• We look at what’s priced into stocks following year-to-date strength to help gauge potential impact of surprises and disappointments.
• When we look at what’s not priced in, we see several possible surprises that could propel the stock market to new highs.
• Possible positive surprises include the stimulus boost from a potential China trade deal and better-than-expected corporate profits in 2019.

After such a strong rally for stocks this year, you may be wondering what could drive stocks higher from here. With the S&P 500 Index less than 1% away from its all-time high set September 20, 2018, a lot of good news has been priced into stocks. You may also be wondering what possible disappointments could cause stocks to pull back from here, especially given the soft patch in the U.S. economy and corporate profits during the first quarter.

To help us with these questions and in consultation with our friends at Strategas Research Partners, we have taken a look at what may or may not be priced into stocks. In doing so, we have attempted to identify some potential surprises that could drive the next leg of this rally, as well as some possible areas of disappointment if something that is priced in does not occur [Figure 1]. [backc url='http://www.dynamic.ca/leadership/eng/active.html?fund=dreii2f&utm_source=aa&utm_medium=banner&utm_campaign=alts_2019&utm_content=dreii2f']

U.S. Economy – What’s Priced In

GDP growth between 2% and 2.5%. Bloomberg consensus stands at 2.4% real gross domestic product (GDP) growth in 2019. The short stint above 3% last year was considered a one-off and not sustainable after the boost from tax reform that became law at the end of 2017.

A sugar high after tax cuts. Tax reform in December 2017 provided significant stimulus for the U.S. economy. The consensus view is that the peak impact of the tax law has already been felt and that the benefits to the U.S. economy are quickly diminishing, which we believe may be overly pessimistic.

Stubbornly low inflation. The Phillips Curve depicts the relationship between unemployment and inflation. The labor market has been tight for a while, yet wage growth has been moderate, causing many to think the Phillips Curve is dead.

No Fed rate hikes in 2019. The Federal Reserve (Fed) has told us as much, so this is already fully reflected in stock prices. On a related note, markets are pricing in low interest rates and a flat yield curve well into the future.

What’s Not Priced In

GDP growth reaccelerates to 3%. Our forecast for 2.5% puts us near consensus. That means if growth comes in well above that mark (or below, for that matter), the market reaction could be sizable. We believe an upside surprise is more likely than a big miss.

A pickup in capital spending helps extend the business cycle. A China trade deal may unlock animal spirits and drive more capital spending and higher productivity, which may enable more growth with less wage pressure as companies efficiently produce more output. Capital investment incentives from the December 2017 tax reform, including lower levies, repatriation of foreign-sourced profits, and immediate expensing, remain in place.

Low unemployment sparks rising inflation. A modest pickup in inflation is within expectations, but markets are probably not prepared for more than that. Labor markets have been tight for quite some time with moderate wage growth, which has anchored the market’s inflation expectations.

Higher interest rates. With the market having grown accustomed to low interest rates and the Fed on hold, a jump in financing costs would surprise investors. We expect rates to gradually move higher over the rest of 2019, with increases capped by low interest rates overseas.

Global economy – What’s Priced In

A trade deal with China. All indications are that some form of a deal will get done by June, if not sooner. Recent reports that China has agreed to the U.S. demand for an enforcement mechanism are encouraging.

Secular declines in Europe and Japan. Economies in Europe and Japan have lagged behind the United States in economic growth for quite a while, and markets are inclined to expect lackluster growth to continue for the foreseeable future.

What’s Not Priced In

A good China trade deal stimulates global economic activity. A deal is widely expected, but market participants may be surprised by the economic and market boost from the removal of uncertainty and greater access to Chinese markets for U.S. companies. The possible rollback of existing tariffs could be a positive surprise.

Stimulus-induced growth in Europe and Japan. Recent data in Europe have suggested that economic growth is stabilizing. Possible catalysts for better growth in the second half in Europe include reduced trade tensions and a soft Brexit. In Japan, fresh stimulus could help offset the impending increase in a value-added tax (VAT) increase slated for October 2019.

U.S. Equities – What’s Priced In

Profit margins are heading lower. We’ve heard calls for lower profit margins for several years now. Those calls will be right at some point, but the market seems to be quite confident that time has come, suggesting the potential for a positive surprise. As a result, analysts are calling for stronger sales growth than earnings growth in the first quarter and the rest of 2019.

Continued growth stock rally. The market appears to be pricing in a sustained period of subpar economic growth based on the continued strength in growth stocks. Slower economic growth has tended to make growth companies more attractive as growth becomes tougher to find.

What’s Not Priced In

Earnings estimates for 2019 are too low. We see economic growth ahead as sufficient to drive 2019 S&P 500 earnings growth above current consensus estimates in the 3–4% range, pushed by fiscal stimulus, robust manufacturing output, healthy labor markets, and resolution of the U.S.-China trade dispute.

Value stock comeback. After roughly 10 years of growth stock outperformance, value may be due for a comeback. Relative valuations favor value stocks, while a pickup in economic growth—should it occur—could give cyclical value sectors a boost, notably financials and energy.

CONCLUSION

We believe there are enough potential positive surprises to push the S&P 500 to new highs this year and beyond. That said, clearly there are risks, as there always are. Those risks led us to reduce our recommended U.S. equities allocations from overweight to market weight in late March.

We would not be surprised if the market gets more than it expects out of the U.S.-China trade deal and corporate profits. On the other hand, we are not particularly optimistic that Europe and Japan can deliver better growth in the near term, and the market may be underpricing the possibility that a Fed rate hike later this year could push interest rates higher.

We continue to expect the S&P 500 to end 2019 at or near our fair value target of 3,000, but with the index only about 1% away from that target, and considering the global economic soft patch in the first quarter, we see the risk-reward trade-off between stocks and bonds in the near term as fairly balanced.

