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First Quarter 2017 Recap: Tech Reboot Leads Strong Stock Market

After a lull in the fourth quarter of 2016, the information technology sector of the S&P 500® is leading the way this year with a gain of more than 12% through the first quarter.

robotic armsThe surge in tech has been fueled, in part, by strong earnings from Apple and optimism that potential cuts to corporate taxes would give U.S. companies extra spending money to upgrade their technology.

At the other end of the spectrum, sputtering oil prices drove the energy sector down all three months of the first quarter, even as the overall market (S&P 500) climbed 5.53%. For the first quarter of 2017, oil prices (West Texas Intermediate) were down 5.81%, and the energy stock sector dropped 6.68%.

Here are some other highlights from the month (Exhibit 1), covered in more detail later in this report:

  • Employment growth stays strong. Employment surged in January and February, rebounding from subpar job growth in the final months of 2016, according to the U.S. Department of Labor.
  • Retail sales keep climbing. Retail sales growth was up more than 5% year-over-year, according to the March 15 retail sales report from the U.S. Department of Commerce. 
  • March Fed rate hike fails to boost market interest rates. Although the Federal Reserve Board approved a 0.25% rate hike in March, its action did little to boost market interest rates on longer maturity instruments, which have declined slightly in 2017.
exhibit 1

Drilling down

US stocks post strong quarter but flat month

exhibit 2The S&P 500 closed on March 31 at 2,362.72, which was flat for the month – down less than a point from the February close of 2,363.64 – but strong for the quarter (Exhibit 2). For the first three months of 2017, the market was up 5.53% from the 2,238.83 close at the end of 2016.

The total return of the S&P 500 for the first quarter was 6.07%, although it was only up 0.12% for March.

The NASDAQ also had a strong first quarter, with a 9.82% gain; up 1.48% in March.

Employment growth remains strong

The employment picture remained strong in the first quarter of 2017, with job growth exceeding 200,000 for both January and February, according to the U.S. Department of Labor, Bureau of Labor Statistics Employment Situation report issued March 10.

After several subpar months of job growth at the end of 2016, U.S. employers added 227,000 nonfarm payroll jobs in January and 235,000 in February. That marks 77 consecutive months of job growth.

The unemployment rate, which has been hovering just under 5.0% for the past 12 months, was at 4.7% in February. However, the labor force participation rate for those in their prime working years (age 25 to 54) remained at a low level of 81.7%.

Although that marked a slight improvement over recent months, it is still about 1.3% below the prerecession level. (See "Job Growth Remains Strong in February".)

Steady retail sales growth

Retail sales growth remained strong in the first quarter of 2017. Retail and food services sales for February 2017, adjusted for seasonal variation, were up 5.7% from a year earlier, according to the March 15 retail sales report from the U.S. Department of Commerce.

Total sales for the December 2016 through February 2017 period were up 5.4% from the same period a year earlier.

Gasoline station sales were up 19.6% from a year earlier, due partially to higher gasoline prices. Online and related sales ("non-store retailers") have also grown rapidly, up 13.0% from a year earlier.

Corporate earnings projections rising

The estimated S&P 500 earnings growth rate for the first quarter of 2017 is 9.1%, which would represent the highest (year-over-year) earnings growth for the S&P 500 since the fourth quarter of 2011, according to FactSet.

The biggest contributors to the growth are the energy, materials, financial and technology sectors. Industrials, telecoms and consumer sectors were negative contributors. 

While the first quarter earnings growth was the strongest in over five years, it was meaningfully below the 12.3% expected at the beginning of 2017. 

As a result, full-year 2017 earnings growth expectations have also fallen from 11.4% to 9.8%. The full-year S&P 500 earnings growth is expected to be led by the energy, materials and financials sectors, with the weakest growth expected in telecom, utilities and industrials.

While it is normal for earnings estimates to decline from levels expected at the beginning of the year, there is increased caution about the benefits of anticipated regulatory and tax reforms in 2017.

