MID Special Update: First Quarter 2017 Review & Look Ahead

Summary:

• Large cap stocks were the driver during the first quarter, advancing by 5.5%.
• Small caps underperformed after strong outperformance in Q4 and over the past year.
• Growth outpaced value among both large and small cap stocks.
• S&P Info Tech (+12.2%) was the best performing sector index for the quarter, while S&P Energy dropped by 7.3% and telecom also lagged, down 5.1%.
• The Nasdaq 100 Index had its best quarter since March 2012, rising 11.8%. The Nasdaq Composite also out performed, up 9.8%

Stocks had their best quarterly gains since the fourth quarter of 2015, adding to the 3.3% gain experienced last quarter. Tech stocks led the way, up over 12%, while energy shares lagged based on the price of the commodity. At the same time, volatility, as measured by the CBOE VIX index, remains near historic lows. It was not quite that easy though. Broad indices gave up gains in March amid concerns over the likelihood and timing of tax cuts, regulatory change and spending initiatives that have driven stocks since the election.

Smooth sailing or muddy waters?

The reflation trade (aka Trump trade) was the story in Q4 and the narrative continued into Q1, albeit with some twists. During the quarter stocks made a series of all-time highs, peaking in early March as investors bid up stocks in anticipation of an improving economy. Underpinning the rally was the hope that tax and regulatory changes would help corporate profitability and unleash “animal spirits” in the stock market and business confidence in the C-Suite.

The failure by the House to pass its Healthcare bill in March exposed divisions in the Republican Party, causing investors to question how easy it will be to pass other agenda items, like tax reform, seen as business friendly. As the drama unfolded in Washington D.C., stocks sold off for 8 straight days, and lost 317 Dow points during the week of the failure to vote. Prior to the focus on D.C., the implied probability of a FOMC rate hike rose to about 100% from under 40% over a one-week period in early March. Generally equities traders would not cheer such a hike, but an improving US economy that justified such talk was also seen as a positive for the market.

By the time of the FOMC’s rate decision on March 16th, the market had discounted a 25bp increase. The committee did not disappoint, raising the fed fund rate by 0.25% to a range of 0.75%-1.00%. Investors interpreted the accompanying statement as dovish, helping the market rally about 100 Dow points on the day of the meeting. Chair Janet Yellen believes the economy continues to improve, but reiterated that fiscal tightening would be a gradual process. Inflation is moving closer to the committee’s long-term goal of 2%. Three rate hikes in 2017 seems the most likely scenario, which weakened the US Dollar to worst 3 day performance (-1.4%) since early December.

Historically, large cap stocks are typically favored over small cap names when the US Dollar is declining. The weakening dollar in March didn’t scare investors in March, as Vanguard experienced its largest weekly inflow for the iShares Russell 2000 ETF and Vanguard Small-Cap ETF in 3 years.

Narrow Trading Ranges:

Stocks were range-bound for most of the quarter. The S&P 500 experienced only two sessions all year where the index moved by more than 1%. On March 1st, SPX jumped by 1.4% on the heels of President Trump’s speech to congress, while on March 21st the S&P fell 1.2%, the first 1% decline since October. By comparison, the large-cap index moved by more than 1% on 48 occasions last year.

Low Volatility:

Volatility remained low, with the CBOE “VIX” recording its second-lowest quarterly average on record. Despite a spike when the market slumped amid healthcare turmoil, The CBOE Volatility or “VIX” index ended the month at 12.37, indicating that traders are not expecting sharp equity movements over the next 30 days.

So where is the risk? The CBOE SKEW index measures the “tail risk” of outlier returns based on prices of out of the money options on the S&P 500. SKEW typically ranges between 100-150. A reading of 100 implies that the perceived distributions of the S&P500 are normal and the risk of outlier returns is low. Despite the low reading for the “VIX” index, the SKEW index hit an all-time high of 154.34 on March 17th. The index has fallen somewhat sharply into quarter-end but remains elevated relative to the past year. The options market seems to be telling us many traders are ready for…something.

The implied correlations of stocks in the S&P 500 have been declining steadily, meaning stocks are moving together less and stock/sector selection is more important to returns.