Thank you to our friends at Strategas Research Partners for their contributions to this report.

*****

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

LPL Financial and Strategas Research Partners are not affiliates of each other and make no representation with respect to each other.

DEFINITIONS

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

INDEX DESCRIPTIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Copyright © LPL Financial

KEY TAKEAWAYS

• The market rally continues, with stocks off to their best year’s start since 1991.
• Near-term stocks are quite overbought and a pullback could be warranted.
• Yet, from a sentiment perspective, we still aren’t seeing signs of the over-the-top optimism that is consistent with major peaks.

The rally continues, as the S&P 500 Index gained for the seventh week out of the past eight, while the Dow Jones Industrial Average, Russell 2000 Index, and Nasdaq all closed higher for the eighth consecutive week. Sparking the rally this week were Washington striking a deal to avoid another government shutdown and hopes that President Trump might push back the March 1 deadline on higher tariffs on Chinese goods.

With the S&P 500 off to its best year’s start since 1991, how much further can things go? This week we’re going to take a look at market sentiment, which can play an important part in determining how long the bull will run.

ABOVE THE 200-DAY

As Figure 1 shows, the S&P 500 finally closed above its 200-day moving average for the first time since early December 2018. Since October, the index hasn’t stayed above this long-term trend line for more than a few days. Given the S&P 500 has now bounced more than 18% from the December 24 lows, some type of consolidation or maybe another pullback would be normal.

As we discussed in That Was The Easy Part, a retest of the December 24 lows likely won’t happen. Historically, you see retests at major market lows, but this could be one of those rare times that we don’t. Two main reasons are:

• On January 18, 2019, more than 70% of the S&P 500 components made a new 4-week high, and the returns after such a rare blast of strength have been quite impressive 3, 6, and 12 months later.
• We saw two 90% up days coming off the December lows, on December 26 and January 3. This means that 90% of all stocks on the New York Stock Exchange were higher and 90% of the volume was also higher on those days. When we see two strong days like that so close together coming off a low, continued future gains without a rest is likely, in our view.

CHECKING IN ON SENTIMENT

The overall technical backdrop continues to look strong, but one other substantial positive is that investor sentiment is still not near areas we would consider to be a major warning sign.

History has shown that the crowd can be right during trends, but it also tends to be wrong at extremes. This is why sentiment can be an important contrarian indicator. If everyone who might become bearish has already sold, only buyers are left. The reverse also applies.

On multiple levels, we see increasing optimism—but not at levels that have shown it paid to be contrarian. In fact, with a more than 18% bounce off the December lows, we are quite surprised there isn’t more excitement.

• The Bank of America/Merrill Lynch Global Fund Manager Survey had the highest number of investors “overweight cash” since early 2009. Additionally, investors with an “overweight global equities allocation” sank to the lowest level since September 2016. This shows managers aren’t giddy over the good start to the year and suggests there could be potential cash on the sidelines waiting to come in.
• The CNN Money Fear and Greed Index hit single digits back in December, but has bounced to only 64 recently (on a 0–100 scale), again suggesting overall optimism isn’t near previous warning signs.
• The National Association of Active Investment Managers (NAAIM) Exposure Index was recently over 80 for the first time since October, but again this has peaked much higher in the past.
• The number of bulls in the weekly American Association of Individual Investors (AAII) Investor Sentiment Survey has been beneath 40% for 14 consecutive weeks, the longest such streak since last spring, when the first 10% correction in nearly 18 months occurred. What is so interesting about it this time around is bulls aren’t springing into the picture even after week after week of gains.
• Investors continue to pull money out of equity mutual funds and equity exchange-traded funds (ETF). In fact, according to weekly data from the Investment Company Institute (ICI), only seven weeks over the past year have seen inflows into U.S. domestic mutual funds and ETFs. Additionally, the week of the December 24 lows saw the largest weekly outflows of funds since February 2018. We would expect to see more inflows and optimism before an ultimate market peak could take place.

CONCLUSION

The rally continues, and although we see many signs potentially indicating new highs for equities later this year, some type of market consolidation or pullback could be due. We have an improving technical backdrop that should support any pullback as a buying opportunity, and overall sentiment is still a long way away from what we’d call over-the-top and troublesome from a contrarian point of view.

We believe the combination of fiscal policy, optimism over a potential U.S.-China trade deal, and our expectation for steady earnings growth is strong enough to support further gains for stocks throughout 2019. We reiterate our year-end fair value range of 3000 for the S&P 500 from our Outlook 2019 publication.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. Any economic forecasts set forth in the presentation may not develop as predicted.

Investing involves risk including loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Because of its narrow focus, specialty sector investing, such as healthcare, financials, or energy, will be subject to greater volatility than investing more broadly across many sectors and companies.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Productivity will need to play a key role to drive gross domestic product (GDP) growth in the coming years, as we recently discussed in our blog. This week, we look at the trend in S&P 500 firms’ use of cash over the past decade and why more granular analysis is necessary to identify which areas of the market are actually driving productivity growth.

The chart below shows that, at the index level, S&P 500 firms’ preference for utilizing excess cash on their balance sheets to return money to shareholders via stock repurchases and dividends had been steadily increasing since the end of the Great Recession. That trend has reversed somewhat in recent quarters, as firms may be reinvesting cash in their businesses to increase productivity through the adoption of new technologies, investments in new equipment, and additional training and education to their employees, just to name a few examples.

