Over dinner the other night, a good friend asked me about my outlook on the stock market.
Having been a corporate bond trader for most of my Wall Street career, I have learned that my crystal ball works better reviewing past price movements than predicting future ones. That said, I stated some obvious caveats — trade wars, inflation, Fed policy, the prospect of rising interest rates and the latest revelations on Stormy Daniels — could cause some ugly downdrafts. But I concluded on a positive note, saying that the outlook for rising corporate earnings has kept me invested heavily in the stock market.
I certainly cannot expect to replicate my 2017 stock market profits. Last year’s robust 20 percent gain in the S&P 500 was largely influenced by expectations that a sharp corporate tax reduction would boost earnings.
According to Thomson Reuters, pretax earnings in the first quarter of 2018 grew 12.1 percent and after-tax earnings grew close to 25 percent over 2017 — the biggest jump in seven years. The tax cut slashed the corporate tax rate from 35 percent to 21 percent, mostly benefiting companies with a large amount of cash overseas and those with historically high tax rates.
Stock market analysts remind us that the market anticipates future events. Thus, they frequently comment that the decline of the major U.S. stock indices from their January record highs could have been anticipated because the market had discounted those upbeat earnings. Since market movements based on subjective factors are hard to quantify and time, I am willing to hold my positions as long as the corporate profit outlook remains upbeat.
So far in 2018, the market has been flat despite positive earnings. Almost 75 percent of companies have reported earnings above analysts’ expectations. Energy, technology and financial firms have enjoyed 30 percent earning gains. Companies in materials and industrial sectors showed 25 percent increases. Consumer staples have compiled a 13 percent growth.
During the debate over the Trump tax cut, critics expressed concerns that companies would spend their added cash hoard primarily to increase dividends and stock buybacks. The record to date is mixed. Corporate buybacks in the first quarter rose by more than 50 percent over the fourth quarter of 2017 according to the S&P Dow Jones Indices. Tax cut supporters can point out that, according to Thompson Reuters, capital expenditures are up 25.9 percent, led by the tech industry, which registered close to 60 percent growth.
The U.S. economic outlook remains fundamentally healthy. The Gross Domestic Product should grow by 2 to 3 percent over the next few years. Unemployment has fallen to a 17-year low, 3.9 percent. In part because wage growth remains stagnant, the core inflation rate remains close to the Federal Reserve’s 2 percent goal. Because economic growth is steady and not overheating, the Fed’s Open Market Committee is expected to raise interest rates slowly.
In answer to people’s assertions that stocks are merely a piece of paper, I have countered strenuously that they represent ownership in a business. Stock ownership allows individuals to benefit from a company’s fortunes. The increase in corporate profits raises the prospects of higher dividends and stock valuations.
I understand fully that the possibilities of trade wars and the on-going investigations about Russian interference in our 2016 presidential election could hurt the market. Regardless of these possible headwinds, however, I remain confident that the stock market will go higher because I subscribe to the thesis of Benjamin Graham (1894-1976), who is considered the father of value investing.
Graham believed that, in the short run, the market is little more than a popularity contest. But in the long run, it assesses the substance of a company. In other words, what matters, in the long run, is a company’s actual, underlying business performance.
Originally published in the Sarasota Herald-Tribune