Sector Rotation:

Risk is also present in sector selection. The widely quoted VIX captures the implied volatility for the overall market. Individual sectors however had widely different outcomes. Energy stocks, for instance, have been under pressure for most of the year as the commodity weakened (See “Commodities” for additional detail). Income substitutes like Utilities, REITs and Staples turned from losses in January to sharp gains in February. Active managers are making a comeback, as stock and sector selection becomes more important.

Commodities:

The Bloomberg Commodity Index saw a 2.5% decline in the quarter as heavily weighted crude and natural gas took the index down for the largest decline since July ’16. In February crude oil traded in the narrowest monthly range since August 2003, but that pattern fell away in the face of rising US inventories. WTI crude pricing plunged 9.1% in the second week of March after the DOE reported a ninth consecutive inventory build. The sharp decline was exacerbated by a reversal of record long positions in the futures market present at the beginning of the month, as these bullish bets declined by the largest amount on record by mid-March. As the quarter concluded, investors were looking for an extension of the OPEC production agreement that is set to expire in June. WTI crude fell 5.8% and Brent dropped 7% in the quarter, the most for both since 4Q15.

Economy:

Stocks have been moving higher in part due to a reflation trade in both the US and Europe. This is not solely a U.S. phenomenon, as evidenced by higher interest rate expectations in the Eurozone. Morgan Stanley has pointed out also that “soft” economic readings like Consumer Confidence—at a 16-year high—are indicating more optimism than “hard” data such as GDP, business spending and retail sales. GDP is admittedly backward looking but the Atlanta Fed’s GDP Now survey is projecting 1Q at 0.9% growth, down from their initial forecast of 2.3%. Consumer Spending (released 3/31) was lackluster in February and is on track for the worst quarterly performance since 2009. The used-car market is signaling warning signs. Offsetting that, income growth looks solid and 1Q GDP has been weaker seasonally in the past few years—and tax refunds may kick in later this year.

Earnings preview:

Earnings season gets underway in the third week of April with reports from the major banks. Analyst expect earnings will grow by about 8.8% with top line revenues growing 7.2%, and that compares to respective declines of 6.7% and 1.4% in 1Q16. The S&P-500 index closed Q1 with a multiple of 21.8, the highest since 2009, so investors will look to growing earnings for justification of the rich valuations. Second quarter earnings are expected to continue the momentum from Q1 with earnings growing about 8.7% and revenues 5.3%. For the year, earnings and sales are expected to show growth of 10% and 5% respectively, the most since 2011.

Valuation:

At current prices, the S&P is currently trading at over 21.5 times trailing 12 month earnings, well above the 10 year average of 16.5. The P/E based on forward earnings is over 18X. The Wall Street Journal noted recently that corrections occur about once per year on average with the eight-year bull market only seeing four. A BAML Fund Manager Survey found 34% of portfolio managers believe stocks are overvalued, the most since the survey began in 2000. The widely followed Shiller P/E, which adjusts for earnings over a 10 year cycle, is over 29, 75% higher than its historical mean of 16.7. Finally, Guru Focus calculates the total market cap of the US market is 130% of GDP, indicating a significantly overvalued market. High valuations are not a new theme and the market has continued to climb this wall of worry primarily because rates remain historically low and on hopes of stronger US growth so that the “E” can catch up with the “P”.

Trading Volumes:

Consolidated trading volumes for the quarter are lighter this year than 2016, but more in line with previous years. The consolidated tape (volume for all stocks on Tape A, B & C) averaged 6.82 billion shares per day with a high of 9.76 billion and a low of 5.84 billion. Q1’16 averaged 8.5 billion shares a day with a high of 12.5 billion and a low of 5.14 billion. Q1’15 and Q1’14 have similar numbers to this year, averaging 6.83 billion for 2015 and 6.91 billion for 2014. This should come as no surprise as equities stumbled out of the gate to start 2016 following the first FOMC rate hike in over a decade. In a March 30th article, The Wall Street Journal discussed the decline in trading volumes over the past year despite the markets posting healthy gains. The Journal notes that about $15 billion in trading revenue has vanished for the bulge firms and cites low volatility and the rise in passive investing as the culprits. In this environment investors use ETFs and lower cost algorithms, bypassing high touch trading desks, to get the lowest-cost execution. The MID calculates Q1 average daily market volumes are down 20% YoY.