But it’s important to understand how capex is being deployed to better determine which industries’ capital expenditures are supporting efforts to drive productivity gains. Let’s look at the healthcare sector as an example. Generally speaking, large cap pharmaceutical companies spend most of their capital on research and development (R&D) in hopes of developing a new drug. As a group, their spending on productivity improvements/efficiency gains is significantly less under most circumstances. In contrast, the healthcare equipment and technology space invests material amounts of capital in products and processes that either improve internal processes or can be sold to improve the productivity of other healthcare companies. This isn’t to say pharmaceuticals don’t have other investment merits; however, it shows that determining which market segments will likely drive productivity gains requires more granular analysis.

Increasing productivity will be key to GDP growth; tentative signs indicate that some firms may be placing a higher priority on it. Taken together, these companies and market segments could help to enhance not only shareholder returns by means such as increased profitability, greater market share, and a more skilled workforce, but also economic growth. However, investing in market segments leading this trend will likely require a more targeted approach.

*****

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor

Member FINRA/SIPC

Tracking # 1-613943 (Exp. 06/18)

Copyright © LPL Research

PDF Version

KEY TAKEAWAYS

• June brings several significant events that have the potential to be market movers.
• A rate hike is widely expected at the Fed meeting, but what the Fed says about future hikes will be very important.
• The European Central Bank (ECB) and Bank of Japan (BOJ)also have highly anticipated meetings.

Summer will soon be here, as June 2017 brings with it longer days and summer vacations in the United States. It is also a month with three major central bank meetings. So far in 2017, the global equity rally has continued with new highs in the U.S., Europe, and emerging markets (EM). The global earnings backdrop is strong as well, supporting the moves to new highs. Not to mention 2017 has been one of the least volatile ever, with only four 1% moves for the S&P 500 Index in the first 100 trading days of the year. As we turn the page to June, it is important to stay on top of the most significant upcoming events. To help, we’ve created this guide to the June 2017 market calendar, providing an overview of the key events.

JUNE 2

EMPLOYMENT REPORT (MAY)

The U.S. economy created only 79,000 jobs in March 2017, but it bounced back with an impressive 211,000 in April, avoiding the first back-to-back sub-100,000 total since December 2010 and January 2011. One-year average job creation peaked in February 2015 at 261,000 per month and has slowed since to a still strong 186,000 [Figure 1]. Economists anticipate the trend continuing, with consensus expectations currently at 185,000 jobs created in May.

The center of gravity at the Federal Reserve (Fed) probably sees job growth as low as 100,000-125,000 per month as enough to continue to support the unemployment rate, currently at 4.4%. Wages will also be watched closely by the Fed. Average hourly earnings grew at 0.3% month over month in April and 2.5% year over year, with similar expectations for May. The labor force participation rate will receive some attention too as it has seen a small increase from the expansion low of 62.4% in September 2015, hitting 62.9% as of April 2017. A higher participation rate could help to limit wage pressures by increasing the supply of people willing to work. Wage pressures thus far have remained modest, and the Fed will be watching closely for any increase that may signal a pickup in inflation.

Last, going back to 1990, June has been the third-worst month for jobs growth (with August and December worse), so some type of seasonal weakness is a possibility. At the same time, jobs have been positive for a record 79 consecutive months, and job creation would need to slow to a sustained 25,000-50,000 per month to signal that a recession is near.

JUNE 8

ECB MEETING

The ECB meets June 8, with a lot of tension underneath a calm surface. The ECB has committed to buying 60 billion euro of bonds each month until December 2017. The ECB believes its program has been successful in aiding the economy and keeping the region from slipping into deflation. Eurozone inflation has been as high as 1.5%, still below the ECB’s 2% goal on an annual basis. However, economic growth and inflation in Germany has been running hotter than many in the country are comfortable with. Even German Chancellor Angela Merkel recently complained that ECB policy is keeping the euro too weak. In addition, the ECB is concerned that it may run out of bonds that meet its self-imposed guidelines for purchase.

Although we do not expect any change in policy at the upcoming meeting, the ECB will likely provide some guidance regarding future changes, specifically the amount of bond buying that will occur after the current program expires. The expectation is that bond buying will be reduced (a policy referred to as tapering) through the end of 2018. But with some countries, like Germany, desiring an end to monetary intervention and others (probably most notably Italy) looking to extend current policies, the ECB statement will be closely scrutinized. It will be hard, if not impossible, for it to satisfy all parties in the long run.

JUNE 13-14

FED MEETING

The Fed’s policymaking arm, the Federal Open Market Committee (FOMC), holds its fourth of eight meetings this year on June 13-14, 2017. At 2 p.m. ET on June 14, the FOMC will release its policy statement, a new set of members’ forecasts on the economy, labor market, and inflation, and a new set of “dot plots”(members’ forecasts of where they think the fed funds rate will be at the end of 2017, 2018, 2019, and in the “long run”). Fed Chair Janet Yellen will also hold the second of four post-FOMC meeting press conferences of the year at 2:30 p.m. ET on June 14. As of Friday, May 26, 2017, the market, as measured by fed funds futures, is pricing in an 88% chance of a 25 basis point (0.25%) rate hike at the June 2017 meeting.

Our view -- as expressed in Outlook 2017 -- remains that with the economy near full employment and inflation running near the Fed’s 2% target that the Fed will raise rates one to two more times in 2017 (for a total of two to three rate hikes in 2017). The minutes of the Fed’s May meeting also showed continued discussion of starting to allow maturing bonds to roll off the Fed’s balance sheet, though at a measured pace, potentially beginning later this year. Markets will be watching for more clarity on this issue from the Fed’s statement and press conference. Additionally, there is plenty of information for markets to digest between now and mid-June, which may change the odds of a hike at the June meeting. Key reports coming between now and then include consumer and producer inflation, the Institute for Supply Management’s (ISM) manufacturing and non-manufacturing indexes, employment, and retail sales. If these reports underwhelm, rate hike expectations may fall.