Sector returns: Tech stocks booming

exhibit 3Tech has been on a tear this year. After moving up 2.55% in March, the information technology sector of the S&P 500 was up a total of 12.57% through the first quarter of 2017.

That leads all sectors, followed by consumer discretionary, up 8.45% for the quarter, and health care, up 8.37%. Trailing the pack was energy, down 6.68% for the quarter and telecom services, down 3.97%.

Exhibit 3 details the March performance and the 2017 year-to-date performance of each of the 11 S&P 500 sectors, as well as the total return of the S&P 500.

Bonds: Yields barely move after Fed hikes rate

Despite two rate hikes of 0.25% by the Federal Reserve over a three-month period, market interest rates for 10-year U.S. Treasuries have actually declined so far this year (Exhibit 4).

exhibit 4A post-election surge had pushed market rates up from about 1.80% in the weeks prior to the election to 2.47% on Dec. 13, the day before the Fed made its first and only rate hike of 2016.

While money market and other shorter-term rates have edged up slightly since then, market rates on longer-term instruments have been treading water this year. The rate on 10-year Treasuries dipped to 2.39% at the close of trading on March 31, down from 2.44% at the end of 2016.

That rate is about the same as it was on March 15 when the Fed approved its second hike of 0.25% to a new range of 0.75% to 1.00%. 

In announcing the latest rate hike, Federal Reserve Board Chair Janet Yellen said that if economic factors such as employment and business investment continue to strengthen, she expects the Fed to continue to gradually increase rates over the next two to three years. (See "Fed Approves First Rate Hike of 2017".)

Equity earnings projections edge up

exhibit 5The consensus 12-month forward earnings for the S&P 500 has moved up slightly this year, from $132.83 per aggregate share at the close of 2016 to $134.95 at the close of the first quarter of 2017 (Exhibit 5).

The market remains optimistic that forward estimates have potential upside as the global markets improve and progress emerges on tax and regulatory reforms. This has helped buoy the stock market at fairly full levels relative to historic levels.

exhibit
      6As Exhibit 6 illustrates, the forward 12-month price/earnings ratio (P/E) for the S&P 500 ended the first quarter at 17.6 – an increase of 3.8% from the 16.9 level at the close of 2016, and up about 9.0% from its 16.1 P/E at the start of 2016.

The forward 12 months earnings yield for the S&P 500, which is the inverse of the P/E, ended the quarter at 5.71%, which was down from 5.93% at the close of 2016 and the 6.31% yield 15 months ago at the beginning of 2016 (Exhibit 7).

exhibit
      7These two factors – a rising P/E (and a declining earnings yield) – indicate that stocks are becoming increasingly expensive relative to the earnings produced by the companies in the S&P 500. This is a trend that has been consistent since 2011.

While the 17.6 P/E is well below the mid-20s level of the tech bubble in 2000, it is the highest we’ve seen in seven years and about 3% above the historic average.

exhibit 8If corporate earnings growth continues to strengthen, that should offset the higher P/E, but if earnings flatten or decline, that could spell trouble for the market.

The 12-month forward earnings yield can be helpful in comparing stock earnings yields with current bond yields.  

At 5.71%, the equity earnings yield is still significantly higher than the 2.39% market rate of U.S. Treasuries, but that gap has closed by more than 1.00% since bond yields hit their low mark in July.  

Dollar trends down

exhibit 9After experiencing a solid bump in value versus the world's leading currencies immediately after the election, the value of the dollar has declined slightly in 2017. The dollar is down 1.40% versus the euro through the first quarter of 2017 (Exhibit 8).

The dollar has fallen even more against the yen. Through the first quarter of 2017, the dollar was down 4.46% versus the yen (Exhibit 9).

Oil & gold in stall mode

exhibit 10After a late rally last year that pushed oil prices up 45% for 2016, the market has stalled this year due to a continuing – though dwindling – oversupply.

In 2017, despite a recent decision by OPEC to cut production, the combination of increased U.S. production and a seasonal spike in U.S. stockpiles helped drive down oil prices into the high $40s through most of March (Exhibit 10).

exhibit 11By the close of the month, however, the price had edged back up to $50.60 per barrel (West Texas Intermediate), but the price was still down 5.81% through the first quarter.

