It was both long overdue and arguably healthful that the market experienced a noticeable pullback last week (and that appears to be bleeding into another). The S&P500 skidded -2.1% on Friday and ended the week roughly -4% below its January 26 highpoint. In virtually all our writings and conversations over much of the last 6 months, we have conveyed that investors should at some point anticipate a rise in volatility as periods of extended calm like enjoyed since late-2016 are rare. But as much as one tried to emotionally condition themselves for the possibility, pullbacks are never fun, and the magnitude with which Friday capped an already difficult week likely creates anxiety for those who have enjoyed seeing their portfolio values steadily climbing to new heights on almost a daily basis in the early days of 2018. So what many may find most interesting then is that this overdue reversal comes amid economic news that is actually quite strong.
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.
As hard as it may be to believe, there are just 9 trading days remaining in 2017. Most notable is that through the first 242 trading days of this year, the worst S&P drawdown was a benign -2.8% decline. That hardly-sinister setback is the second skinniest calendar year correction ever (1995 was the narrowest). And the S&P maintains a perfect calendar-month winning streak through November. The 2nd full week of December continued the upward melt theme of 2017 with the S&P climbing on 3 of the 5 trading days and adding a little more than +0.5% for the week. In that vein, it would seem to be an easy statement to say that 2018 is likely to contain more uncomfortable moments than witnessed in the last 12 months.
From an economic perspective, the biggest news so far in December is that the US economy appears to be building on its 3Q momentum. With both stock and home prices well-higher YTD, measures of consumer confidence continue to hover near attractive high levels. In that regard, it is not surprising to learn that nominal retail sales were up +5.8% over last year in November; a much faster pace than the +4% rate enjoyed in recent years and setting the stage for 4Q GDP to be up an estimated 4% after backing out the effects of inflation (which is still quite tame, but perhaps starting to show some signs of life). And strength should beget more near-term strength; in the last 20 years there is an 85% correlation between the YTD performance of the S&P and holiday sales; with that in mind it suggests holiday sales could be up 7% over last year. As indicative as that all is (healthy consumer tends to lead to more confidence by businesses as well) the big news is actually that the tax reform bill looks set to be passed by Republicans before year-end. We realize that there are conflicting views on the appropriateness of any of the many changes contained in the bill (any legislation that purports change will always create marginal winners/losers), and are not offering an endorsement or opposition in that regard; but the body of work we read and receive on that subject suggests that on balance it (corporate tax changes in particular) will be accretive and boosting of the economy in at least the short-term (next few years). And, a strengthening economy generally has positive implications for financial markets as well, all else equal.
As offered in the opening, 2017 has been a fantastically encouraging year for those who remained disciplined and invested over the interval despite no shortage of negative media. Calm, low volatility, has been a hallmark of the last 12 months; so calm in fact that it will go down as one of the least volatile years ever. In that regard, 2018 should offer more bumps. The question in the most immediate term is whether the final trading days of the year will add to what is already a great performance, or if Santa has already done his giving for 2017? With eyes toward what 2018 might offer; despite valuations being perhaps worrisome, the economic and fundamental picture continues to look supportive in the coming 12 months. [Bitcoin: hard to imagine that it will experience an ongoing run without a significant crash at some point!] Internationally, we were also pleased to see allocations rewarded as foreign economies appear to have moved into a more stable growth pattern and look to be at the earlier stages of their recovery than the US. In that regard, they may continue the market-leading performance observable throughout the last year into 2018 and beyond.
Most important, we wish all of our clients and their families the Merriest this Christmas! We look forward to visiting with you as we turn the calendar to a New Year!
The final trading week in November was decisively positive for US equities; in fact on Thursday the Dow achieved its 5th 1,000 point milestone by crossing the round number of 24,000 and was led by financials and transportation companies in what is ordinarily a signal of fundamental economic strength. The Dow actually concluded up +2.9% on the week (with financials up +5.2%!) while the S&P500 managed a weekly gain of +1.5%. It was noteworthy however that the technology sector, which has been the far and away leader throughout 2017, surrendered -2% and causing the Nasdaq to slip -0.6% during the week. In that vein, it would seem as we enter the final month of the year that some of the most swiftly appreciating names and areas of the market are taking a breather while others play catch-up. Fortunately, some of these areas most notably participating in recent days are those that tend to be thought of as more cyclically sensitive. Is this the start of a broader thematic shift, or just an overdue catch-up in participation by areas of the market that would seem to benefit most from the passage of tax reform making its way through Congress (more on that in a moment)?
