At the beginning of every new year, many people start to think about their finances. It’s a good time to get some positive momentum going. I think a lot of people are wondering, is the stock market going up in 2017?
Surveying social networks and newspapers, most of the conversation seems to be about our new president. Are the changes he’s proposing going to affect the economy positively? Is his view on trade going to be good for American companies? Much focus is concentrated on the economic and trade positions of the president.
Four Basic Factors
I think it’s important to start with the basics. The market is affected by four external factors — the economy, inflation, interest rates and commodity prices. So, let’s first evaluate the current status of each of these factors. Right now, the economy is expected to grow about 2.0% in 2017. That’s a higher increase than we saw in 2016. The rising aspect of this trend is what’s interesting.
Forecasted inflation currently is targeted at about 2%, which is also higher than 2016. Inflation is expected to rise and it will be up to the Federal Reserve whether the economy or inflation grows faster. How do they do that? By changing the price to borrow money. But, the stable rising of this metric, from a relatively low number, is what’s compelling.
Interest rates are historically low with the 10-Year Treasury at roughly 2.4%. However, interest rates are rising. In 2016, we saw only 1 rate hike from the Fed, which sets the Fed funds rate at 0.50%. Interest rates are expected to rise and the Fed is expected to raise rates 2–3 times in 2017. The decisions they make will affect how much momentum gets generated throughout the financial system. It’s the historically low rate, in relation to history, that makes this factor compelling for the stock market in 2017.
Finally, commodity prices are currently fairly low with oil prices being about $50 per barrel. Historically, commodities tend to rise in an economic environment that exhibits rising inflation. Inflation is equated to higher prices. There are times when the price of oil are really high, like $150 per barrel or when the rate of change is really high, like when prices spike from $60 to $90 per barrel in a month. But, as of now, commodity prices are fairly priced in the middle range and rising slightly, not too fast.
Current State of Affairs
Therefore, generally speaking, all of these factors are relatively low but rising slightly and steadily. That means, if the market is not “expensive,” then we would anticipate the market to be higher based on the evaluation on these four factors. Is the market currently “expensive?” Let’s see.
When we say “the market” we usually mean a tracking index of stocks like the Dow Jones Industrial Average or the S&P 500. The Dow is an index of 30 stocks, picked each year, to represent the overall market. The S&P 500 is an index of the 500 biggest companies by market capitalization. What is market capitalization? It’s the total value of all outstanding stock of a company (total shares multiplied by share price).
So, is the market currently expensive? To answer that question, it comes down to how much investors are willing to pay for a certain type of “value.” In the most basic sense, a stock’s value can be measured by its earnings. How much in earnings does a company produce in a given year? Hence , what price are we willing to pay for those earnings? Often, you will hear of a P/E (price to earnings ratio).
Generally speaking, if a P/E ratio of a stock is 10, the stock is considered cheap. If the P/E ratio is 15, the stock is seen as fairly priced. If the P/E ratio is over 25, investors view the stock as expensive. This is a very general statement, and we are just looking to be able to answer the question of whether the overall market is bargain or not at this point in time. Right now, the S&P 500 has a P/E ratio of about 21 (trailing twelve months). So, it is getting closer to “expensive”, but there’s still room before we can characterize it as such.
As with most things in life, there are several other factors to consider on whether the market is a bargain or not. Some factors relate to comparing the asset classes to one another. For example, a 10-Yr Treasury is currently only going to provide 2.5% yield. In historical terms, that is low. In 1981, the yield was 12.5%! So, when comparing stocks to government bonds, people tend to take more risk and pay more for earnings when their alternatives are so low.
Other Methods for Evaluation
Alternatively, we can look at estimates for how much we think the market may increase in earnings and work backwards into an estimation. One of the big investment houses, Goldman Sachs, is estimating earnings per share (EPS) of roughly $120 for 2017. If we multiply $120 (EPS) by 21 (P/E) then we get a value of 2520 for the S&P 500. Right now, it is trading at 2296, so Goldman Sachs is estimating an 8.8% rise in the index, assuming the P/E investors are willing to pay, stays the same at 21.
Other factors on whether the market goes up depends on how fast interest rates rise here in the US and whether or not we see any systemic threats from Japan, Europe or the emerging markets. Europe is still implemeting quantitative easing, so they are actively weakening their currency in order to stimulate their economy. That may have an effect on the US stock market. Japan is still set on negative interest rates on their government bonds, so that’s built an incentive for people to borrow in Japan and invest elsewhere (called the “carry trade”). If Japan changes their tune, a lot of investors and speculators will have to adjust their game plan. There may be a few volatile bumps along the way in 2017, but in general the market set up to do well over the year.
Therefore, based on these factors, do you think the market will go up in 2017? I would say based on this assessment, the market is in a mid-cycle bull market, with some room on the upside. Once the market multiple (P/E) gets to 25 (meaning a P/E ratio of 25 for the S&P 500 index), then that would signal the market is getting expensive.
Hopefully this has helped you evaluate for yourself, whether the market is a bargain or not and whether it will do well in 2017. You’ve know some of the components to look for from a broad prospective. It is always good to check and question assumptions, so evaluate my numbers and thresholds to see if you come up with different assumptions and conclusions. Hopefully, this gives you a framework to continue your evaluation.