Global Equity Strategy

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

February 15, 2017

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

Equity-Market Valuations Are Higher—But Not Extreme

  • Absolute domestic stock valuations have risen since 2011 and 2012.
  • Yet, U.S. inflation and interest rates remain modest, and could leave more room for valuations.

What it may mean for investors

  • We believe that the S&P 500 has moved beyond the earnings recession, and we expect cyclical earnings growth to support equities.
speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

When investors were concerned over weakness in the international economy and worried about a second dip in the U.S. economy, the price/earnings (P/E) valuation of the S&P 500 Index was roughly 12-13x (in 2011 and 2012). Today, the trailing 12-month P/E multiple is near 19x, and the S&P 500 index multiple on our $127 earnings estimate for this year is roughly 18.3x. The long-term median trailing multiple over the past 30 years has been 16.7x.

On an absolute basis, looking back 20 years, the S&P 500 Index valuation has been lower than today roughly 60 percent of the time, which means that it was higher only 40 percent of the time. We have to look to the markets of the late-1990s and early 2000s to find most of those higher valuations.

However, inflation rates and Treasury yields are much lower today than they were in those periods. It still appears that Federal Reserve (Fed) rate increases will come along at a modest pace. Even though absolute valuations are lower today than they were 60 percent of the time in the past 20 years, they were lower relative to the 10-year Treasury yield only 32 percent of the time. On that basis, U.S. large-cap stocks do not show extreme valuations today. Stocks and bonds vie for investor attention. Late within a cycle, inflation and valuations can rise together if markets are supported by continuing earnings expansion.

Chart 1. S&P 500 Index Earnings Yield versus the 10-Year Treasury Yield Chart 1. S&P 500 Index Earnings Yield versus the 10-Year Treasury YieldSource: Bloomberg, Thomson Baseline, Wells Fargo Investment Institute, 2/13/17. This is a plot of the earnings yield of the S&P 500 Index (earnings/price) versus the 10-year Treasury yield. When the S&P 500 Index is attractive relative to the 10-year Treasury yield, the blue line is in the territory above the long-term average. The 10-year Treasury yield is currently 2.47 percent. The S&P 500 Index has been more attractive, relative to the 10-year Treasury yield, 32 percent of the time over the past 20 years.

The U.S. economy has emerged from an earnings recession that was largely impacted by falling energy prices. With 353 of 500 S&P 500 Index companies having reported fourth-quarter 2016 results, eight of the 11 sectors have shown year-to-year earnings growth. Overall, earnings for 2016 came in roughly flat, while the fourth-quarter earnings results have risen by 6.9 percent versus the fourth quarter of 2015. Over both timeframes, energy comparisons were the primary culprit during 2016.

Chart 2. S&P500 Sector and YoY Earnings Growth

Overall, 69 percent of companies in the S&P 500 Index have reported fourth-quarter 2016 earnings results that exceeded consensus expectations. In fact, roughly 50 percent have reported revenues that were above consensus estimates (which is better than what we have experienced in many quarters of this economic cycle).

We recommend that investors continue to rebalance their overall portfolios so that they remain in line with their long-term investment objectives. We continue to expect S&P 500 Index earnings growth of 6-7 percent in 2017, and believe that inflation will remain at moderate levels that could allow for further multiple expansions in late 2017 and 2018.

Weekly Wrap and Look Ahead

All major domestic and international indices were positive for the week and year to date.

Index Last Week’s Performance1 2017 YTD Performance
S&P 500 +0.8% +3.5%
DJIA +0.1% +2.6%
NASDAQ +1.2% +6.5%
Russell 2000 +0.8% +2.3%
MSCI EAFE +0.0% +3.5%
MSCI Emerging Markets +1.2% +7.9%
1.For the week of February 6 – February 10, 2017.
Source: Wells Fargo Investment Institute, Bloomberg, 2/13/17.

Five of 11 S&P 500 Index sectors outperformed the index; 10 of 11 gained ground on the week.