JUNE 15

BOJ MEETING

Like the ECB, the BOJ is still engaged in buying bonds, but it is also buying stocks, to help support the economy. Also like the ECB, the BOJ can point to progress being made on the economic front, but with growth still subpar and inflation below target, we expect the BOJ will maintain its current policy. There may be an acknowledgement of the BOJ’s growing balance sheet, but little if any real policy changes.

If both the BOJ and the ECB largely maintain the status quo, we expect it to be modestly positive for global equities. One would also think that a tightening Fed and continued loose policy in Europe and Japan would be positive for the dollar relative to the other currencies. However, the dollar has been in something of a downtrend recently. Should either the BOJ or ECB statement be more dovish than anticipated, that may be enough to bump the dollar higher, at least in the short term.

JUNE 29

THIRD ESTIMATE Q1 2017 GDP

The third estimate of first quarter 2017 gross domestic product (GDP) will be released on June 29. The second estimate was released on May 26, and saw real GDP growth revised up from 0.7% to 1.2%. The average revision (up or down) from the second estimate to the third is 0.2%, smaller than the 0.5% from the first to the second. The big story for first quarter GDP was the largest contribution from business fixed investment since the first quarter of 2012 and the fourth-best contribution of the millennium. However, weak consumer spending (slightly upgraded in the last revision) and a large negative contribution from inventory growth extended the persistent seasonal pattern of a disappointing first quarter.

The third estimate of first quarter GDP will have economists looking ahead to the initial estimate of second quarter GDP on July 28. Based on the Fed Bank of Atlanta’s NowCast model, expectations are for growth to rebound to over 3%, helped by a bounce back in inventories, which have a tendency to reverse extremes, and consumer spending, which has been a mostly steady contributor throughout the expansion. Business investment is likely to slow but is expected to make another meaningful contribution, a theme we believe will continue as the economic and policy environment becomes more supportive of businesses investing in their own future growth and productivity.

CONCLUSION

June is a month that historically has seen some volatility. Who could forget last year and the Brexit sell-off? With three major central banks set to announce new interest rate policy in the span of one week, the odds for some summertime volatility is higher than usual. After weak growth in the first quarter, all economic data will be heavily scrutinized to see if the U.S. economy might stage a second half bounce. With summertime upon us, it is important to remember to have a plan in place before these events unfold. And don’t forget your sunscreen!

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Any economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The eleven-person FOMC is composed of the seven-member board of governors, and the five Federal Reserve Bank presidents. The president of the Federal Reserve Bank of New York serves continuously, while the presidents of the other regional Federal Reserve Banks rotate their service in one-year terms.

The Fed Funds futures contract represents the average daily fed funds effective rate for a given calendar month as calculated and reported by the Federal Reserve Bank of New York. It is designed to capture the market’s need for an instrument that reflects Federal Reserve monetary policy.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The U.S. Institute for Supply Managers (ISM) manufacturing index is an economic indicator derived from monthly surveys of private sector companies, and is intended to show the economic health of the U.S. manufacturing sector. A PMI of more than 50 indicates expansion in the manufacturing sector, a reading below 50 indicates contraction, and a reading of 50 indicates no change.

Copyright © LPL Research

by Jeffrey Saut, Chief Investment Strategist, Raymond James

For the College Humor Magazine I submitted a collection of many “Laws” and other items, including my “College Course Descriptions”: 1) If it’s green, wiggles or slithers, it’s biology; 2) If it stinks, it’s probably chemistry, but don’t rule out economics; 3) If it doesn’t work, it’s most likely physics – but keep the economics option open; 4) If it is incomprehensible, it’s probably mathematics, but that’s part of economics also; 5) If it stinks, doesn’t work, is incomprehensible and doesn’t make sense – it’s either economics or philosophy.

. . . Ray DeVoe, analyst and author of “The DeVoe Report”

Raymond DeVoe was one of the best stock market newsletter writers on Wall Street. I had the pleasure of meeting him when I moved to Baltimore to be director of research and run capital markets for a brokerage firm. Unfortunately, Ray is no longer with us, having passed away. As written in his obituary:

Tom Keene on Bloomberg Television’s, “Surveillance Midday,” called him a “legend of Wall Street.” DeVoe wrote the weekly “DeVoe Report” for 35 years and continued until August. The newsletter was known for DeVoe’s original thinking on economics, his humor and his wide-ranging interests. He often discussed classic movies along with stocks. The financial website “Global Province,” named The DeVoe Report “The Best Wall Street newsletter” in 2004.

I recalled this “College Course Descriptions” while reading last week’s moribund economic releases. As our economist Scott J. Brown, Ph.D., writes:

The 2nd estimate of 1Q17 GDP growth was stronger than anticipated, not a big surprise given the normal uncertainty in the figures. Consumer spending was revised a bit higher (still soft). Business fixed investment was revised higher. Inventories were more of a drag on the headline figure than in the advance estimate. Underlying domestic demand (Private Domestic Final Purchases, which is GDP less net exports and the change in inventories) was revised higher (a 2.7% annual rate and +2.9% y/y). A pop in military aircraft prevented durable goods orders from falling as expected, but ex-transportation, results were disappointing. Orders and shipments of nondefense capital goods ex-aircraft appear to be on soft trends into 2Q17, suggesting that the 1Q17 pickup in business fixed investment (+11.4%) may be a one-off.

