KIM: First quarter of this year a mirror image of 2016

April 22, 2017

KimWhat a difference a year makes! Stocks tumbled out of the starting gate in 2016, with the S&P 500 experiencing a harrowing plunge of 11 percent between New Year’s Day and Feb. 11, when the Dow Jones industrial average closed at 15,660, a two-year low.

Investors had many reasons to have their confidence shaken in the first quarter of 2016, as headlines blared that U.S. stocks had their worst start to the year in history. The possibility of an economic hard landing in China and further devaluation of the yuan, oil free-falling 50 percent, and weak manufacturing data led to fears of a global recession.

As usual, this brought out market pundits trying to become famous for calling the next crash out of the woodwork. RBS, a major global bank, advised its clients to “sell everything,” predicting a “fairly cataclysmic year ahead.” Wow!

Fast forward to the first quarter of 2017, which saw the DJIA close above 20,000 on Jan. 25 and break the 21,000 barrier on March 1. Oil and other commodity prices rebounded strongly off their lows. Not only was there no global recession; the world is now in the midst of a synchronized growth spurt. Consumer and CEO confidence (“soft,” attitudinal measures) have surged, and “hard” economic data has started to confirm.

Unfortunately, the first-quarter celebration was mostly limited to larger-capitalization and “growth” stocks. Bespoke Investment Group examined returns for the Russell 3000 Index by market-cap decile, which showed performance was driven exclusively by the 600 largest stocks (i.e. top two deciles), as the 1,200 smallest stocks (i.e. bottom four deciles) were negative.

We think smaller-cap stocks are poised to do better, as they tend to 1) have less international exposure (a risk under threats to globalization) and 2) pay higher effective tax rates (they have fewer ways to shield income and should benefit if taxes are lowered).

Our positive investment thesis and outlook for 2017 remain firmly in place. We believe stock prices follow corporate earnings. The U.S. economy and corporate profits showed signs of accelerating ahead of the election, so we believe the post-election rally has been well-supported by improving fundamentals.

Some pundits have referred to the rally as a “Trump bump,” which presumably puts the stock market at risk of a significant correction if the new administration is unable to quickly deliver on campaign promises related to lower corporate tax rates, repatriation of cash trapped overseas, increased infrastructure spending and a less burdensome regulatory environment. While these initiatives would enhance profits, the U.S. and global economy have already been strengthening and the outlook for profits is improving.

Even with stocks at record highs, valuation is reasonable. When inflation is high, earnings are worth less than when inflation is low. The “forward” price-to-earnings ratio (i.e. price/next four quarters of earnings) for the S&P 500 is 17.6, just average for 1958-2016 under current inflation of 2 percent to 3 percent. In other words, stocks would have to advance and/or earnings decline fairly dramatically to get to a worrisome condition.

We recognize there are always risks, here and abroad, known and unknown. Global financial markets are subject to violent downdrafts for any or no reason. Still, we believe the preponderance of the evidence points to higher stock prices and decent returns for the year.•


The column is an excerpt of Kirr Marbach & Co.’s client letter, available at www.kirrmar.com. Kim is the firm’s chief operating officer and chief compliance officer. He can be reached at (812) 376-9444 or mickey@kirrmar.com.


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