Can Stocks Become the Market Vigilantes? – Week Ended 8/25/17

US equities broke their two-week losing streak with the S&P500 advancing +0.7%; US political noise seemed to cool slightly from what has otherwise been a disgusting month of turmoil and backlash against the President by both parties. Despite the favorable weekly result, the daily path of the market remains relatively choppy compared to the low volatility experience observed over the first 7 months of 2017. Indeed, most are pinning the recent uptick in volatility and daily swings to none other than the unpredictable rants and feuds being generated by Donald Trump. No other way to put it than a huge distraction from meaningful progress. And in a slow-growth economic environment that is hopeful for any ingredient including less restrictive policy to spur an faster pace of growth, this perceived importance of politics makes sense. It is from that perspective we believe the road will become even more choppy as we move through the balance of 3Q (September). In the month ahead, action by Congress will need to occur on the topics of the US debt ceiling and a budget resolution. To the extent that the debt limit would not be successfully negotiated and a government shutdown occurred, the market would surely exhibit stress. While that risk should be and seems still remote, it feels equally challenging to entirely dismiss the potential for idealistic dysfunction despite the well-known self-destructive consequences.

From an economic perspective, the most clear message conveyed by data last week is that we are enjoying a period of synchronized global growth. Improving metrics around the world remain constructive and according to the IMF, in a way that has not been seen in a decade. Objectively and as reported by the WSJ this past Thursday, all 45 countries tracked by the Organization for Economic Cooperation and Development are on track to grow and 33 of those are poised for acceleration. Even here in the US the number of cities that are reported to be enjoying robust economic conditions is outstanding. And at the same time as growth is supportive, inflation remains tepid and a non-threat. This remains surprising when considering the degree to which monetary stimulus has been pursued over that same 10-year period; traditionally such a notable expansion of the monetary supply accompanied by economic growth might be assumed to produce problematic inflation. But the fact that inflation is yet to manifest continues to provide central bankers the flexibility to remove stimulus extraordinarily slowly and carefully.

While price inflation remains MIA, it would be hard to argue that central bankers have not achieved asset inflation. Asset inflation is visible through the levels of arguably most markets including housing, stocks, and bonds alike. From a valuation perspective, it is challenging to suggest that any asset class is cheap. It is in that regard, that the calls from market skeptics continue to call for the end of the bull market. This relatively pervasive notion probably best explains why money continues to flow out of equities in a way that is starkly different from what would be expected if investors were euphoric. But given the resiliency of the financial markets despite political noise, coupled with the observation that the President regularly likes to cite the performance of the Dow as a barometer for his success, might the stock market become the vigilante that gets Washington to focus on making progress on issues that have real fiscal significance? Will stock market vigilantes begin to exert pressure (via falling market) on Washington as we move into September? We think it might. In fact, one strategist is suggesting that should the stock market pressure via a more noticeable decline amid a sloppy political negotiation on the looming debt ceiling, it would be a buyable moment. While Trump and a partisan Congress seems deaf to criticism or wisdom in pursuit of achievements for the greater good, we have hope there is at least one vigilante left who can successfully get the message through: stocks. In the short-run, we suspect the market may get sloppy; but that may just be what the doctor ordered to incentivize leaders to get their act in gear and move forward with reforms that have the potential to extend the real business cycle.

Political Turmoil Quickly Shifts From N. Korea to Domestic Providing No Relief to Cautious Investors Week Ended 8/18/17

As North Korean dictator Kim Jong Un pulsed back from recent threats aimed toward the US early last week, the overall stock market initially surged. Hopes for a diplomatic solution to the recent back and forth war of words between the US and North Korea suddenly appeared more plausible. Yet President Trump quickly reminded investors that he can be a distraction and tail risk following what appear to be less than calculated remarks in response to recent extremist violence occurring on our own soil in Charlottesville, VA. His reaction to the tragedy seemed to be the final straw for many on his business advisory councils, and is perhaps a good barometer for just how isolated he is making himself from both legislators as well as the broad public. Investors by extension, are solidly of the perspective that any meaningful pro-growth policy achievements campaigned upon and celebrated in the immediate aftermath of the November election now have virtually zero chance of advancing. On that deepening belief, US equity markets slid sharply again late-week with the S&P, Dow, and Nasdaq each finishing lower by between -0.6% and -1%; that marks another consecutive weekly decline to US.