To be sure, U.S. economic data has been disappointing for a while, yet the equity markets continue to shrug off bad news. That action reminded me of one of legendary strategist Bob Farrell’s favorite books “One Way Pockets,” first published in 1917 under the nom de plume of Don Guyon. I like this quip:

Most traders (investors) seem to become convinced of the genuineness of a movement in either direction only when it approaches a culmination. One reliable indication of the start of an upward swing is afforded when, after a period of decline prices, or less frequently, dullness, the market advances or refuses to go down following the receipt of bad news. News can seldom be utilized by the public for market purposes, even when its authenticity is beyond question. For instance, if tomorrow morning’s newspaper should announce the death of a President or the failure of a great “corner house,” or the complete destruction of Gary, Indiana, it is more likely that stocks sold on the news would bring the lowest prices of the day, for the very good reason that each seller would be competing with thousands of other sellers who would have learned the news at the same time.

Indeed, shrugging off bad news, what a novel concept, and for the equity markets it seems to have been the case for quite a while. It certainly was the case last week as the D-J Industrials (INDU/21080.28) rallied 1.3% (to within 35.27 points of its all-time high), the S&P 500 (SPX/2415.82) rose 1.4% (to a new all-time high), and the Nasdaq Composite gained 2.1% also to a new all-time high. Such action caused one old Wall Street wag to comment, “When markets ignore bad news that’s good news!”

That said, Andrew and I think the equity markets are making a short-term peak. That’s what our short-term proprietary model is “thinking” as well. However, we are not looking for much downside traction, but rather more of an upside stall for the next few weeks while the stock market’s internal energy is rebuilt. If there is a downside, headline induced, shock, we believe it will be short-lived with stocks quickly rallying back.

Also arguing for a “stall” is the fact that many of the major indices are at the top of their various channels (see Chart 1 on page 3). Additionally, most of the sectors are pretty overbought in the short term (Chart 2 on page 3). It is interesting to note the performance of those macro sectors year-to-date (see Chart 3 on page 4). Notice that Energy and Telecom have lagged badly, and that Financials are virtually flat for the year. Recently the Financial ETF (XLF/$23.60) has traced-out a head-and-shoulders bottom, which could also be construed to be a spread triple-bottom, and is attempting to vault above its 50-day moving average (Chart 4). As the article in today’s Barron’s states, “It’s Time to Pounce on Banks”; to which we add, only if you pick you banks carefully. A good starting place would be the Raymond James Equity Research universe of stocks rated Strong Buy by our fundamental analysts.

The call for this week: As stated, we are looking for an “upside stall” with no real downside traction unless there is a headline induced “shock.” Our friend, and founder of the insightful SentimenTrader organization (Jason Goepfert), is kind of looking for a short-term stall as well as he writes:

When stocks took a brief spill last week, the smart money quickly stepped in and started buying. They haven't let up too much over the past week, which isn't too unusual. What is unusual is that the dumb money is right there alongside them. Both groups are now relatively confident in a further rally, and that's not something we often see. That's especially the case when stocks are ticking at new highs. The "smart" and "dumb" monikers are just shorthand to depict groups of indicators that tend to be non-contrary (smart) or contrary (dumb) when they reach extremes. Almost by definition, the "dumb" money will be on the right side of the meat of a trend, and that's how some prefer to use it – as a kind of trend-following model. That's fine until it reaches extreme optimism, then the likelihood of a further sustained rally diminishes. Smart money acts more like hedgers, buying into declines and selling into rallies. That's why it's so odd to see both groups at essentially the same confidence level, and the S&P at a new high. [see Chart 5 on page 5.]

Bear in mind that this “stall call” is just a short-term trading finesse call because longer term we remain in a secular bull market that has years left to run! And then there was this, about the balance of 2017’s stock market trading pattern, from LPL’s eagle-eyed Ryan Detrick (as paraphrased):

The S&P 500 has gained 7.9% through [last] Thursday, the 100th trading day of 2017. Since 1950 the S&P 500 has never finished lower after gaining at least 7.5% during the first 100 trading days – it’s 23 for 23. And on 20 of these occasions, the benchmark continued to rise, with an average gain of 9% over the remainder of the year.

Ladies and gentlemen, if correct that would imply a gain for the SPX of some 16.9% for the year (7.9% + 9.0% = 16.9%), which is considerably better than the +13.1% the SPX on average has returned as the stock market has transitioned from an interest rate, to an earnings, driven secular bull market . . . QED.

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Copyright © Raymond James

Asset growth in sustainable investments, a term that refers to strategies that attempt to augment traditional financial analysis with analysis of additional factors such as environmental, social, and governance (ESG) practices, has been strong in recent years, with U.S. assets under management totaling more than $8.7 trillion in 2016, or nearly one out of every five dollars under professional management.[1] However, even with recent growth, there are still some broad misconceptions about these types of strategies, two of which we address below:

• Sustainable investing methods haven’t changed over time.

Sustainable investing strategies actually have evolved, and the changes may surprise those who haven’t looked at the space in some time. Many investors associate sustainable investing with socially responsible investing (SRI), which avoids investments in companies or industries on the basis of moral values and standards. However, SRI is just one strategy among many. The term sustainable investing also includes several other strategies outlined in the infographic below:

• Sustainable investing constrains the investment universe, potentially leading to lower returns.

This is a common concern about sustainable investing that may keep some investors away from the strategy. However, sustainable investing has evolved from its SRI roots to incorporate other strategies, including ESG investing, which focuses on finding companies that are best in class in this area rather than using an exclusionary approach. The idea is that by selecting companies with stronger ESG practices, investors may be able to avoid legal, reputational, and other risks that could lead to financial losses. Our recent Thought Leadership publication, Sustainable Investing, begins with examples of such situations.

Sustainable investing is not a new concept, and we understand the trepidation that some investors feel regarding the term. Although exclusionary approaches have worked well for some, we recognize they are not for everyone. Our main goal in bringing this topic back to the forefront is to ensure that investors and their advisors are aware of the evolving nature of the space, and that it may be worth a second look, not only for those who want to align their investments with their values, but also for investors who are concerned that ESG factor risks could turn into financial challenges for companies.

