US Equities again surged higher during the trading week ending January 26 with the S&P up another +2.2% and now a staggering +7.2% higher YTD. Thats getting close to what many strategists expected might be the full-year result in just 1 month; with just 3 trading days remaining January looks to be one of the best new year starts ever (presently ranking 5th). Historically January strength in the magnitude of that witnessed bodes well for the full-year. With that said, there are some big divergences opening in recent performance. Notably, mega-cap tech (growth) is again fueling gains at the aggregate index level while more cyclical and value-oriented names are more muted. Smaller-size companies with generally lesser foreign exposure are not fully participating as many cite a dramatic weakening of the US$ so far in 2018. Too, bonds are the stark contrast to a stock market where it seems everything is up. Yields have risen materially in both the US and abroad these first weeks of 2018, resulting in softening prices and negative total return. The great rotation, hypothesized as imminent in almost every year since the financial crisis but nearly forgotten now, finally seems to be unfolding before our eyes. One favorable aspect of that does appear to be a modest steeping of the yield curve which grew ever flatter (and nearer to inversion) throughout much of 2017.
The melt-up as it is being more widely referred to, continues. The S&P, Dow, and Nasdaq each logged new highs adding roughly 1% each during the week ended January 19. In the just 13 trading days since the New Year began, the 3 major indexes are all up between +4.8% and +5.3%; a pace that if sustained would result in a full year climb of more than +170%! It seems less than a bold call to offer that the current pace of upward progress enjoyed over that short span should be expected to moderate. Careful, such a prognostication does not mean doom or gloom or that a correction is imminent, even though it has been an extraordinarily long stretch tallying 400 trading days since US markets experienced a -5% setback.
Global financial markets are continuing where 2017 left off: moving higher and with optimism. In fact, the S&P did not experience its first negative performance day of the new year until Wednesday (Jan 10) of last week. It is under that context we came across a rather timely comic depicting the near-extinction of the market bear investor species. News stories also highlight that investors are shedding their use of market hedging tools here in the early days of 2018 because those positions are being viewed as too costly and have provided no benefit in quite some time. Headlines like that suggest such investors are believing the good times will continue throughout the coming 12 months and perhaps becoming complacent to the idea markets will ever go down again. Make no mistake, we believe the current economic backdrop is supportive for the new year as well; but also suspect that 2018 will hold at least a few more nervous moments than were observed during 2017.
From an economic perspective, data remains supportive of stocks and limited volatility. In particular, inflation and expectations for inflation in the future are ticking higher but still not problematic. This can be attributed to the historically low level of unemployment in the US, high corporate profits and margins, and recent boost to business optimism generated by the passage of tax reform (particularly corporate rate reductions). Higher inflation expectations are favorable near-term, so long as they do not rise too far that the Federal Reserve and other global monetary authorities began to view them as a threat of creating bubbles. US retail sales also were reported to rise 0.4% in December, confirming the solid holiday season and economic momentum perceived in 4Q. But last week was not without some eye-catching developments either. China officials were reported to be recommending the slowing or stoppage of purchases of US Treasuries after studying their foreign exchange holdings. That created a knee-jerk selloff in sovereign debt (bonds). At the same time, talk of trade war continues, with the Trump administration continuing to tout America-first perspectives that are surely not making friends with other global economic superpowers, or life easy for multinational companies.
With earnings season set to commence in earnest for the 4Q period this week, most analysts are expecting a continuation of expanding corporate profits. Earnings are important at this stage of the cycle, because the market is not cheap from earnings perspective relative to historical norms. In order to justify such elevated market multiples, earnings growth must continue to be robust. The question is however, are expectations for growth ahead of what companies can actually deliver? In the last two years, it seems the bar set by expectations was relatively low and companies generally had an easy time beating both street projections AND prior-period comps. With the streak of exceeding expectations getting longer, the bar is arguably higher for generating surprise. In a similar fashion, consumer and business optimism is also at a level that is hard to improve further upon. We are not calling for this bull market or economic expansion to end soon, but it seems that we are overdue for market participants to be reminded that stocks do not typically move so linearly ahead as they have over the last nearly 400 trading days (wherein we have not experienced even a 5% peak-to-trough pullback). In that regard, we remain invested but trimmed some of the most recently high-flying areas of the market. We are not sure what might trigger an end to the streak without a noticeable retreat, but believe the probability of one occurring is relatively high even as 2018 should be another attractive year when we are reflecting 12 months from now.
