ECONOMIC AND STOCK MARKET COMMENTARY

A year ago, we were looking back on the 2015 equity market, which like its predecessor had been relatively unimposing—at least in terms of the Dow Jones Industrial Average and the smaller indexes. What’s more, entering the final weeks of 2016, it looked as if we might be closing out another year of lackluster results. Then, the election intervened, and thoughts of a listless 2016 faded.

To recap, following a stellar 2013 for Wall Street and a rather ordinary 2014 and 2015, the now-ending year has seen plenty of back-and-forth action, with a notable setback early in the 12-month cycle, a selective and uneven recovery during the middle quarters, and then a strikingly fast close, buoyed by unrelenting gains in the wake of the surprise election of Donald J. Trump. Stocks have taken well to his pending accession to the Presidency on the expectation that it will mean substantial infrastructure spending, a more business-friendly tax code, and a wave of deregulation. Time, of course, will tell just how much of this ambitious agenda will be enacted by a Congress that often has emphasized cost-containment in recent years.

As for the Dow Jones Industrial Average in the concluding 12 months, there was a core of standouts, led by financial services giants Goldman Sachs and JPMorgan Chase. Also in the spotlight in 2016 was a quartet of old-line industrial behemoths—Boeing, Chevron, Caterpillar, and DuPont. On the other hand, after leading the way higher in 2014 and 2015, the iconic footwear giant NIKE brought up the rear in 2016; Coca-Cola shares also struggled. That said, unlike 2015, most of the 30 composite members saw their fortunes rise in 2016.

As was so a year ago, there were divergences among the averages. This also was apparent within the Dow group, itself. Here, for example, there were a handful of outsized gainers. However, many more made just modest strides. So, too, it was with the major averages. On point, the Dow soared to near 20,000 en route to an annual rise at press time of 14.3%. Lesser gains were tabulated by the broader S&P 500 Index, and still smaller increases were secured by the NASDAQ and the companion NASDAQ 100. Meantime, leadingthe way higher was the Russell 2000, the leading small-cap benchmark, which was in the black by more than 20%, after having trailed most of the key averages in 2015.

As has been the case for years now, there was a rationale for this divergence. Among the Dow leaders in 2016 was a core group of the basic materials stocks and a sprinkling of industrials, as rebounding oil prices and the promise of better days for infrastructure gave a boost to old-line names and the industrial heavy 30 Dow stocks. At the same time, some consumer equities, which had done comparatively well in 2015, faded in 2016, especially late in the year, as drug pricing issues and profit taking exerted selective pressure. In many cases, the winners in 2014 and 2015 were the losers in 2016. It was a similar story for many stocks that had struggled earlier in the decade, as some came to life in the latest year, in particular those tied to the commodity cycle and the international economy, as oil prices doubled from early in the year, while many of the economies around the world stopped eroding.

Meanwhile, at the end of 2015, we had forecast that the average price for the Dow Jones Industrial Average in 2016 would be 17,335. That prediction proved conservative, with the 30-stock composite actually averaging a little over 17,860. Lower interest rates than we had forecast and the strong post-election rally, which lifted the Dow to a series of record closing highs, proved a tough combination to beat. Meanwhile, the forecast figure reflected our earnings projection for the Dow, our dividend estimates for that composite, and a sense, once again, that interest rates would remain historically low. In all, the average price for the Dow as the curtain falls on 2016 is 17,863. That is nearly 3% above our estimate of 17,335. Our price target fell short of the mark, even as earnings came in below expectations (due to another annual shortfall in the energy sector). On the other hand, interest rates stayed near historical lows, as the Federal Reserve refrained from lifting its target federal funds rate again until two weeks ago. Now, we would look for the Fed to be more aggressive in 2017. Meantime, dividend growth for the Dow again topped our forecast. Looking ahead to 2017, we see a strong increase (up 11.5%) in Dow-30 earnings, as the projected benefits from a further strengthening in the economy and a big comeback in the energy category should carry the day. Note, however, that our forecast does incorporate at least three rate hikes from the heretofore reticent Federal Reserve. Still, with rates so low and the economy seemingly on the mend, this more aggressive rate tone should not prove disruptive. Meanwhile …

Our 2017 net earnings estimates reflect the probability that the nation’s economy will hold its own, and then some, on the strength of resiliency in housing, retail spending, job growth, and a rise in business investment. The suggested upturn in spending on infrastructure, however, might not be fully felt until late in 2017, or even 2018. Based on these rather benign assumptions, our forecast calls for Dow earnings of just over $1,190 and dividends of $510 in 2017. Putting into place those metrics and allowing for the first appreciable rise in interest rates since before the recession, the average (but not necessarily the high) price for the Dow in 2017 would be 18,550. The accompanying table shows a likely earnings increase of 11.5%, which would be a strong gain given the mature phase of the long business recovery and the overall likelihood of a notable rise in interest rates in the upcoming year. In all, this 30-stock index should enjoy a solid pickup in 2017 net.

Note also that after likely gaining 4.4% in 2016—even with softness in the oil patch and a rare decline in profits at tech icon Apple—earnings at 28 of the 30 Dow components are expected to rise in 2017. As noted, our average projection for the Dow in 2017 is 18,550. That is 3.8% above the average 2016 price for the Dow of 17,863, but still more than a thousand points below the recently extended price of nearly 20,000. This would suggest that the recent price discounts the forecasted increase in earnings and dividends that we see in 2017. The Dow target for 2017 also incorporates a year of moderately higher interest rates.

In 2017, as noted, we expect the Dow’s earnings to increase by 11.5%, dividends to climb 6.2%, and interest rates, reflecting a more aggressive Federal Reserve, to be moderately higher by the end of 2017. That likely rise in rates, coupled with the rather extended level of the market recently, will most assuredly make it hard to sustain, let alone widen, P/E multiples in the new year. Meantime, such a mix of variables is the basis for an average Dow price in 2017 that is well off recent levels, with the latter at a record as we went to press. In all, given the projected average price of 18,550 next year, the Dow would be selling for 15.6 times our earnings forecast of $1,191. Note that a year ago, we had been estimating a 2016 P/E multiple of 14.9. Meanwhile, the 2017 estimated P/E implies that the market is now richly capitalized even with the relatively upbeat economic fundamentals now in place.

Note: The band about the 18,550 Dow Industrials target allows for a wide variance in price during 2017. Specifically, our Dow model’s target of 18,550 represents the midpoint of a wide projected range in which the average price of that composite is statistically likely to wind up in 2017. The range for 2017 is 23,185 on the high end and 14,840 on the low end. The forecast for the 2019-2021 band for the Dow is 21,100 to 26,400. Note that on the chart on the prior page, the vertical lines represent the annual highs and lows for the Dow.

Conclusion: Adding all of this up, and balancing out the likelihood of a succession of interest rate increases, a noted divergence in fiscal direction, a modestly more vigorous domestic business backdrop, the potential for somewhat higher inflation, and the rather extended valuations currently in place, our sense is that any future market gains will come with effort. This makes the market vulnerable to a degree—especially if the generally favorable fundamentals now in place are not sustained. As such, while we may see further gains in the year ahead, we still counsel caution…

Source: Valueline.com