Best-Performing Sectors
Sector Last Week’s Performance2
Industrials +1.6%
Consumer Discretionary +1.4%
Information Technology +1.2%
Worst-Performing Sectors
Sector Last Week’s Performance2
Energy -0.7%
Materials +0.1%
Financials +0.3%
2. For the week of February 6 – February 10, 2017.
Source: Wells Fargo Investment Institute, Bloomberg, 2/13/17.
Past performance is no guarantee of future results.

More fourth-quarter earnings on tap this week. So far, results are just ahead of our expectations. In addition, Fed Chair Janet Yellen is presenting her semi-annual testimony to committees in both houses of Congress (Tuesday and Wednesday). In her remarks to the Senate Banking Committee on Tuesday, Ms. Yellen continued to emphasize a data-dependent approach to monetary-policy normalization. Following the meeting, fed funds futures markets continued to reflect a higher probability of a rate hike at the June meeting (than in March). Our Fixed Income team believes that the June and December meetings hold the highest probability for rate hikes this year. We believe that the stock market is more comfortable when our central bankers start dropping hints about rate hikes at least two months before they are likely to occur. Further, with fourth-quarter gross domestic product (GDP) growth coming in well below expectations and wage gains remaining modest, we believe that there is no need for the Fed to be in a rush. We believe that stock market participants are thinking the same way.

For now, our recommendation is to remain invested. The S&P 500 Index is approaching the upper end of our year-end target range (2230-2330). As previously noted in this publication and others, we are looking for the index to hit its high for 2017 in the middle portion of this year, before drifting lower in the second half. Second-half headwinds include worries that 2018 will bring more meaningful wage pressure and that the Fed might be “behind the curve” and need to “catch up” with more interest-rate hikes than equity investors have been expecting. Our analysis suggests that those concerns will be a drag on stocks. We are not calling for the end of the current cycle. Instead, we anticipate a year that offers minimal market returns “net-net” from January 1 to December 31.

S&P 500 Index Sectors: Wells Fargo Investment Institute Fourth-Quarter 2016 Earnings Estimates
  Percentage Change Y-o-Y (Est.)
Consumer Discretionary 3.0
Consumer Staples 7.0
Energy -15.0
Financials 17.5
Health Care 7.0
Industrials -2.0
Information Technology 8.5
Materials 7.0
Real Estate -14.0
Telecom Services -1.0
Utilities 8.0
S&P 500 Index 4.0-6.0
Source: Wells Fargo Investment Institute, S&P Capital IQ 2/13/17. Y-o-Y = year over year
Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.2% Overweight 14.9%
Consumer Staples 9.3% Underweight 5.5%
Energy 7.1% Underweight 4.0%
Financials 14.7% Overweight 16.4%
Health Care 13.7% Overweight 17.2%
Industrials 10.3% Overweight 11.6%
Information Technoloy 21.5% Evenweight 21.8%
Materials 2.9% Evenweight 3.0%
Real Estate 2.8% Evenweight 3.1%
Telecom Services 2.4% Evenweight 2.5%
Utilities 3.1% Underweight 0.0%
S&P 500 Earnings Estimate for 2016 $119.00
S&P 500 Earnings Estimate for 2017 $127.00
S&P 500 Year-end 2017 Target Range 2,230-2,330

Sector weightings may not add to 100% due to rounding. Weightings as of 2/13/17. Targets are not guaranteed and may change.
Source: Wells Fargo Investment Institute, Bloomberg, 2/13/17.

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, 2/14/17.
Developed Markets: MSCI EAFE Index (Europe, Australasia, and Far East). Emerging Markets: MSCI Emerging Markets Index.
*EV = Enterprise Value. EBIT = Earnings before Interest and Taxes. EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization. EPS = Earnings per Share.

Risk Factors

Equity investments are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.

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.

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

There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.


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 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 Midcap® Index measures the performance of the 800 smallest companies in 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 Wells Fargo Investment Institute. 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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