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Sustainable Investing is subject to numerous risks, chief amongst them that returns may be lower than if the advisor made decisions based only on investment considerations.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor

Member FINRA/SIPC

Tracking # 1-611818  (Exp. 05/18)

Copyright © LPL Research

by Burt White, Chief Investment Officer, LPL Financial

Key Takeaways

• At times of uncertainty we suggest investors focus on the fundamentals of the economy and corporate profits.
• Like everyone else, we don’t know what will happen with the Russia investigation, although we have made some observations about what the latest news could mean for fiscal policy.
• We have a better handle on the basic fundamentals, which look pretty good right now and tend to drive stocks over time.

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What are we telling our investors? Focus on fundamentals. It was an up-and-down week for stocks as market participants became increasingly worried that the Trump administration’s agenda was in danger following the latest news surrounding the Russian investigation. On Wednesday (May 17), the S&P 500 Index suffered its biggest one-day drop in nearly a year (-1.8%), while the Nasdaq Composite (-2.6%) and Russell 2000 Index (-2.8%) suffered even bigger losses.

Stocks then recovered nicely Thursday and Friday (May 18-19) to end the week with only a modest loss, the S&P 500 falling 0.4% for the week. As hard as it is to believe, the index is still less than 1% off its all-time closing high [Figure 1]. Some attributed the late-week rebound to the market’s approval of former FBI Director Robert Mueller as special counsel for the Russia investigation. Perhaps markets got more comfortable with where the investigation might lead. More good economic and earnings data probably helped; it’s difficult to know. But whatever the reason for the rebound, this week we focus on the market’s fundamentals which look pretty good.

Focus on Fundamentals

Regarding the Russia situation, we are still in the headline risk stage. We just don’t know what is going to happen. At times of uncertainty, especially the political variety, we suggest investors focus on the fundamentals of the economy and corporate profits, as we do below. At this point we believe the likelihood that headline risk will become fundamental risk is low.

Macro Picture Continues To Improve

The macro picture looks good. We are not seeing any concerning recessionary warning signs and, despite the weak start in the first quarter, still see a pickup in economic growth this year from the 2% pace of the past eight years. We see U.S. gross domestic product (GDP) growth near 2.5% in 2017, and it may even exceed that pace in the current (second) quarter*. The Conference Board Leading Economic Index, released last week, continues to signal a low probability of recession over the next 12-18 months. Confidence among businesses and consumers is still high, which we think will translate into faster growth. Job gains have been steady, supporting wage increases and consumer spending. Capital spending has picked up some in recent months, as energy markets have stabilized. And the U.S. dollar has been falling, supporting U.S. exports and overseas earnings for multinational corporations.

* Our forecast for GDP growth of between 2.5–3% is based on the historical mid-cycle growth rate of the last 50 years. Economic growth is affected by changes to inputs such as: business and consumer spending, housing, net exports, capital investments, and government spending.

Earnings Outlook Brightening

The earnings picture has brightened recently, supported by a firming U.S. economy and capped off by a very strong first quarter earnings season. Not only did the S&P 500 produce 5% upside to quarter-end (04/01/17) consensus estimates, but estimates for the balance of 2017 hardly budged during the reporting season (a rare and positive occurrence) and 2018 estimates have actually inched higher.

The earnings picture right now is as good as it has been in a while, with 2017 positioned to bring solid gains after flat earnings over the past three years; we think the improved earnings outlook has the potential to push stocks higher between now and year-end even without any policy impact. Policy matters, but its potential impact on earnings is a 2018 story. Should the market’s optimism about reforms in 2018 rise, stock valuations may be pushed higher later this year in anticipation of the earnings bump.

Little, if any, sign of credit stress

We have not seen signs of stress in the fixed income markets that might suggest some deterioration in the fundamental outlook for stocks. Corporate credit spreads on high-yield and investment-grade credit remain narrow. Financial conditions have eased, based on the Federal Reserve Bank of Chicago’s National Financial Conditions Index (financial deregulation prospects may have something to do with that). The yield curve flattened a bit this week, and the 10-year Treasury yield fell 10 basis points (0.10%), but these levels are nowhere near those that would suggest stress in credit markets. Although some of the economic data slowed in the spring and pushed U.S. Treasury yields lower, we are not concerned that lower yields signal a pronounced or sustained economic slowdown given evidence of a potential pickup in the second quarter.

Fiscal Fallout

We advise focusing on the fundamentals, as we have done above. But fiscal policy, and particularly tax reform, is part of the fundamental story—with the potential to add to economic growth and profits in 2018 and beyond. So while predicting the outcome of the Russia investigation is difficult, we can make some observations:

Hopes for major policy achievements in 2017 have come seriously into question, and the latest controversies increase the odds that corporate tax reform gets pushed into 2018. The possibility exists that reform gets scaled down and becomes just tax cuts and a lower tax rate for repatriating overseas profits, which would still be expected to drive more capital spending and profits in 2018.

The latest distractions may light a fire under Republicans increasingly desperate for a “win.” The political costs of potential failure on healthcare (which also faces a difficult road) and tax reform are high. This may explain why an infrastructure proposal is likely coming within several weeks.

Republicans may fear their majority in the House is at risk, pushing them to accelerate their timetable. The tight-lipped special counsel may actually help the Republican policymakers compartmentalize and focus.

Distractions may slow the pace of staffing up key regulatory agencies and could therefore slow the pace of financial regulatory reform, a key pillar of the Trump administration’s agenda.

