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.