From an economic perspective, the synchronized global growth theme seems to remain in good health judging from recent data points. To this end, the Citi global surprise index made a new high, and the Baltic Dry shipping index with the price of industrial commodities such as iron ore also made upside breakouts. In the US, stronger data included an upward estimate to 3Q GDP, rising oil rig count, vehicle production, consumer confidence (now approaching a record-high), and a concert of stronger home-related data. This is all while inflation related measures continue to remain a non-problem. In fact, so much of the data recently seems to be coming in favorably, that the narrative surrounding the market performance YTD is beginning to attract some irrational exuberance type labels (a term used to describe the markets by then Fed Chair Alan Greenspan in 1996 when the tech bubble was building). Indeed, there are some signs that some market participants are getting a bit euphoric and chasing or piling into what would seem to be some of the most risky areas. [Bitcoin for instance; without veering too far off-track, the appreciation of cryptocurrencies is making a number of prior bubbles that preceded their historic crashes look benign by comparison and that is to say nothing of the challenges we have with trying to understand the fundamental case behind the trade at any price level. Bubbles like Bitcoin can of course persist longer than reason suggests they should; precisely what makes them so alluring and risky] Interestingly, Greenspan first referenced the famous irrational exuberance term in 1996, a good 3 years before the high-flying technology sector and broader market experienced its day of reckoning.
As we enter the final month of 2017, a review of how far the markets have come is encouraging. Improving economic fundamentals seem to have delivered upon what the market was anticipating or suggesting when it began the current move higher back nearly 23 months ago. Now, what seems to be a rising probability of success with respect to Congress delivering tax reform (particularly at the corporate level), has the potential to add fresh fuel to the tank in terms of helping companies boost earnings margins and further lift confidence. At the same time however, it is the same virtually uninterrupted walk higher that has many investors growing concerned. YTD, the largest peak-to-trough decline is just -3%; that is the 2nd narrowest giveback from January to December in at least 70 years according to market research group Strategas. That alone suggests volatility will go higher from its current levels of tranquility; and volatility is historically inversely correlated to the price direction of equities. But before getting too spooked, it is worth noting that history offers that gains are still probable in the following 12 months; the pace of those gains however slowed and a much wider range of outcomes was possible. Bluntly stated, the probability of some form of corrective price action in 2018 appears high even if the longer-term theme of upward economic momentum remains intact as we think it can. Such an interruption might likely occur because inflation should pop up from its current non-visible state at some point, causing participants to fear a quick shift to a less accommodating monetary policy mix. In the near-term however, the final month of 2017 seems set to push higher.
US financial markets saw riskier assets, those including equities and lower quality corporate bonds, come under pressure at the start of last week as the utopian backdrop of low inflation, real interest rates, and economic volatility were all put into question following two key data points (CPI and PPI). These better readings, amplified by a new Federal Reserve chairman and board changes and the relative uptick to uncertainty that creates, raised concerns that monetary policy will become less accommodative. In fact, while the daily index moves were all mild in absolute terms, Wednesday (the worst of the 3) was actually the 13th worst day of 2017 with the S&P500 slipping of -0.53%. But in what has become a familiar pattern, the buy-any-dip mentality again held true when on Thursday the index sprung back with its 13th best day of the year (a rebound of +0.85%). All told, major US indexes concluded the week roughly where they entered it with the S&P off just -0.1%. And, with the Thanksgiving holiday now almost upon us, historical seasonality provides the expectation by many that smooth sailing and favorable returns should persist through year-end.
