2016 was marked by significant stock market volatility within the context of rising stock prices during most of the year. The S&P 500 declined 12% during the first six weeks of the year, bottoming at 1829. From there, the index rallied to 2238, a gain of 22% from the bottom, and 10% on the year. The three most important factors impacting stocks during the year were:
- Reasonably good aggregate corporate profit growth (6% year-over-year ex-energy for the 12 months ending September 30)
- Trump’s surprise presidential win
- A sharp rise in interest rates since early July (the 10-year Treasury yield rose from 1.36% on July 8 to 2.54% on December 23)
Small cap (+25%) and midcap (+20%) stocks outperformed large cap stocks as investors embraced riskier equities during the second half of 2016. Many companies that struggled in 2015 performed much better in 2016; examples included Berkshire Hathaway (-12% in 2015, +25% in 2016) and Union Pacific (-33% in 2015, +38% in 2016). Post-election, sectors of the market perceived to be beneficiaries of Trump’s articulated policy goals of reduced federal government regulation, meaningful tax code reform and infrastructure spending rallied sharply. Stocks ended 2016 close to our year-end 2015 estimate of year-end 2016 fair value of 2250-2300.
We believe that the capital markets outlook for 2017 will resemble 2016: on balance a positive year for stocks, stocks likely to outperform bonds and plenty of capital markets volatility during the year. U.S. stock valuations ended 2016 at levels that are close to our estimate of “fair value” (at about 18 times 2016 earnings), which would suggest that stock returns in 2017 should approximate the level of year-over-year corporate profit growth, without much change in valuation levels. Our year-end 2017 fair value estimate for the S&P 500 is 2350-2425, or roughly 18 times estimated 2017 earnings per share of $130-135 (versus 2016 earnings per share for the S&P 500 of about $120). Profit improvement in 2017 could result from higher year-over-year oil prices, higher interest rates (which would benefit bank profits), improved overall economic growth (especially if Trump has early success on some of his economic policy initiatives) and a moderation in the strength of the U.S. dollar (which would help profits of U.S. companies that derive significant sales outside the U.S.).
If Trump has early success on his policy objectives of reducing the burden of federal regulation and tax code reform (including a reduction in corporate income tax rates), corporate profits would likely be higher than currently reflected in consensus expectations, giving upside to stock prices. A key risk to stocks in 2017 is the degree to which and speed with which Trump is able to make material progress toward his stated policy objectives. The 5% rise in the S&P 500 since the election indicates that investors are anticipating meaningful federal regulation and tax code reform. If Trump struggles on some or all of those fronts, stocks could give back some of their post-election gains.
We expect stock price volatility to remain elevated in 2017 and would not be surprised to see the S&P 500 trade both 20% lower and 20% higher during 2017 from its year-end 2016 level of 2238. Periodic short-term downside stock price volatility does create opportunities for long-term investors to buy great companies at attractive valuations. We continue to expect that stocks will outperform bonds (they did by a wide margin in 2016: S&P 500 total return was 11.9% versus 2.7% for the Barclays U.S. Aggregate Bond Index) as we believe interest rates are likely to rise on balance in 2017, which will make generating positive returns from bonds difficult.
Longer term, we believe that current valuations for U.S. stocks imply annual total returns of 6-9% on average over the next five to ten years, well above the returns implied at present by interest rates.