Inside The Stock Market ...trends, cross-currents, and outlook

Remember the special amplifiers used by the fictional rock group Spinal Tap that could be dialed up to eleven? S&P’s decision last year to designate Real Estate as a full-fledged sector means that our GS rankings can now be dialed down to eleven, and unfortunately the Energy sector has been a frequent occupant of that undesirable spot.

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We’ve seen several pundits’ analyses of the “Sell In May” phenomenon of late, but none of them has addressed the most salient feature of this anomaly, which is that it’s historically been a predominantly Small Cap phenomenon.

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Quantitative investing has become an integral component of professional investment management, and smart beta funds have become popular vehicles for advisors as they assemble actively-managed client portfolios.

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Following 2016 underperformance, High Quality stocks eked out an advantage over Low Quality stocks to begin 2017 (+5.3% versus +2.1%, respectively). Yet, the “Junk Rally” trend seems difficult to reverse.

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The S&P 500 has gained about 5% on the year, respectable but hardly consistent with the “melt up” scenario we thought might occur.

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Second-half results showed the U.S. emerging from the 2015-2016 profit recession, and our early read is that the first quarter should show more of the same.

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While the Russell 2000 loss during the 2015-16 correction was almost double that of the S&P 500, the decline did not fully erase the P/E premium Small Caps have enjoyed since the middle of last decade. The premium might need to be entirely erased before a multi-year Small Cap leadership cycle can begin.

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Based on a median of six measures, today’s S&P 500 valuation profile equates to the one prevailing on August 31, 1997. From there, the S&P 500 rallied >60% over the next 2 1/2 years before peaking. However, the same can’t be said of valuation readings for the “typical” or median stock.

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Foreign equities beat the U.S. in the first quarter, but the performance gap that’s opened up since the 2007 market highs remains astounding. While foreign equity valuations (especially within EM) have rebounded from February 2016 lows, the bounce has done little to close the enormous P/E discounts relative to the U.S. market.

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Last month we highlighted the extraordinary performance gap that had opened up between crude oil and the relative performance of Energy stocks.

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The tone of global economic reports in the last four months has turned decisively up, sending Citi’s Global Economic Surprise Index to the highest level since mid-2010

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With U.S. real GDP growing about 2% year-over-year and the rest of the Developed world growing even slower, it’s hard to imagine that economic momentum may be peaking.

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The distinction between reported GAAP earnings and adjusted operating earnings has long been a source of debate among fundamental investors, and the choice of “E” will materially impact each investor’s view of the market’s P/E ratio.

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The S&P 500 was up 6.4% YTD through March 3rd, a bit above its average annualized gain of 5.9% since 1926. In other words, 2017 would be a good year if the books were closed today.

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The hoopla falls short of that which surrounded birthdays #3-#7; based on the flood of assets into passive stock funds, it appears complacency has set in. Current bull close to becoming longest in history.

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Our disciplines remain bullish, but we periodically wonder whether we’re being too cavalier in keeping our tactical portfolios “almost” fully-invested (at 65% equities) in the face of valuations that are higher than those seen in all but perhaps 24 months of stock market history.

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A look at the potential upside for the median S&P 500 stock, based on the theory that each of four valuation ratios reaches its individual all-time high set during the last phase of the 1990s’ market mania.

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One of our disappointments with the Group Selection (GS) Scores in 2016 was their failure to latch on to the rebound in Energy groups.

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Over the last 70 years, stocks have made no cumulative progress when Producer Price Inflation runs above 4%. Returns have been average when PPI inflation runs between 2% and 4%—where it is today.

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We should emphasize that any inflation pickup is likely to be a traditional, late-cycle phenomenon stemming from rising wage growth and rebounding commodity prices. We do not expect a secular move toward significantly higher inflation rates (say, north of 3.0%-3.5%).

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