2017 Investment Review and 2018 Outlook

In 2017, the bull market in stocks continued for a ninth year. The S&P 500 Index returned 21.83% for the year. The increase in stock prices was driven by higher earnings and a price to earnings (P/E) multiple expansion. The market has viewed the Trump economy in a positive light. In 2017, the economy saw less regulation, stronger growth and the passing of a corporate tax cut.

Strong stock returns continue to be powered by growth stocks. The S&P 500 Growth Index returned 27.44% for the year compared to the S&P 500 Value Index which returned 15.36% for the year. The P/E ratio of the S&P 500 Growth Index has stretched to 28.77. This compares to a P/E ratio of 19.72 for the S&P 500 Value Index. The S&P 500 Index has a P/E ratio of 23.7. Over the last ten years the average trailing P/E ratio of the S&P 500 Index has been 17.83.

In the US, Large Cap Index returns as measured by the S&P 500 returned 21.83% and outperformed both Mid-Cap Index which returned 16.24% and Small Cap Index which returned 13.23%. There was finally strong performance from international stocks with the EAFE Index returning 24.94%; the Emerging Markets Index returned 34.35% and India returned 36.19%. Fixed income continued to trail equity returns as measured by the Barclays US Aggregate Index which returned 3.54%.

In 2017, the US economy saw strong GDP growth with quarterly returns of 1.4% in the first quarter, 2.9% in the second quarter and 3.2% for the third quarter. The GDP of the United States is $18.57 trillion. The difference between 3% growth and 2% growth is $185 billion dollars. The upward trend of the GDP is one of the reasons the stock market has embraced the Trump economy. If the lower regulations and lower taxes can create an economy growing at 3% a year compared to 2% a year that is a difference of $185 billion in the first year. The ten-year compounded growth at 3% a year versus 2% a year would add approximately $2.3 trillion more to the overall GDP. Those trillions would result in higher paychecks, higher spending and higher earnings.

A large variable for the 2018 stock market is the effect of the recently passed corporate tax cut. At Virtue Asset Management we try to find profitable companies to invest in that have a positive risk to reward ratio. With our focus on historically profitable companies, we expect many of our individual stock holdings to receive a benefit from the corporate tax cut. For example, the effective tax rate for Walmart was 32.9% for the nine months ended in October 31, 2017. LGI Homes had a tax rate of 33.3% for the nine months ended in September 30, 2017. These companies should see both short term and long-term advantages of a tax rate at 21%. There are some short-term headwinds because of the tax cut. Companies that repatriate cash, bringing cash back from overseas to the US, will have to pay a 15.5% tax and this would lower their earnings over the short term.

As we discussed at the beginning of the year, analyst estimates for 2017 earnings for the S&P 500 Index were $125. Earnings for the last twelve months were approximately $114. Analysts are estimating earnings at $135 for the S&P 500 Index in 2018. The ten-year trailing P/E ratio has moved up to 17.83. If the P/E ratio moved down to 17.83 with $135 in earnings, the S&P 500 Index would be at 2407 or a 10% drop from current levels. A more conservative estimation of $125 in earnings with a 17.83 P/E ratio would put the S&P 500 Index at 2229 and a 17% drop from current levels. Our view is that a 17% drop is the lower range scenario for the S&P 500 Index.

It is hard to predict the changes in the P/E ratio because it is partly due to the confidence of investors. The current P/E ratio of the S&P 500 Index of 23.7 is higher than the ten-year average of 17.83. In the past, investor greed drove the P/E ratio over 29 in the 1999 dot-com bubble. Using the current P/E ratio of 23.7 and earnings of $135 provides a target of 3200 and an almost 20% return. At Virtue Asset Management, we are using a more conservative $125 in earnings estimates. Combined with the current P/E ratio of 23.7 creates a target of 2962, providing a return of 11%.

Our upper range scenario for the S&P 500 Index is 11% and our lower range scenario is a decrease of 17%. Given this outlook, we recommend that investors maintain their stock exposure at the lower end of their target range. We recommend that investors understand their overall exposure to growth stocks and try to rotate into value stocks. Our individual stock holdings have a P/E ratio of 18.5 compared to the 23.7 P/E ratio of the S&P 500. We recommend overweighting our individual stock holdings versus other asset classes; in a stock market pull back the lower valuation could provide better downside protection.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.  The opinions expressed are as of the date noted and may change as subsequent conditions vary.  The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable.  The letter may contain “forward-looking” information that is not purely historical in nature.  Such information may include, among other things, projection and forecasts.  There is no guarantee that any forecast made will materialize.  All information is illustrated gross of investment advisory fees. Reliance upon the information in this letter is at the sole discretion of the reader.  Please consult with a Virtue Asset Management financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives and tolerance for risk.  Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438.

Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.