Since we believe that interest rates have bottomed, the key to the stock market and investor performance in 2017 will be earnings. S & P earnings growth has been held back over the last few years by huge declines in energy, industrial commodities and all associated industries’ profitability, which historically comprise over 25% of S & P earnings. Well, that is about to change!
Even if earnings for these industries were flat in 2017 vs 2016, S & P earnings would grow 6-8% but that is not the case. Earnings in these industries have bottomed off of a very low base, which will result in double-digit growth for over all S & P earnings in 2017. So even if the 10-year Treasury bond yield rises to 2.5% next year, as we expect, as the yield curve steepens, the stock market remains statistically undervalued today.
As you now know, Paix et Prospérité does not buy the market, we buy stocks that are undervalued and under-appreciated with strong management. We continue to recommend selling the old “winners” of years past including consumer non-durables, drugs, REITs and utilities and buying the past “losers” that are leveraged for economic growth including technology, industrials, energy and commodities. Only buy best in class–those with strong balance sheets, rising cash flow, great managements and overweight financials, which will benefit from a steepening yield curve. I am sure you saw Bank America, Goldman Sachs and Morgan Stanley’s third quarter earnings reports.
The best is yet to come.
Key data points to confirm our belief that acceleration in the global economy is on the horizon include:
1. The U.S. economy will report this week that third quarter growth accelerated to a 2.0+% gain from 1.4% the prior quarter. Fourth quarter growth will likely exceed 2.0% again led by consumer spending.
2. The dollar hit a seven month high as expectations of a December Fed funds hike got stronger.
3. Third quarter earnings exceeded estimates with better numbers predicted ahead.
4. In their final debate, both Presidential candidates reiterated their intent to stimulate domestic growth utilizing fiscal and tax tools in the hundreds of billions.
5. The ECB maintained its current aggressive policy of monetary ease and indicated that it may extend its debt buyback program beyond mid 2017
6. Politicians’ throughout Europe support more fiscal stimulus despite continued resistance out of Germany.
7. Industrial output in the Eurozone rose a surprisingly 1.8% in August from one year ago
8. Global stock markets were strong last week.
9. China reported third quarter growth of 6.7%. Both monetary and fiscal policy tools are being used to stimulate growth. Consumption is now approximately 71% of GDP and rising.
10. Saudi Arabia began selling a $17.5 billion tranche of debt and indicated a willingness to let oil prices increase. Bringing Aramco is now on the docket, which bodes well for oil prices.
11. Japan passed a 4.11 trillion yen supplemental budget to stimulate consumer demand and business investment.
12. M & A activity picked up dramatically as corporations take advantage of low interest rates
There has been a clear shift in market leadership over the last few months as we predicted and our portfolios continue to significantly outperform the averages.
Third quarter earnings reports for the most part exceeded expectations although volume growth was below plan. You may ask why and what are the implications for future profitability. Corporations, for the most part, have been reducing operating costs and overhead; pruning subpar businesses; reducing capital expenditures at or below depreciation to generate growing free cash flow; refinancing their balance sheets with lower cost debt for years now; buying in stock and raising their dividends. Can you imagine the positive operating leverage if volume and prices both begin to increase as the global economies accelerate? Well, that is what is on the horizon! This won’t happen overnight but global fiscal stimulus, which we expect to begin in 2017 thru 2018, will boost overall economic activity and with it, higher volumes, prices and profitability.
For months, we have been discussing corporations using additional employees to meet volume needs rather than expanding capacity, and in many cases are now operating beneath levels of efficiency. In fact, I expect shortages to occur down the road in several industrial commodities as so much capacity has been mothballed and capital expenditures cut which will lead to much higher prices in several years as demand grows. Remember that the time to buy cyclical stocks is when pessimism is at its highest and companies are bleeding, cutting all capital costs and don’t see the end of the tunnel. Parenthetically, you sell them when optimism is rampant; capital spending is accelerating and the end of the cycle cannot be seen. We bought the best in class 6 months ago including BHP.RIO, NUE, AA and several more. The best is yet to come.
One of the tools that I use for investing is change in incremental rates of return. I tend to buy those companies where incremental returns are rising and sell those and/or short those companies whose incremental rates of return have peaked and/or are declining. I buy at or near the bottom of a cycle, often early, and sell at or near the top of the cycle. That is why I bought industrial commodity companies early in the spring. The stocks are already up 50% from cost with years to run, as we are not near another peak in earnings.
Saudi Arabia clearly led the way of a mindset shift on oil prices, which has positively affected the mindset on pricing of all industrial commodities. As volume and pricing improves, earnings for cyclical companies will surprise on the upside over the next two years. Right now, bearishness still exists about these companies, which I like. Again, none of this will happen overnight but it will be visible by the second quarter of 2017. Stocks anticipate change six to nine months before it actually happens.
The bottom line is to structure your portfolio for an accelerating global economy by mid 2017 into 2018, rising inflation and a steepening in the yield curves as the monetary authorities stay one step behind and a surge in earnings led by cyclical and commodity companies.
The best strategy is to look through the front windshield to create and maintain a future-focused strategy for investing. And, as always, review the facts; pause, reflect and consider mindset shifts; consider the proper asset allocation with risk controls at all times; do first hand independent research on each investable idea and