Gold prices – after strong gains the first two months of the year – declined slightly in March by $2.70 per ounce. But for the quarter, gold prices climbed 8.6% from $1,151.70 per ounce at the close of 2016 to $1,251.20 March 31 (Exhibit 11).

International market moves up

exhibit 12The international market has tracked closely with the U.S. market. The MSCI EAFE Index closed the month at 1,792.98, up 6.47% from its 2016 close of 1,684.00 (Exhibit 12).

CIO outlook – Russ Swansen

Headwinds

Stagnant oil prices in recent months have continued to drag down energy stock prices, even as most of the other sectors posted strong first quarter growth. While OPEC has managed to cut production in recent months, production increases in the U.S. have offset some of the OPEC cuts.

The dollar has recently remained fairly stable relative to the other major currencies, but still remains a concern at its relatively high level. Some estimates suggest the dollar is about 20% overvalued versus the euro – and that gap widened still further in the first quarter. 

A strong dollar makes imports cheaper, but makes American goods and services less competitive abroad, and makes foreign earnings less valuable when translated into dollars.

Although corporate profit growth estimates continue to rise, we continue to be concerned about the pace of earnings growth, as well as weak manufacturing output levels. We would also like to see more allocation of assets to fixed investments in areas such as structures, equipment and intellectual property. 

Wage growth has been slow, with the median income below the 2009 level. Productivity growth has slowed markedly. The relatively low workforce participation rate among workers age 25 to 54 also continues to be a concern. (See "Where's My Raise? As Employment Climbs, Wage Growth Left Behind".)

The financials sector had shown some signs of life as market interest rates climbed, but the increase in rates has stalled recently and so have financial stocks – the sector was down 2.77% in March.

Tailwinds

Gross domestic product (GDP) growth has increased and the economy appears to be strengthening.

Consumer spending has been one of the lynchpins of the economic recovery, with retail sales (adjusted for seasonal variation and holiday and trading-day differences) up 5.7%, year-over-year, through February. The housing market has also remained solid with improved activity and rising prices in many parts of the country.

Employment continues to be strong, with solid growth through the first two months of 2017. Although the participation rate is relatively low, trends show more people steadily entering the workforce.

Proposed government infrastructure spending could lower the unemployment rate still further, boost the workforce participation rate and push up wages, but the gains could come at the cost of steeper growth of inflation. 

Expectations

We estimate real GDP growth of about 2.7% for 2017, which is slightly higher than the consensus view (2.3% for 2017 and 2.4% for 2018, according to the Blue Chip Economic Indicators).  

Our projections are based on the optimism that we have seen in other sentiment indicators and arguably market values.

Inflation growth, which has been in check in recent years, is expected to increase, but at a modest level. The consensus view for inflation is 2.4% for 2017 and 2.3% for 2018.

That is a bit higher than we might have expected, although rising wages along with increased consumer spending and additional government infrastructure spending would all likely contribute to rising inflation.

We expect the Fed to follow the March rate hike of 0.25% with additional rate hikes throughout 2017 and 2018, if the economy continues to strengthen. (See "Fed Approves First Rate Hike of 2017".)

The rate hikes could serve to strengthen the dollar still further, which may be detrimental to U.S. companies that do business abroad. For net savers, however, we believe a series of small rate hikes would be beneficial without adversely affecting the economy or consumer spending. In fact, as noted earlier, money market rates have increased slightly this year, giving investors a very small return on their savings.

Globally, over the next 12 months, we estimate that China will have GDP growth of about 7.0%, Japan will have growth of 1.5%, Europe will have growth of about 2.0%, and the UK will grow about 3.0%.

While the economy seems to be strengthening, current economic growth remains relatively slow. We are not projecting a recession in the near term, but we believe the risk of recession in the next 12 months remains elevated, though slightly less elevated than a few months ago. 

To continue the recovery, we believe that the job market needs to continue its steady growth, retail sales need to remain solid and corporate spending and manufacturing production need to improve.

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