Earnings power is propelling the bull market into its next stage

In June, the bull market for U.S. stocks appeared to pause as investors turned their attention to geopolitics. A government investigation into alleged Russian meddling in last fall's U.S. presidential election and any potential involvement by President Trump's campaign caused a fair amount of angst among investors, as did leaks of classified information to the media.


While that intrigue played out, market sentiment became somewhat subdued as investors began to assess the possibility that the Trump administration's pro-growth proposals to reform taxes and cut government red tape could be put on hold amid the probe into election meddling. As we see it, President Trump's agenda remains intact, and recent developments represent only a temporary delay in the agenda's implementation, rather than a change in direction.

In our view, the U.S. economy remains fundamentally solid, with the U.S. consumer in excellent condition, supported by strong employment and steady wage growth. The balance sheet of the average American household appears to be sound, and recent data on the housing market has been encouraging. Crucially, the U.S. banking system appears to be in good shape; capitalization levels are healthy, while overall loan growth has remained steady.1 Taken together, these factors suggest to us that the equity market is likely to snap back into growth mode once current uncertainties recede.

At the sector level, we continue to view financials and industrials positively, and, from a valuation perspective, we believe the pause in the equity market's recent gains created windows of opportunity for astute investors. We've also maintained our broadly favorable view of consumer discretionary, as we believe this sector will continue to receive ample support from a strong macroeconomic backdrop.

As for the broad market, equity valuation levels have recently attracted plenty of attention, as U.S. valuations climbed from a price-to-earnings ratio of about 12 in 2008 to around 18 at the end of 2016.2 In our view, much of this increase was fueled by the implementation of accommodative monetary policies in recent years. We view monetary policy as having been the key catalyst during the first part of the bull market that began in March 2009. That phase appears to have ended, and we're entering a second stage that we expect will be powered by earnings growth. The results of the recently completed first-quarter earnings season support our view, as net income among large-cap U.S. companies grew 13.5% from the previous year's first quarter, exceeding analysts' expectations of about 8.0% growth prior to earnings season.3 We expect this positive earnings momentum to continue.


That said, as long-term fundamental investors, we seek to avoid being distracted by short-term market movements and try to focus instead on quality companies with competitive advantages and attractive valuations. We view these elements of our investment approach as particularly important within the current environment.

Looking ahead, we'll be monitoring whether President Trump's administration manages to make progress in Washington, as its ability to push its agenda forward will have a material bearing on market sentiment. There's a lot of white noise at the moment, and this has been a source of distraction for investors.

1 FDIC Quarterly Banking Profile, FDIC, as of 5/24/17. 2 FactSet, 2017. 3 FactSet, as of 5/31/17.