From an economic standpoint, recent data remains supportive of the view that global economic growth is stable to improving both through year-end and into 2018. This includes the prospects for both developed and developing economies. This theme of better economic activity is most likely the reason behind why we observe commodity prices (including oil, copper, industrial materials) moved noticeably higher in recent months as well. Also evident is that the global supply of money in recent years is massive; it seems to be manifesting itself in the form of major corporate deals; new plans for investment in plant, property, and equipment (cap-ex); and even flowing into high-ticket luxury items as evident through the record-shattering transaction price for a famed DaVinci painting last week. Clearly all the cash needs somewhere to land. With so much money sloshing around and economic readings looking increasingly favorable, the biggest near-term concerns seem to revert back to the evolving shape of the still-positive yield curve which has flattened significantly year-to-date and did so again last week. An inverted yield curve (where short-rates exceed longer-dated yields) has signaled economic recession would be coming; but on average the signal was some 5 quarters before the economy turned lower.
As investors and economists begin to look into 2018, the focus is on the potential for above-trend growth, a lower unemployment rate, and increasing inflation & wage pressures. Those themes while all short-term favorable from a consumption perspective, have the potential to be less supportive to corporate profit margins (if you are paying more for material inputs and labor, profits decline all-else equal). That is not to suggest these themes would not run for quite a while before the corporate earnings actually decline. So what permits this economic and market cycle to continue? Enter corporate tax reform. A lower, flatter corporate rate would seem to offer a quick boost to the level of corporate earnings which remain a key input to stock prices and valuation. That is why tax reform is such a big deal. But, after what seems like years and years of dysfunction from Washington and inability to work together, most remain pessimistic that anything meaningful or worthy of the word reform will be enacted. This remains the sentiment even as congress seems to be making faster than expected progress. But aside from that important theme, it will be interesting to watch activity around this holiday season. Historically, holiday retail sales directly benefited from strong financial markets as individuals feel wealthier and more generous. At the same time however, Amazon has created such disruption for traditional retailers that the number of companies benefiting from holiday shopping seems to be narrowing. In fact, an ETF was recently introduced aiming to capitalize on idea; owning Amazon and selling short more traditional retailers who have already seen their share prices severely punished this year. But has this winner-take-all view become too consensus (does the creation of such a product support that argument)? That may be the most interesting narrative over the coming few months in what seems like a year in which the wind is at the back of consumers and holiday spending.
Meantime, we want to take express our gratitude for each of our clients and the ongoing opportunity to work on their behalf. We pray you enjoy safe travels and a wonderful Thanksgiving this week.
After 8 consecutive positive weeks for the S&P, the index suffered its first weekly loss since early September. Make no mistake however, the -0.2% giveback for the S&P500 and Nasdaq on the week was anything but panicky (Dow off -0.5%) and probably does little to change the broad perception that markets have not experienced any meaningful pause in 2017 and are long overdue for a setback. But could volatility and some heightened pressure be developing? Credit markets, specifically high yield spreads, seemed to awaken a bit last week in what has otherwise been a sleepy year of flat-line activity. Often, widening high yield spreads lead observable hiccups in equity markets. At the same time, the yield curve continues to flatten; it is not yet inverted (worrisome signal), but is worth watching closely as it has never provided a false positive signal preceding economic recession by an average of 5 quarters.
With that said, data continues to support the theme that the US economy and the vast majority around the world are soundly growing and not yet experiencing much inflation. It seems that creating inflation is extraordinarily difficult in a world where large technology companies are disrupting so many industries (ie Amazon and retail, pharmacy, grocery, etc). This explanation is particularly sound when noting that the 4-week average of US unemployment claims declined to a 44 year low last week (persistently low unemployment should be the starting point for inflation via upward wage pressure). At the same time, areas like Japan and Europe which have only managed to see short spurts of better economic activity for much of the post-financial crisis period are continuing to enjoy a strong activity in 2017. Nominal retail sales in the Eurozone are up 5% over last year and China is reporting metrics indicative of robust activity. These readings support the theme that more favorable economic activity is not just a US story, but rather synchronized across the globe. Still, it is noteworthy that corporate profits in the US for 3Q are +7% higher than their year-ago levels and 4Q estimates project high-single to low double-digit year over year gains; that is particularly relevant when considering there has never been an economic recession when corporate earnings are buoyant.
