high-performing U.S. equity markets, and note below the historically low bond spreads in Emerging Markets credit. Either the premises are wrong (that the Fed is about to tighten rates, and/or Trump will be hard on global trading partners, OR the market has overpriced these things to the extreme). We voted for the latter, and continue to do so.
If you follow one thing, follow this.
Nearly everything happening in the broad market right now is a by-product of the expectations that exist around 2017 earnings growth. Should earnings rebound as projected, stock prices are reasonable though pricey. Should earnings growth disappoint, a significant correction would be in order.
In all thy China fears, fear this.
Our discussion of anxiety in global markets caused by potential issues in China center very purposely around their own capital flows and debt bubble. The issue of a trade tension with China provoked by the Trump administration does not make us anxious about China, it makes us anxious for the American economy. We don’t see a way China could plausibly be labeled a currency manipulator in this environment. Tariffs imposed against China would do much damage to the U.S. which relies on their imports, and would hurt the exporters China would surely retaliate against. We are watching all aspects of trade action and evaluating where we see portfolio consequence potential.
Pipeline Shortages up North Means Profit Growth down South
We have not spent nearly enough time over the years talking about the Canadian oil industry and the role their need to transport oil and gas plays in the story of MLP’s (pipelines). Their production industry took a huge hit during the price collapse of oil two years ago, but with production ramping back up we are reading more and more of a mostly undiscussed story with profound environmental and economic impact: The inadequate pipeline supply to transport Canada’s vast oil and gas production capacity. More pipelines will have to be built as the ecological risk and economic inefficiency of using rail to transport oil and gas is a big problem. More projects means more volumes. Canadian crude exports are the highest they have been in over a year,
and growing. Pipeline companies are improving their technology and systems to allow for greater volumes, but new projects are needed, and that is good for the entire space.
Tax Time 2017 vs. Next Year
We are entering the season where investors are preparing all of their tax documents from the year prior to give to their CPA’s towards their annual tax filing. We know what tax rates were on income, dividends, and capital gains in 2016. At this time next year, the market is fully expecting that marginal income tax rates will be lower, that AMT will be gone, that corporate rates for businesses will be lower, and that the ObamaCare 3.8% surtax on investment income will be gone. Will investors be celebrating these things one year from now when they file their 2017 tax year returns, or will the market have to re-price expectations in the coming months if there appears to be bumps in the road. On this outcome hinges so much of what markets will do this year.
Chart of the Week
To reiterate our belief in active management in a period like we find ourselves, take note of the correlations of sectors to one another, and individual stocks to one another. These extraordinary lows are the things active managers pray for. And while we are on the subject, the massive flows into passive index funds last year provide even further support (as contrarians) for our position.
Quote of the Week
“Some things change with elections. Successful dividend investing does not.”
Originally published on Dividend Cafe.
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