Global Equity Strategy

Weekly discussion of recent equity market action with equity sector highlights and what it may mean for investors.

March 29, 2017

Stuart Freeman, CFA, Co-Head of Global Equity Strategy
Scott Wren, Senior Global Equity Strategist

Market Breadth and Clues for Forward Performance

  • While the domestic equity markets face some headwinds, we believe that market breadth remains generally supportive.
  • Currently, nine of a diverse set of 26 industry groups we monitor have declined from one year ago. We use this data along with a variety of fundamental measures to evaluate our expectations for U.S. equities going forward.

What it may mean for investors

  • While we expect modest economic growth for this year and next year, we also expect higher market volatility.
  • We continue to recommend that investors rebalance their equity holdings (and portfolios) after the recent post-election rally.
speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

The S&P 500 Index is currently trading just above the top of our year-end 2017 target range of 2230-2330. Overall, most leading economic indicators are pointing toward continuing domestic growth this year. We are currently projecting domestic gross domestic product (GDP) growth of roughly 2.3 percent for 2017, which continues below long-term averages. Although year-to-year earnings comparisons offer a tailwind for stocks, particularly in the first half of the year, domestic equity valuation increases just after the presidential election appear to have pulled equity returns forward. Investors and the Federal Reserve (Fed), alike, are working diligently to forecast whether growth-positive policies actually will add to U.S. job growth, inflation, and revenue and earnings growth during 2018.

Generally, we expect more volatility this year as the markets hang on weekly signs of any growth-friendly progress being made in Washington. At the same time, the domestic economy still continues to be poised for modest growth this year and next.

The positives for domestic stocks include the following:

  • Easy earnings comparisons this year versus last year
  • Leading economic indicators that point toward modest growth
  • Continuing growth in the job market and for consumer confidence
  • Signs of somewhat better fundamentals, internationally.

But there are some intermediate-term headwinds:

  • Valuations appear extended, particularly since the post-election surge.
  • Many higher volatility or higher-beta segments of the domestic equity market have been underperforming the S&P 500 Index since early December 2016. These include the small and midcap segments and, more recently, the very early cycle transportation groups (truckers, airlines, railroads, etc.).
  • Any clear setbacks to still-anticipated favorable policies coming from Washington have the potential to result in some valuation corrections.
  • The Fed is now in the process of increasing rates. While those increases may be moderate, investors also must keep in mind that any acceleration in economic growth may result in a Fed that must move faster to keep up with inflation. This would not typically be a cycle-ending event, but could result in valuation pressures for stocks.

Market Breadth

Our S&P 500 Index market breadth work continues to be supportive. We maintain a diversified set of 26 industry groups from which we monitor upward versus downward movement over rolling 12-month periods back to early 1984. Currently, of those 26 groups, nine are lower than one year ago. The current level represents average historical breadth. Historically, when trailing one-year breadth has been at these levels, the S&P 500 Index has generated an average move of roughly six percent over the following 12 months.

Generally, the more troubling periods for stocks tend to occur after breadth drops to 13-18 groups in decline. Under current breadth conditions, based upon 23 historical instances of similar breadth levels, the S&P 500 Index has been lower a year later only 22 percent of the time, based upon our data back to 1984. Our market breadth work does not, on its own, represent sufficient analysis from which to base equity-market targets. Our equity targets are based upon a much larger basket of analyses. However, this longer-term breadth analysis does provide additional guardrails with which we can monitor directional performance beneath the surface of the S&P 500 Index’s headline price level. From our perspective, current large-capitalization market breadth is not sending red flags suggestive of market correction potential out of line with normal intra-cycle pullbacks.

We continue to recommend that investors rebalance their equity portfolios after the recent post-election move, so to keep their portfolios aligned with their long term investment objectives.

Weekly Wrap and Look Ahead

Most major domestic and international indices were positive year to date, but most declined last week.

Index Last Week’s Performance1 2017 YTD Performance
S&P 500 -1.4% +4.7%
DJIA -1.5% +4.2%
NASDAQ -1.2% +8.3%
Russell 2000 -2.7% -0.2%
MSCI EAFE -0.1% +6.8%
MSCI Emerging Markets +0.4% +12.4%
1. For the week of March 20 – March 24, 2017
Sources: Wells Fargo Investment Institute, Bloomberg, 3/27/17

Six of the 11 S&P 500 Index sectors outperformed the index; only two of 11 gained ground on the week.

Best-Performing Sectors
Sector Last Week’s Performance2
Utilities +1.3%
Real Estate +0.7%
Consumer Staples -0.7%
Worst-Performing Sectors
Sector Last Week’s Performance2
Financials -3.8%
Telecom Services -1.9%
Industrials -1.8%
2. For the week of March 20 – March 24, 2017
Source: Wells Fargo Investment Institute, March 27, 2017
Past performance is no guarantee of future results.

What will move the stock market this week? We think it is safe to say that indications of cooperation, or lack of cooperation, between Congress and the new administration have the distinct possibility of pushing the major market indices one way or the other. The fundamentals (in terms of modest earnings and economic growth) are in place and unlikely to change. Stocks likely will react to data pertaining to wage inflation, but that will not come until the March employment report on the first Friday in April. We continue to believe that wage inflation will creep higher over the balance of the year and cause some concerns and headwinds for stocks in the second half of this year.

We would argue that most of the data on the economic calendar this week has little possibility of causing the equity market to move in a meaningful way. Consumer confidence is on the schedule, and the reading is expected to remain high. In our opinion, as long as the labor market continues to improve and the stock market is anywhere near current levels, consumers will remain confident. The question is whether this confidence will turn into increased consumer spending and result in better corporate profits in coming quarters. After all, it has been consumer spending that has pushed this recovery along to a large extent, while business capital spending has lagged throughout the recovery.

Job one for the new administration is to attempt to implement policies that will extend the current expansion, which is long in the tooth if time is your sole criteria. In our opinion, if economic growth can be boosted into the 2.5 to 2.8 percent range on a consistent annual basis, and inflation can be kept low, stocks are likely to respond favorably in the coming years.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.2% Overweight 14.9%
Consumer Staples 9.4% Underweight 5.5%
Energy 6.5% Underweight 4.0%
Financials 14.3% Overweight 16.4%
Health Care 14.1% Overweight 17.2%
Industrials 10.0% Overweight 11.6%
Information Technoloy 22.1% Evenweight 21.8%
Materials 2.8% Evenweight 3.0%
Real Estate 2.9% Evenweight 3.1%
Telecom Services 2.4% Evenweight 2.5%
Utilities 3.2% Underweight 0.0%
S&P 500 Earnings Estimate for 2016 $127.00
S&P 500 Year-end 2017 Target Range 2230-2330

*Sector weightings may not add to 100 percent due to rounding. Weightings as of March 27, 2017. Targets are not guaranteed and may change.
Sources: Wells Fargo Investment Institute, Bloomberg; March 27, 2017.

Valuations and Fundamentals for Five Primary Equity Asset Classes Valuations and Fundamentals for Five Primary Equity Asset Classes*Enterprise Value.
Source: Wells Fargo Investment Institute, Bloomberg, 3/27/17. Developed Markets: MSCI EAFE Index (Europe, Australasia, Far East). Emerging Markets: MSCI Emerging Markets Index.

Risk Factors

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

The prices of small- and mid-capl company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.

Definitions

An index is unmanaged and not available for direct investment.

DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

NASDAQ is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade.

Russell 1000® Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index.

Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25 percent of the total market capitalization of the Russell 1000® Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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