U.S. equity markets have enjoyed huge gains since the presidential election on 8 November, but the “Trump rally” has been less about broad market participation and more about dramatic sector rotation.
For many years, unconventional monetary policy has forced investors out on the risk curve, increasing their appetite for “safe haven” income-generating stocks. Since the election, however, we’ve seen a significant move into sectors that could benefit from reflation, such as financials, energy and industrials (see chart).
The S&P 500 is currently trading at a price-to-earnings (P/E) ratio of 18.5x fiscal 2016 earnings estimates. Given these high valuations, we believe investors should acknowledge that a portion of President-elect Trump’s fiscal stimulus has been pulled forward and is already priced in to equities. So where do we go from here?
What to watch
We see four key themes for U.S. equity market investors in 2017:
- Expect continued support for equities. Given the potential for fiscal stimulus, tax reform and higher inflation, we expect the rotation into reflationary hedges (and out of “safe-haven” assets) to continue next year.
- Prepare for higher volatility. Since the global financial crisis, monetary policy has driven multiple expansion in the equity markets. Going forward, we believe a transition from monetary to fiscal policy means that earnings growth will propel the equity markets higher. However, new policy tools will likely have unintended consequences that could spark uncertainty, increase cyclicality and potentially lower multiples.
- Keep an eye on technicals. Much of what has driven the recent market moves is fund repositioning, including selling over-owned technology stocks and buying under-owned financials and energy. Technical factors such as hedge fund outflows, low short interest levels and crowded trades remain areas of concern, but they are likely to be more than offset by a rotation out of fixed income into equities.
- Be selective. Given that multiples are at or near five-year and historical highs, future appreciation will most likely come from stocks that exceed (not just meet) earnings expectations.
Given our views, we are currently finding attractive risk/reward opportunities in energy, industrials, materials and select consumer discretionary companies. We’re a bit cautious on financials, considering how quickly and dramatically they have outperformed, and would look for opportunities following pullbacks. Finally, we are underweight consumer staples, health care and technology based on issues ranging from high valuations to a stronger dollar to the potential for protectionist trade policies.
After years of broad expansion in U.S. equity valuations, the wide dispersion of returns we’re seeing (and expect to continue to see) among different industries provides opportunities for discerning investors and active portfolio managers.
John Devir is a PIMCO portfolio manager focused on long/short equity strategies.