Year-end letters are always difficult to write because there is a tendency to discuss the year gone by, or worse, to predict what is in store for the New Year. Quite frankly, how many pundits predicted Brexit or a Donald Trump victory? Certainly it wasn't Andrew Adams and I. Yet, we think by far the biggest message as we prepare to enter 2017 is that the equity markets are transitioning from an interest rate-driven bull market to an earnings-driven bull market. This is being reflected in the analysts' earnings revisions, which have taken a decided turn upward.
Currently, S&P's bottom-up, operating earnings estimate for 2017 is around $131 for the S&P 500. That leaves the S&P 500 trading around a price/earnings (P/E) ratio of about 17x. However, Thomson Reuters notes that for every 1% decline in the corporate tax rate, it "hypothetically" generates an additional $1.31 in earnings for the S&P 500. If President-elect Trump can get his envisioned 15% corporate tax rate, that would imply about another $26 in earnings for the S&P 500 (20 x $1.31 = $26.20). Accordingly, if you hold the P/E constant at 17x, and add another $26 to the $131 estimate, it yields an earnings estimate of $157, leaving a forward price target for the S&P 500 of about 2670 ($157 x 17 = 2669).
Yet, getting corporate tax rates down to 15% could prove to be difficult. Still, a 25% tax rate would produce an earnings estimate for 2017 of about $144. Again, holding the P/E ratio constant at 17x gives us a price target for the S&P 500 of roughly 2450 in the new year. In either event, we believe stocks are going to trade substantially higher over the next few years.
Will there be pullbacks? You bet there will be, but in our view pullbacks are for buying. Going into the presidential election, our models suggested the equity markets were set up for a decent rally no matter who won the election. Bingo, because the S&P 500 futures have rallied some 200 points from the November 8 overnight lows. From those lows, our models forecasted that the S&P 500 would grind higher into late-January/early-February; and, they remain in that rally mode.
Another theme we think is surfacing is inflation driven by Trump's potential fiscal stimulus program. Hence, a return to "real assets," or stuff stocks, should have an increased weighting in portfolios. Verily, the price of real assets, relative to financial assets, is at historic lows. Consequently, investors' mindsets should be focused towards higher inflation, higher interest rates, and reduced disinflation. As an example, China's PPI hooked up in September for the first time since 2012. We believe the same thing is happening here in the U.S.
Accordingly, REITs, timber, agriculture, collectibles (wine, art, diamonds, precious metal coins, farmland, etc.), and MLPs should have an increased weighting in portfolios, in our view. To this MLP point, we recently met with one of the savviest MLP-centric portfolio managers on Wall Street, who believes the midstream and downstream MLPs are ripe for a number of good years going forward. He suggests the bad news is in the rearview mirror: the capital markets are wide open for the MLPs; we are consuming an extra 1 million barrels of crude oil per day, and the MLPs traded at around a 30% discount relative to par.
Speaking to valuation, of the major asset classes, emerging markets remain the cheapest and we recommend tilting portfolios accordingly. And we favor active management over passive management at this stage of the market cycle. Manifestly, when stocks are undervalued, and the indexes are rallying, you want to own cheap beta. But, when stocks are neutrally valued, you want to be an active manager who can say, "I don't want to play the FANG stocks and low volatility names."