Technical Perspective

From a technical perspective, we see support at around the 2320 level on the S&P 500 (roughly 60 points or 2.6% below Friday’s close). The magnitude of Wednesday’s sell-off was certainly jarring, especially given how long it has been since the S&P 500 dropped more than 1% in a day. The rally late in the week off the Thursday morning lows was encouraging, as has been the stock market’s tendency to recover from sharp one-day declines when the S&P 500 has been near all-time highs. We also like seeing the S&P 500’s break back above its 50-day moving average which, from a technical perspective, tends to be a positive signal (the index is now above its 50-, 100-, and 200-day moving averages).

These are positive signs, but from a technical perspective, it would be nice to see the broad market settle down for a few days before potentially putting fresh money to work.

Conclusion

Like everyone else, we don’t know what will happen with the Russia investigation, although we have made some observations about what the latest news could mean for fiscal policy. We have a better handle on the basic fundamentals of the economy and corporate profits, which look pretty good right now, tend to drive stocks over time, and are where we think investors should be focused.

*****

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate, and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.

High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

All investing involves risk including loss of principal.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the 3-month, 2-year, 5-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

INDEX DESCRIPTIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Leading Economic Index is a monthly publication from the Conference Board that attempts to predict future movements in the economy based on a composite of 10 economic indicators whose changes tend to precede changes in the overall economy.

The National Financial Conditions Index (NFCI) measures risk, liquidity and leverage in money markets and debt and equity markets as well as in the traditional and “shadow” banking systems. Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate financial conditions that are looser than average.

The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S.-based common stocks listed on the NASDAQ stock market.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

by Ryan Detrick, LPL Research

A recent Gallup poll showed that the percentage of U.S. adults invested in the stock market is near a 20-year low. With the S&P 500 Index at new all-time highs, this lack of participation in stocks is quite surprising.

The poll asked respondents if they were invested in an individual equity, stock mutual fund, or a self-directed 401(k) or IRA. This same poll, which reflected that up to 65% of adults were invested in the U.S. stock market in 2007, just ahead of the financial crisis, indicates that participation has dropped 11% over the past 10 years.

Per Ryan Detrick, Senior Market Strategist, “The big question is: Do you need Mom and Pop investors to come back full force into equities before the bull market can end? From a contrarian point of view that makes sense, but it isn’t quite so simple. We’d continue to focus on the improving fundamentals, strong technicals, and modest valuations (when you factor in low inflation and historically low interest rates) as a reason to expect higher equity prices. Still, this survey shows we are a long way away from seeing Uber drivers giving stock tips or your Aunt talking about the next hot tech IPO at Thanksgiving dinner.”

*****

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor

Member FINRA/SIPC

Tracking # 1-611482 (Exp. 05/18)

by Ryan Detrick, LPL Research

We are often asked in which direction the 10-year Treasury yield is headed. If we, or anyone else for that matter, could answer that question accurately, we’d be sunning on a yacht surrounded by breathtaking islands. But given that we don’t have a crystal ball on hand, we instead look to various data points and charts. One such chart, a fairly common one for fixed-income traders, is the 10-year Treasury bond versus the cooper-to-gold ratio.

As can be seen above, the 10-year Treasury bond followed the directional moves of the copper/gold ratio fairly closely during the time period in the chart. For example, in mid-December 2016, as investors were flocking to risk-on assets such as stocks and copper, the ratio spiked and 10-year yields increased (prices declined) shortly thereafter. This rally seemed to be driven by speculation that the Trump administrations expected increase in infrastructure spending would drive up future demand for copper. After all, the durable metal can be used to produce products such as wires, pipes, and fittings that have wide applications throughout the economy. Because copper is highly sought after when new infrastructure projects develop, it is considered to be a decent indicator of global and U.S. economic health. Generally, when copper prices rise, the economy is expanding: which often leads to higher inflation, and thus lowers demand for safe-haven assets such as gold and bonds.

Recently, amid signs that the administration’s policies may take longer to materialize, the copper/gold ratio has declined. A move lower in the ratio may signal that economic growth is decreasing and copper is losing its appeal. Lower copper prices suggest lower inflation, which helps bonds and gold move up in price. To date, the copper/gold ratio has been a fairly accurate predictor of 10-year Treasury rates, but this is just one chart and relying solely on this will probably not lead to a yacht. That said, if the pattern holds and the ratio rises, the 10-year and gold may decline in price.

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Commodity-linked investments may be more volatile and less liquid than the underlying instruments or measures, and their value may be affected by the performance of the overall commodities baskets as well as weather, geopolitical events, and regulatory developments.

This research material has been prepared by LPL Financial LLC.

 To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

 Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

 Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor

Member FINRA/SIPC

Tracking # 1-609758 (Exp. 05/18)

Copyright © LPL Research

by Burt White, CIO, LPL Research

KEY TAKEAWAYS

• First quarter earnings season has been excellent by almost any measure.
• The comparison to depressed first quarter 2016 earnings was very easy, so the bar will be raised over the next several quarters.
• Market participants generally expect fiscal policy to begin to provide an earnings boost around New Year’s, an expectation that has become increasingly tenuous.

PDF Version

We continue to expect earnings may provide support for stocks in the months ahead.

Excellent earnings season but bar will soon be raised. First quarter earnings season has been excellent by almost any measure. Results beat expectations by more than usual. The overall growth rate is very strong, even without the big boost from energy. The ratio of companies lowering versus raising second (current) quarter earnings forecasts is well above average and guidance has provided better-than-usual support for analysts’ estimates for the balance of 2017. In total, these are all good things.

While we do not want to rain on the well-deserved earnings parade, two potential headwinds are worth noting. One, the comparison to depressed first quarter 2016 earnings was very easy and the bar will be raised over the next several quarters. Two, market participants generally expect fiscal policy to begin to provide an earnings boost around New Year’s, an expectation that has become increasingly tenuous as healthcare reform, other competing priorities, and various distractions have pushed the timetable back.

