By Nicholas A. Vardy, CFA
With the New Year almost upon us, Wall Street soothsayers are out with their predictions for 2017.
As usual, they are predictably restrained.
Most house projections from the big investment banks and brokers converge around the S&P /zigman2/quotes/210599714/realtime SPX -1.18% closing the year at 2350 — a scant 5% above current levels. Only one strategist — Merrill Lynch's Savita Subramanian — dares to suggest that 2017's gains could be as much as 20%.
That's a big number.
A 20% gain in U.S. stocks from current levels would put the Dow at 24,000, the S&P 500 at 2,700 and the Russell 2000 at 1,650. Yet, if you combine robust earnings growth, greater infrastructure spending, tax cuts and deregulation with a boost to the market's "animal spirits," 2017 could be a banner year for U.S. stocks.
Why U.S. stocks could surge in 2017
I see two crucial factors converging, which could send the U.S. stock markets surging by double digits in 2017.
First, the fog of the earnings recession in the S&P 500 has lifted. This was always somewhat of a red herring, with the energy sector bearing the brunt of the weak headline numbers.
Today, energy stocks are recovering with Dow components Chevron /zigman2/quotes/205871374/composite CVX -0.68% and /zigman2/quotes/204455864/composite XOM -0.08% expect to grow earnings by 277% and 84%, respectively. Other S&P 500 sectors are also gathering steam.
The current forecast of 11.5% earnings growth and 5.9% revenue growth for the S&P 500 are the best since 2013. The Dow Jones Industrial Average fares even better with earnings expected to surge 14%.
Second, U.S stocks have a strong recent history of outperforming in the first year of a presidency. Since the year 2000, stocks have had three 20% plus years- 2003, 2009, and 2013.
Note that two of the three recent 20% gains came the year after a presidential election.
Why the bulls could be wrong
Still, before you pile into U.S. stocks, keep in mind three caveats.
First, the U.S. stock market is expensive. Long-term measures of stock market valuation like Robert Shiller's Cyclically Adjusted Price Earnings (CAPE) ratio puts the S&P 500 is an eye-popping 28.1. That is 68.3% higher than the historical mean of 16.7- though far from its dot-com boom peak of 44.2. Run the numbers Shiller style and you get an implied annual return of -1.2%.
That's hardly impressive.
Second, I'm worried about the uniformly bullish market sentiment since the Trump election. The CNN Fear and Greed Index — which tracks seven separate measure of market sentiment — is firmly entrenched above 80. The Consumer Confidence Index is now at its highest since July 2007. When too many investors are on one side of the trade, you eventually run out of buyers.
Third, both wage growth and interest will go up under a Trump presidency, whether triggered by a jump in government spending or accelerating economic growth. Either factor will weigh heavily on the stock market.
How to bet on a bullish 2017
If you cannot resist the siren call of a potential blowout in 2017, how should you best bet bullishly in your portfolio?