Outside of the political mess that seems to continue circling (or be self-inflicted) Trump, fundamental data in the latest week was supportive of a view that the global economy is on sound footing. US retail sales advanced +4.2%; Chinese retail soared +10.4%; consumer sentiment is up high single-digits while the money supply is also on the rise despite slowly climbing interest rates (suggesting velocity of money is picking up slightly). Wage data shows that workers are seeing bumps in pay that slightly outpace reported inflation. And Eurozone real GDP is up roughly 2%. Corporate earnings reports, while weaker in these last couple weeks (very normal during the later weeks of reporting season), are concluding the 2Q in aggregate strongly ahead of last year. Admittedly, 3Q will present harder comparisons to year-ago results than enjoyed during the first half of 2017.

In recent years, the month of August has not been kind to global investment markets (stocks in particular). Low summer trading volume tends to amplify negative developments. And following months of extraordinarily low volatility, recent sharp dips feel even more alarming; this is especially the case against a growing count of scary news stories proclaiming that the bull market (usually referred to as only a rally) is highly fragile. For example, the markets logged several new all-time highs in one week during the month of July, and no mention was made of it by the mainstream media. Negative stories seem to ignore how this bull market has recovered from dozens of major shocks in the last 8 years. This is not to suggest that investors should dismiss recent troubling developments. In fact, elevated valuations while not a useful market timing tool do imply that forward returns look muted. Still, reviewing valuations relative to historical averages inside a vacuum ignores the fact that investors still have few viable alternatives for where to allocate savings in pursuit of real (after-inflation) returns considering that bonds and cash yield almost nothing after the effects of inflation. We believe that growth of corporate earnings must continue to facilitate this bull market enduring longer, and the economy remains highly dependent on consumer and business confidence staying accommodative. But amid recent signs that economic conditions continue to improve internationally, US demand should also remain healthy. Continued skepticism over the durability investment assets also likely affords this bull market more time and keeps the risk of full-blown bubbles low. Taken with the acknowledgment that investors believe pro-growth US fiscal policies are dead in the water (and been fully removed from asset prices in the months since inauguration), a positive surprise in the form of tax reform or repatriation, or any reduction in regulatory burdens could setup stocks to receive another nice leg up. Short-term, rising volatility and still-low trading volume keep this market vulnerable in the month or so ahead.

Sabre Rattling Upsets Calm in Markets – Week Ended 8/11/17

As one market commentary this morning put it, the heated rhetoric from both North Korea and the US fell like a rock into the still pool of the markets last week. Tensions escalated between the two countries on Tuesday as Trump tweeted that the US would respond to any actions by N. Korea against the US or its allies with fire and fury like the world has never seen. On that headline, the S&P500 reversed -0.8% from what was an attractive intra-day advance. The bleeding of financial markets continued through Thursday which experienced the most notable drawdown in roughly 3 months. Markets managed to stabilize Friday, but the Dow, S&P, and Nasdaq each declined by -1.1%, -1.4%, and -1.5%, respectively for the week. It was not just domestic equities that sold off; Eurozone banks fell -4.1% and other international also swooned by anywhere between -1% to -2.5% for the week. As might be expected, safe-haven bond yields again moved lower (prices up). Following what has been months of market and investor calm despite ongoing dysfunction in Washington and pro-growth policy (like healthcare or tax reform progress) stagnation, the colorful exchange of words and threats over the use of nuclear force seem to be scary or uncertain enough to reawaken volatility.