While underlying fundamentals continue to support the idea that more time remains this economic cycle despite its longer-than-average age, a key theme with sentiment heightened (hard to see consumer sentiment move much higher increasing the prospects for short-run disappointment) is the urgency for the US economy to break out of its sub-par trajectory. Yes, 3Q GDP (nominal) was quite respectable and a needed start; better earnings and nominal GDP gains are the hard data that many were looking for to support confidence-related readings evident around the end of last year. But valuations are still above historical average creating the sense that the market is quite vulnerable to shocks. When that is true, there are a number of mistakes that can be made by policymakers that quickly erode confidence. For example, a Fed that moves too quickly even in the absence of inflation or bubbles can choke off the access to capital and spook markets (yield curve inverts). Alternatively, failure to pass corporate tax reform could also hurt small business confidence and impair the ability to further grow corporate earnings. Make no mistake, in talking with most it would seem that few expect Congress and actually agree on reform. If they can defy the pessimism on that front, it would seem a number of sectors are due for a quick upward adjustment. Amid what should be rising wage pressure, corporate tax reform may likely be the missing key ingredient to boosting real and nominal growth from this point in an already long cycle.
With October nearing conclusion, US equities indexes extended their streak without so much as even a 5% pullback to near 350 trading days! In fact, at times it feels as if upward momentum is accelerating if one views the absolute level of indexes in isolation (ie Dow over 23,000; S&P500 nearing 2,600) and new highs occurring regularly. But last week, equities generally struggled for direction amid slightly higher volatility; it was by the pull of several mega-cap tech stocks that powered the car with their reported 3Q earnings solidly beating street expectations (Amazon rose by more than +13% Friday). While the S&P500 index for example closed last week at a level of 2,581, adding a tepid 0.2%, the tech-heavy Nasdaq bounded by +1.1% and is now up +3.8% over last month. Yet if one reviews the equal weight variant of the S&P index (instead of by market size), the constituents actually posted a -0.58% loss last week. Small size companies as measured by the Russell 2000 slipped -0.1%.
From an economic perspective, the story of an accelerating economy globally continues to be supported. Most notable was the preliminary estimate of 3Q GDP, which showed the economy expanding at an annualized rate of 3% when backing out the effects of inflation (2.2%); it means the US economy is running at a level 5% higher than a year ago in absolute terms. That is quite respectable considering the 3Q period included two nasty hurricanes that likely softened activity in the short-run. China reported that its GDP was 11% higher over a year ago in the 3Q. Commodities and bond yields seemed to confirm the improving growth theme, with Brent crude rising above $60 per barrel and US treasuries managing to climb above 2.4% (often a gauge of economic growth and inflation expectations). The odds of tax reform also seem to be improving as Congress is settling upon budgets and broad terms of what a revised tax system might look like. As we monitor the landscape this week, the economic conditions increasingly support a Fed and global monetary authorities continuing to normalize interest rates. Will the new Fed chair expected to be named this week, be viewed as a continuation of Janet Yellen and her cautious well communicated approach (Jay Powell, frontrunner is expected to be); or will a more hawkish contender emerge victorious from Trump consideration and upset investors who still ponder if the economy can stand without extraordinary monetary accommodation.
As we interact with clients, two question regularly recur: how much longer and farther can this bull market run? And, if tax reform does not occur the markets appear due for a pretty sharp setback. In response to those themes, we remain highly cognizant of how long its been without even a modest market pullback. One seems overdue. But with economic fundamentals and corporate earnings continuing to surprise on the upside, short-term weakness so far is being met quickly with buying from those who remain under-invested. Secondly, it is our perspective that the market performance throughout most of 2017 is actually not being driven by the expectation of meaningful tax reform. In fact, the sectors of the market that stand to benefit the most from the proposed tax framework, are actually faring the worst YTD suggesting that investors do not believe it will occur. That presents opportunity for the market to advance further if tax reform can lend a boost to reported corporate earnings and create a fresh stimulant to business confidence and optimism. To the extent that economic metrics continue to support the view that the global landscape continues to accelerate, and that monetary policy remains cautious and accommodative, the fuel remains for this market and economic cycle to extend much further against the concerns of skeptics.