The post-election confidence boom that drove fresh market highs appears to be waning. Confidence-driven trades swing both ways, and should optimism fully revert, we could see increased short-term volatility. At these market levels, we believe it is critical that investors avoid chasing returns in areas of the market that have recently done well, and instead, properly manage expectations in this buoyant environment.
Undoubtedly, the divergence between what individual’s say they will do versus what they ultimately end up doing is at least partially a measurement issue. The various soft data (confidence, intentions, expectations, etc.) are measured by survey. Respondents are subject to many of the same, well-publicized flaws facing all pollsters.
Conversely, the hard data measures are quantifiable (e.g., job hires, retail sales, housing permits, etc.). These data are concrete, hard to fudge, and where the rubber meets the road. Eventually, the two lines must meet. Either confidence will fall back to rational levels or real economic activity will accelerate.
The pullback in confidence and sluggish pace of early reforms from the new administration appear related. Given that fresh political enthusiasm drove the initial surge in sentiment, it is likely that recent political disappointments -- particularly regarding the American Health Care Act (AHCA) -- are dragging enthusiasm back to reality. Last week’s appointment of a special counsel to investigate possible ties between Trump administration officials and Russia is surely not easing investor worries either.
Although the House has since passed a health care bill, the sudden and very public collapse of the bill’s initial iteration highlighted the Congressional challenges facing major reform. Growing philosophical differences between traditional and populist Republicans, along with universal Democratic opposition, is calling into question the amount of political capital Republicans have for passing their other key pro-growth agenda items, such as tax reform.
The initial AHCA failure and peak confidence measures align closely. Starting in April, the main soft data metrics began losing momentum as investors recalibrated their political expectations. Meanwhile, the hard data measure remains subdued. Whether the boost in confidence will ever impact the real economy is less clear.
In an attempt to answer the question, we compared investment intentions to actual capital expenditures (capex) from 1980 through 2016. For soft data, we used the Philly Fed Business Capex Outlook Survey to measure the percent of respondents planning on increasing capex minus the percent planning on decreasing capex. For hard data, we used private fixed non-residential investment contribution to percent change in real GDP. We correlated the series with four quarterly lags in the survey to determine if capex intentions accurately predicted future capex spending.
We found only a mild relationship between investment intention and actual capital spending, and the correlation becomes increasingly poor over time.
To get a sense as to how expectations are normalizing in the marketplace, we took a look at earnings estimates for a wide basket of U.S. small cap stocks, as these domestically-focused companies are likely to benefit most from US-centric policy. Using the Russell 2000 Index and going back to 2015, we tracked the percentage of both upward and downward earnings revisions for the next quarter. Recent data showed that although the usual percentage of companies saw their earnings expectations for 2017 revised downward, there was not an offsetting rise in upward revisions, which there typically is. Said differently, many analysts have found their initial estimates for 2017 to be overly optimistic, and have since adjusted their expectations downward.
At the end of the day, real earnings growth is needed to support stock prices. If earnings persistently disappoint, then stock prices will eventually adjust lower. Although it is too early to declare a soft data or hard data winner, so far, we believe buoyant sentiment is certainly contributing to these elevated market levels.
Instead of chasing sentiment to even higher, more unsustainable levels, investors should fight the urge by focusing on long-run economic fundamentals. At this point, unless there is a change in their long-term objectives, we see little to no justification for investors to deviate from their appropriate asset allocation, or to structurally increase risk.