Last year was a remarkable time for the US stock market as most indices yielded double-digit returns. That rally extended into January of this year.
From December 2016 to January 2018, the market never had a monthly negative return, when dividends are included.
Then, the market unraveled during the past two weeks.
Classic Correction
In my opinion, profit taking and front-running powered the downturn. Year-to-date, the Standard & Poor’s 500 Index is down about 3% and 10% from the market peak on January 29th.
In my view, this is a classic bull market correction. In the past, corrections used to happen at a much slower pace. No more, given computer-driven, algorithmic trading.
Bull market corrections are quite common in my view. It’s a reminder that it’s tough to get double-digit returns every year.
Robust Earnings
Fourth-quarter earnings for most of the S&P 500 companies are beating the expectations, and the majority of them are revising 2018 earnings upwards.
The recently passed tax bill reduces the corporate tax burden to 21% from 35%. That’s an instant 14% gain to corporations in 2018.
In my opinion, the new tax bill is also going to bring back most of the $2.5 trillion in corporate cash parked outside the US border. That repatriated money may be spent on capital expenses, employee salaries and stock buybacks.
The US economy is firing on all cylinders in my opinion. Unemployment is low; consumer confidence is at an all-time high and the housing market is on a tear.
Global Outlook
The global economic outlook is also brightening. The International Monetary Fund recently revised its forecast for European economic growth up to 2.4% from 1.7% for 2019.
The Japanese economy has grown for seven consecutive quarters – the longest streak in 20 years. Both the Chinese and Indian economies are growing more than 6% and 8%, respectively, on an annualized basis.
Valuations
In my opinion, tax cuts and deregulation are good for the general economy. Most analysts are estimating the forward earnings of S&P 500 companies this year at between $150 to $155.
If the market prices in a multiple of twenty times forward earnings, the S&P 500 index should trade around 3000 to 3100 by the end of the year, according to my analysis. The S&P 500 closed at 2620 on Feb. 9.
Fed Tightening
Consumers are starting to spend, and the housing market is picking up the steam.
That’s feeding into wage inflation and increases in the consumer price index. The Fed’s monetary policy is closely tied to the inflation rate and the central bank may raise interest rates three times this year in my view.
In my opinion, this will bring the benchmark interest rate to 2% to 2.25%. The normalization process of interest rates from the prolonged period of zero percent will continue until the middle of 2019 in my view.
Fiscal Policy
The US economy is at full employment and fiscal policy is expansionary. In my view, both the tax cuts and spending on infrastructure are going to boost economic growth by an extra 0.5%, according to my analysis.
However, tax cuts will increase the budget deficit by $1.5 trillion during next decade. Some argue expansionary fiscal policy during full employment may overheat the economy in the near term and increase the debt burden in the future.
Others argue that the benefits from the tax cuts and spending on infrastructure will improve productivity gains and relieve future debt burden.
From a stock market perspective, it is a tailwind at least in the near term in my opinion.
Outlook
Markets never go straight up. In my opinion, the recent market correction is well-needed and may adjust overpriced assets to more appropriate levels.
In my view, this is not the time to sell as I do not foresee a recession soon.
With that in mind, we’ve shifted our allocation to global equities. Higher rates are a boon to the banks. The financial sector is still undervalued in my opinion. As interest rates go up, the banking sector will benefit in the near future.
I think technology, financial and industrial stocks will benefit from latest tax cuts and spending on capital goods. In my opinion, the future looks bright and the bull market will continue its historic run this year.
Occasional corrections are normal in bull markets. I think you should have a long-term perspective on your investments and ignore the market noise.
Photo Credit: Chamathka Udumalagala Gamage via Flickr Creative Commons
