This Is Not Normal

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Dennis DeBusschere, an analyst over at Evercore ISI, put together this next chart comparing historical S&P valuations (vertical axis) against volatility (horizontal axis).

As you can see, the current setup in the market is very unusual, approaching previous extremes in terms of a richly valued but low expected volatility market.


So what’s causing the market to trade at historically high valuation levels with so little concern for risk? There are a couple of plausible explanations.

Let’s start with earnings. With 83% of companies in the S&P 500 having reported, the Q1 blended earnings growth rate is 13.5% (according to FactSet). This is substantially higher than the 9.0% growth initially expected. Some of this is due to a rebound in energy sector earnings, but stripping those out, the blended earnings growth for the quarter still comes in at 9.3%.

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That’s good news for a few months ago but means very little as of today. Investors don’t care where earnings were – they care where they’re headed. And right now analysts are actually expecting earnings to hold up for the rest of 2017.

Consider the following figures, all courtesy of FactSet:

  • For Q2 2017, analysts are projecting earnings growth of 7.2% and revenue growth of 4.9%.
  • For Q3 2017, analysts are projecting earnings growth of 7.7% and revenue growth of 4.8%.
  • For Q4 2017, analysts are projecting earnings growth of 12.5% and revenue growth of 5.2%.
  • For all of 2017, analysts are projecting earnings growth of 10.0% and revenue growth of 5.2%.

Now we all know that most analysts suck (technical term) at forecasting earnings, but the widespread adoption and expectation of these figures points to some form of underlying strength. I’m not suggesting that earnings will hold up this well,  but only that if so many people believe a strong earnings tailwind is behind us, it may lead to some complacency in the market.

But if earnings don’t continue to match or beat these expectations, this pillar of strength could crumble, leading to a decline in valuations and a rise in volatility.

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The other potential driver beneath the market has to do with Trump’s agenda. While we don’t know what to expect in terms of policy changes, most market participants acknowledge that this administration is trying to be much more business friendly than the previous one.

Take corporate tax reform as an example. We have no idea what will come of this, but if a tax reform package can be pushed through, it could result in an immediate benefit to the bottom line of many corporations. This would jolt stock prices higher and may be one of those events that investors cannot afford to miss.

Whether it’s repatriation, a loosening of regulations, revamped trade deals or a big infrastructure bill, there is a lot of “optionality value” baked into the Trump administration. This doesn’t mean that anything positive will necessarily happen, but it suggests the possibility of near-term catalysts. These types of situations tend to get investors excited – which raises their propensity for taking on risk.

Could this be a good time for a contrarian call? I’m not entirely sure, but there is one item in my opinion that screams caution: commodities.

I’ll leave you with the following chart, which shows the CRB commodities index. As you can see, commodity prices have traded in a year-long range and are on the verge of breaking beneath support.


A resumption of the downward trend here – which is already evident from the recent lower highs and lower lows, combined with declining 50 and 200-day MAs – would call into question the idea of global reflation. Instead, it would signal that deflationary forces are gathering steam, and perhaps investors are too complacent for what lies ahead.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.

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About Matthew Kerkhoff