The rise in stock prices in the quarter brought the market to a level that is at or near its historic high. While stock prices rose, so did valuations as earnings increases did not keep pace with price increases on average. The market, as measured by almost any broad based index, is now selling at a price/earnings ratio that is above the historical average. Investors appear to be willing to pay up for stocks in anticipation of an increase in the rate of growth of corporate profits in the near future. Fortunately, consensus earnings estimates are expected to increase in the second half of 2017, which could help allay investor fears regarding current market valuations.
Real GDP growth in the first quarter was about 1.4% according to the latest reading. The yield curve is flatter than at the beginning of the year, indicating that investors have temporarily lowered their expectations for accelerating economic growth. Nonetheless, there are enough positive economic metrics in the U.S. that it is likely that GDP growth will rise, even if at a modest pace. The Atlanta Fed GDPNow model forecast predicts Q2 real GDP growth of 2.7%. The ability of Washington to pass new fiscal policy legislation has disappointed investors. That said, there is still the potential for the implementation of fiscal policies which could significantly benefit economic growth down the road.
The internal dynamics of the market suggest there could be further challenges for investors. The market is being driven upward, in part, by a few large stocks; the so-called FAANGs. These are among the favored few. This group consists of Facebook, Apple, Amazon, Netflix, and Google. While Apple’s stock has a close to market multiple, the other names are selling at valuations well above that of the market; some have multiples of close to 200 times earnings. . The FAANGS have a combined capitalization of about $2.4 trillion, all of which rests on the realization of expectations for outsized earnings growth for a very long time.
In 1973 Burton Malkiel, then a professor at Princeton, published a book titled “A Random Walk Down Wall Street”. In the book Malkiel stated there were two basic approaches to investing; “castles-in-the-air” and “firm foundations”. The castle-in-the-air approach appears to have been dominant for quite some time. In many instances, investors have been buying stocks with valuations that are supported by little or no earnings with the expectation that the earnings will materialize at some time in the future. The source of these forward earnings remains unclear as does the duration for which they will persist. Stocks that are attractive while using the firm-foundations approach, which favors sound financial characteristics and reliable earnings progress, are finally beginning to demonstrate market leadership. This change in trend is consistent with our belief that we very well may be entering a period which is more beneficial to Affinity’s investment approach.
As you recall, two of the most important broad factors within the Affinity model, which drive relative performance, are valuation and improving fundamentals. In aggregate, Affinity’s investment strategies (and the model) generated under-performance in 2016. However, beginning late last year, market sentiment began to shift toward our investment style, and, while there have been fits and starts to relative performance in 2017, we believe the factors in our model will increasingly garner investor favor as the market becomes less narrow.
While the FAANG stocks have accounted for a large percentage of the S&P 500 Index return over the past two years, this type of concentrated performance often fades, as we are beginning to observe now. This reminds us of the 1998-1999 period when large cap technology stocks dominated the market. This was also the last time Affinity under-performed by such a large margin. In the ensuing 2000-2005 period, Affinity’s investment results were quite strong as investors embraced valuations and fundamentals.
Thank you for your continued trust in Affinity, and please give us a call if we may be of further service.