Happy New Year-we look forward to continuing our work on your behalf in 2018!
When we look at the distribution of returns for the S&P relative to history, 2017 could be defined as a year with no left tail. Not only did the index conclude with all 12 months being positive (never happened before), but it also had just 4 trading days where it fell by -1% or more (and just 4 trading days where it rose by more than 1%). Not since 1970 did the market enjoy such persistently low volatility. The year concluded in-keeping with the theme of our November commentary: a year of lots of small, but positive returns that when linked together made for a very attractive year. What might be most interesting however is that the low volatility occurred despite a backdrop in which much was changing. The Fed raised rates four times even as inflation remained weak. US politics were also an area where no calm could be found as evidenced by a headline I observed over the weekend characterizing 2017 and the first of the Trump presidency as one marked by scandal (not sure if that is a fair statement amid what seems to be lots of smoke but a yet to be identified fire; but regardless of disposition toward him or work thus far, his first 11 months cannot be considered conventional or of high public approval either).
With both the monetary and fiscal policy backdrop shifting, it should be noted that many of the developments in 2017 are in fact longer-term positive. For instance, interest rates moving off their near-zero level is desired and healthy, particularly for financial institutions which serve as the transmission of any economy. Regulation also seems to be in a mode of easing for a number of industries critical to economic growth. 2017 was also the year in which international economies joined domestic in expansion; a missing trait throughout most of the post-financial crisis (2009) period. And, on the backs of rising portfolio values, home prices, and tight labor markets, consumer confidence in the US continued to improve and at high levels as we look toward 2018. Corporate earnings also logged healthy progress during the year; something that we said was requisite following the dramatic rebound that disciplined investors enjoyed from financial markets following 2 years of a sideways but volatile trading from mid-2014 to mid-2016. On that front, the passed tax reform package signed into law at the sunset of 2017 should provide a boost to the net earnings that corporate America can deliver, which should help support existing stock prices if not propel them higher on an absolute basis.
As we look to 2018, the economic and fundamental underpinnings of the financial markets appear to be in favorable shape. And, while it is easy to imagine that the historic calm of the markets witnessed over the prior 12 months simply cannot last and suggests that 2018 should contain at least a few more nervous moments, low real rates and a synchronized global economic expansion are supportive of the notion that low volatility can remain a theme. Perhaps the biggest question and risk to the markets in 2018 might actually be that the economy gets too strong. While that statement seems paradoxical, the logic is this: with unemployment already at historic lows in the US, and corporate earnings high, a further boost to earnings derived from reduced corporate taxes and high CEO optimism could well begin to flow to workers in the form of higher wages. Higher wages are desirable, but they also seed inflation. Should inflation meaningfully pickup, it would not be a stretch to envision the Fed and other global monetary authorities grow concerned that their pursuit of monetary policy and interest rate normalization is behind the curve and needs to hasten. Under that scenario, a policy mistake wherein the Fed or another central bank moves too quickly would cause something to break and a broader risk-off and economically cleansing cycle might ensue. For that, we will be watching the yield curve, and the relation of the Fed Funds rate to that of the 2-year treasury. Historically, an inverted yield curve, or a Fed Funds rate that exceeds that of the 2-yr treasury has been a good leading signal that monetary policy has become restrictive and a recession is not far off.
Again, we wish you all the best as we enter 2018. Look for our quarterly newsletter in the days ahead, and call upon us as we can be a resource to you in anything financial this year.