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A Good Mix for Further Gains in U.S. Stocks

About the author:

Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist

 

The Trump rally. We’ve all heard that phrase to describe the sharp gains in equities seen in the immediate aftermath of the November U.S. election. But we believe that undersells what is really going on and lends itself to thinking this rally is more of a temporary phenomenon, which we believe is incorrect. What we believe the election did, as a result of a Republican sweep of Congress combined with the Trump win, was to ignite optimism among consumers, businesses and investors. The incoming administration is pro-business and pro-growth whose plans include much-needed regulatory and tax reform, along with infrastructure spending. But the post-election rally also probably had roots pre-election, as economic data began to improve in mid-October; and corporate earnings growth moved back into positive territory in the third quarter.

We believe this mix sets up a solid foundation for the time being for further gains in U.S. stocks. The recent churning in U.S. equities should be viewed as a healthy digestion of the gains seen since the election. The consolidation of gains is helping to correct investor sentiment, which had gotten a bit frothy according to the Ned Davis Research Daily Sentiment Trading Composite. It also keeps a melt-up scenario at bay for now—for while melt-ups feel good while they’re underway, they typically end badly. We will continue to watch sentiment as excessive optimism represents a threat and could lead to pullbacks; but for now we view pullbacks as buying opportunities for those investors that may need to add to equity exposure.

Inflection points

While the U.S. economy was growing throughout last year, it experienced an uptick in the rate of growth in the second half of the year. Corporate earnings—after a four-quarter earnings recession—rebounded back into the black with a 3.1% year/year increase in the third quarter of 2016 according to FactSet.  Fourth quarter earnings are expected to notch an additional 3.8% year/year gain, while the consensus is now expecting nearly 13% growth for calendar year 2017.  Earnings growth drives sustainable gains in stocks, so the recent improvement bodes well for forward-looking valuations and the sustainability of the bull market.

Numerous surveys have also turned higher as both the Institute for Supply Management’s (ISM) Manufacturing and Non-Manufacturing Indexes remain well into expansion territory. Even more encouragingly, the leading new orders components of both indexes posted solid gains in December, moving to 62.0 and 61.6 respectively (50 is the dividing line between expansion and contraction). Another sign of improving business confidence, which may result in greater business spending, is the National Federation of Independent Business (NFIB) small business index. It staged a remarkable jump to 105.8 in December, the highest reading since 2004, and the largest monthly increase since 1980. The job market also continues to look healthy, as 156,000 jobs were added in December and the unemployment rate ticked slightly higher but remains at a low 4.7%. Perhaps more importantly at this stage of the economic expansion, average hourly earnings rose 2.9% over a year earlier, the fastest pace of growth since 2009. And this positivity is filtering through to consumer confidence-- the Conference Board’s measure moved to the highest level since 2001.

Of course there are always risks on the horizon, which can be helpful in keeping sentiment in check, and this time is no different. A stronger dollar could dent the export market and cause a tightening of financial conditions.  However, the latest strength reflects stronger U.S. economic growth in absolute (not just relative) terms, which should help to dampen the negative impact potential. Another risk is that growth accelerates too rapidly, resulting in inflation concerns and tighter-than-expected monetary policy. We’re already seeing higher mortgage rates and oil prices, so additional strength bears watching.

Buy the rumor, sell the news?

Another risk is that some of the expectations of the Trump administration and the Republican Congress will not be met in a time frame being discounted by markets. Politics is messy and the founders wanted it to be difficult for wholesale changes to be made to policy, so getting things done quickly in Washington is not an easy task. But while there will be some disappointments, we believe there will be substantial enough actions which will support stocks, including regulatory relief and tax reform.

Finally, the Federal Open Market Committee (FOMC) indicated in its most recent minutes release from its December meeting that they are a little nervous about the Trump administration and what his stimulus plans may do to inflation expectations. Inflation currently remains fairly low and supportive of valuations and earnings, but a sustainable rise could lead the Fed to have to raise rates more aggressively than what’s currently expected.

So what?

U.S. stocks have been consolidating gains seen in the aftermath of the November presidential election, a healthy process following such strong gains.  Further appreciation should be supported by improving U.S. and global economic and earnings growth.  Disappointments are likely on the U.S. policy front but we would view those as buying opportunities for now.

Important Disclosures

This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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