Small cap vs. Large Cap:

Small-cap stocks have been notable laggards to start off 2017. The Russell 2000 led 2016 with a 19.5% return, beating the S&P’s 9.5% return but has gotten off to a slow start in Q1. Although the Russell hit a record high earlier in March, it has pulled back in recent weeks. The Russell 2000 finished Q1 up only 2.12% YTD, compared to mid-single-digit percentage gains for the Dow (+4.56%) and the S&P 500 (+5.53%).

The post-election rally in small cap stocks has slowed dramatically as investors have grown concerned over Trump’s ability to get his legislative priorities through congress. A stall in Trump’s healthcare reform has left investors concerned that promises of tax cuts and infrastructure spending also face delays. These programs were anticipated to disproportionately benefit small cap stocks since they stand to benefit from a lower corporate tax rate and are typically more sensitive to domestic economy and policy changes.

The expectation for higher market volatility related to the fiscal policy debate in Washington, a rising-rate environment from the Federal Reserve, and a busy geopolitical calendar, will likely continue to weigh on small caps in 2017.

Look ahead:

As we look ahead to the rest of 2017, it’s hard to imagine a more different scenario than in 1Q 2016. Last year, deflation, global growth, currency devaluations and falling commodity price were feared, with central bank stimulus propping up equity markets and driving bond yields around the world into negative territory. The ensuing year saw the stabilization of currency/commodity markets and a discussion of rate normalization, despite Brexit and a surprise election result. The Dow has since gained over 5,700 points, +37%, off the February 2016 lows.

2017 was expected to be volatile due to a number of geopolitical and market risks including Trump tweets, policy implementation, European elections, central bank policy divergence, China, and lofty valuations. Yet, so far 2017 has been among the least volatile years on record as valuations continue to expand. The yield curve has flattened from its highs in December as part of the Trump trades unwind. The lesson of course is that a lot can still happen.

Traders will watch for the expected two additional Fed rate increases, a Europe that elects pro-Union regimes, China continuing to manage its debt and currency effectively, and for expected earnings to catch up with prices. Global debt hit $215 trillion, up over $70 trillion over the past decade so that back-burner issue could return at any time. Finally, if frustration grows over the ability to quickly pass business-friendly legislation in Washington, valuations could suffer.

Nasdaq's Market Intelligence Desk (MID) Team includes:

Michael Sokoll, CFA is a Senior Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over 25 years of equity market experience. In this role, he manages a team of professionals responsible for providing NASDAQ-listed companies with real-time trading analysis and objective market information.

Jeffrey LaRocque is a Director on the Market Intelligence Desk (MID) at Nasdaq, covering U.S. equities with over 10 years of experience having learned market structure while working on institutional trading desks and as a stock surveillance analyst. Jeff's diverse professional knowledge includes IPOs, Technical Analysis and Options Trading.

Steven Brown is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over twenty years of experience in equities. With a focus on client retention he currently covers the Financial, Energy and Media sectors.

Christopher Dearborn is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Chris has over two decades of equity market experience including floor and screen based trading, corporate access, IPOs and asset allocation. Chris is responsible for providing timely, accurate and objective market and trading-related information to Nasdaq-listed companies.

Annie O'Callaghan is Director on the Market Intelligence Desk (MID) at Nasdaq. Annie has worked for NASDAQ in a variety of roles including support of Nasdaq C-level management in client retention and customer service. Annie also served as a Sales Director in Nasdaq’s Transactions Services business. Prior to joining Nasdaq, Annie worked at AX Trading, managing accounts for its Alternative Trading System and served on Credit Suisse's trading desk as an Electronic & Algorithmic Sales Trading Analyst.

Brian Joyce, CMT has 16 years of trading desk experience. Prior to joining Nasdaq Brian executed equity orders and provided trading ideas to institutional clients. He also contributed technical analysis to a fundamental research offering. Brian focuses on helping Nasdaq’s Financial, Healthcare and Airline companies among others understand the trading in their stock. Brian is a Chartered Market Technician.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.