Excellent earnings season by almost any measure

First quarter earnings season has been excellent by many measures. S&P 500 earnings are tracking to a nearly 15% year-over-year increase (Thomson Reuters), the best since the third quarter of 2011[Figure 1]. Despite easy comparisons against the trough of the earnings recession one year ago, we continue to be impressed with corporate America’s ability to maintain high levels of profitability despite pressures of slow economic growth, volatile commodities prices, and rising wages. Earnings have been an underrated driver of the stock market’s recent success—the S&P 500 is up 14% since the earnings recession effectively ended on July 1, 2016, compared with just 4% during the 12-month-long earnings recession from mid-2015 through mid-2016.

Despite the substantial hit to energy sector profits since oil peaked in late 2014, S&P 500 operating margins are just 1% off all-time highs reached in December 2014 (FactSet data). S&P 500 operating margins were two percentage points higher in 2016 than in 2006, and, based on consensus estimates, are expected to add another percentage point in 2017 and possibly another half point in 2018. Those estimates (based on analysts’ consensus) could prove optimistic, but the combination of stellar profitability and strong revenue growth (over 7% year over year in the first quarter), has enabled S&P 500 companies to produce double-digit earnings growth for the first time since the third quarter of 2014.

Also worth noting, it is typically more difficult to produce big surprises later in economic cycles. This quarter’s 4.5% upside surprise (14.7% increase compared with 10.2% prior to the start of earnings season) and the beat rate of 75% (best since 2010 [Figure 2]) is about as good as it gets, even including earlier in business cycles when analysts tend to be surprised by the initial upturn subsequent to a prior downturn. Frankly, the breadth of companies surpassing expectations caught us off guard; perhaps more so than the magnitude of the upside surprise (4.5%), which is only about one percentage point above the long-term average.

More good news: Guidance

Upside to the completed first quarter is important and has implications for the current and subsequent quarters. But our focus is always on the future more than the past; as stock prices move more on changes in future expectations than past news. On that score, this earnings season has been equally as impressive.

Since the quarter ended on March 31, 2017, estimates for the forward four quarters (Q2 ’17 through Q1 ’18) have fallen just 0.1%, compared with the typical earnings period decline of 2-3%. The back half of that forward period—Q4 ’17 and Q1 ’18—have actually seen estimates rise over the past six weeks, a rare occurrence.

It is probably not a coincidence that the two “out” quarters saw an increase in earnings given that is the likely time frame for potential policy benefits kicking in. Although potential pro-growth policies have had an impact through rising consumer and business confidence, the most impactful policy—namely tax reform—could easily slip into early 2018.

Another way to assess guidance is the pre-announcement ratio. During earnings season, the ratio of companies providing negative outlooks for the current (second) quarter compared with those that are positive is 2.0, better than the first quarter of 2017 (2.4) and the long-term (post-1995) average of 2.8.

Optimistic outlooks from corporate America, our forecast for better economic growth in the quarters ahead, and the potential for a policy boost, all point to continued solid earnings growth in the coming quarters, potentially in the high-single-digit range.

Sector standout: Industrials

Although energy has made the biggest contribution to S&P 500 earnings growth in the quarter (more than 4% of the 14.7% total earnings growth) and produced the most upside to prior estimates (over 50%, though off a low base), the sector has seen its forward estimates slashed significantly. Industrials has produced the second most upside to first quarter estimates among S&P sectors, while also seeing the biggest positive revision to 2017 estimates [Figure 3]. The 2.9% year-over-year growth rate produced by industrials in the first quarter is nowhere near the top of the sector rankings, but the upside to prior estimates and resilience of future estimates have stood out to us.

We continue to like the industrials sector for improving company fundamentals, the potential for an uptick in capital spending as global growth improves, and the possible policy boost.

The bar has been raised

The strong annual increase in first quarter 2017 earnings largely reflects an easy comparison with the year-ago quarter that was depressed by the energy downturn. First quarter 2016 represented the trough of the earnings recession, seeing a 5% year-over-year decline compared with first quarter 2015. Going forward, the comparisons get tougher. As shown in Figure 1, 2016 quarterly growth rates improved to -2.1% in the second quarter, then rose to +4% and +8% in the third and fourth quarters. Growing earnings off of those stronger quarters last year will be tougher and tougher as 2018 approaches.

Policy risk has risen

With tougher comparisons coming, a policy boost will become increasingly important. With markets generally expecting fiscal policy to begin to provide an earnings boost around New Year’s, the potential for disappointment is high. Republicans are still working on healthcare reform and have given little indication that they will be able to work together effectively on complicated legislation. There is also little indication that Democrats are willing to work with the president on tax reform, while the Russia investigation is clearly a distraction. Bottom line, the timetable for corporate tax reform has been pushed back, increasing the odds that it slips into 2018, and what was previously a negligible chance of complete failure has become material.

Conclusion

First quarter earnings season has been excellent by almost any measure, with a strong upside surprise and mostly positive guidance. Although the bar has been raised for subsequent quarters, when tougher comparisons will make double-digit earnings growth more difficult to achieve, we believe more solid earnings gains may lay ahead. The risk of policy disappointment has risen, but the odds still favor a policy boost at some point in the next 12 months, suggesting to us that earnings may provide support for stocks in the coming months and to consider buying any dips that may materialize.

*****

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.

Because of its narrow focus, specialty sector investing, such as healthcare, financials, or energy, will be subject to greater volatility than investing more broadly across many sectors and companies.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

All investing involves risk including loss of principal.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

INDEX DESCRIPTIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.