From an economic perspective, 2Q earnings season is coming to a close in the US. The year-over-year progress is noteworthy, but should also be at least partially attributed to still-easy year-ago comparisons; looking to 3Q, comparisons should become more challenging. But that aside, corporate earnings and guidance commentary still reflects an economy that is progressing and bolstered by steady consumer and business sentiment. Foreign economies also are showing ongoing improvement. At the same time, while unemployment continues to drift lower, wage growth remains benign to corporate margins meaning that inflation should remain a non-issue in the short-run. That view was supported with the release of the Consumer Price Index last week, which again reflected a pace of inflation that falls-short of central bank expectations and goals. When coupled with the recent escalation of geopolitical tension, it would seem the Fed and other central bankers may be incrementally harder-pressed to move forward with additional rate normalization and tightening efforts despite their idealistic notion to do so.

While the drawdowns experienced last week likely re-awaken markets that have been extraordinarily calm throughout much of the year, it should stand as an important reminder to investors that unexpected developments always have the potential to upset markets in the short-run. They are also a normal part of investing. With that said, it is our understanding from following various experts on the topic of actual war with North Korea (beyond words), the risk may still be overstated. Perhaps more importantly, it is the perspective of experts that the abilities of North Korea to strike the US this year or even the coming few (despite accelerating progress) are even more overstated by the media. This is not to suggest that the prospects of any nuclear attack or not to be evaluated seriously, or that N. Korea isnt moving toward that achievement. Or, that one of the biggest risks in this situation is that each country has a leader that seems to lack the rationality or cool head we might normally expect and from that perspective these worries do have the capacity to increase financial risks in the short-run. We do not believe however that this event materially changes the underlying economic fundamentals of either growth here in the US or globally. But in the very short run (next few months), it is entirely possible and perhaps even probable that volatility continues to rise or at least shift to a higher level than enjoyed by investors YTD because it is our perspective that most investors remain on-alert for anything that looks to have potential of upsetting the Goldilocks environment. Further, we are still within 2% of the all-time highs set by US indexes within recent weeks and hardly constitute a correction. Investors and clients should expect that streak without correction to end at some point, but the important question that must always be considered is whether underlying fundamentals are changing for the worse suggesting that a pullback is the beginning of something more sinister. At present, that answer is no. And, perhaps even more broadly, TINY (There Is No Yield) continues to perpetuate TINA (There Is No Alternative [to stocks] for generating real return).

Dow Sets Fresh All-Time High Crossing 22k, but Calls for Correction Getting Louder Week Ended 8/4/17

The summer months are often characterized by sleepy low volume trading, but the experience in 2017 makes that statement even more pronounced than normal. It is no secret that in recent months, observed volatility is extraordinarily low, but Friday marked the 12th consecutive trading session wherein the S&P500 moved less than 0.3% throughout the day; the longest such boring (not that boring is bad) streak on record. For investors who remain long the market, this calm is attractive as the level of volatility tends to be negatively correlated with the direction of markets (low volatility tends to accompany rising markets, while spiking volatility tends to push values lower). In support of that correlation, the Dow managed to set a fresh all-time closing high crossing the level of 22,000 for the first time this past Wednesday while the broader S&P remains within 1% of its record high set a week back or so. Still, while it is neat to see the market moving higher and seemingly unfazed by ongoing noise from political dysfunction, it has been more than 270 days since the US stock market experienced a pullback of 5% or more; this is not the longest such streak without a pause, but it sits among the longer stretches. That fact alone is probably why the number of media outlets and respected investors calling for a top or sharp pullback in the near term seem to be getting louder and more attention.

On the economic front, the Goldilocks (not-too-hot, nor not-too-cold) economic camp continues to see their base case validated by the incoming data. Most notable and watched last week was the employment report for the now complete month of July; the report showed another round of better than expected job creation and a falling unemployment rate. Company surveys also continue to reflect a stable corporate outlook and upbeat sentiment for business both here domestically and abroad. At the same time, a declining US dollar looks to be helping domestic export activity and sharply rising commodity prices like that of Iron Ore and the stabilization to improvement of oil prices suggest economic activity is healthy and perhaps accelerating (even though acceleration has been elusive throughout much of the economic recovery). And in the US, the number of cities that are experiencing robust economic conditions seems to be broad and expanding. Perhaps the most stubbornly curious data point continues to be on the front of low observed inflation; at this stage of the cycle and with unemployment so low, one would typically expect to see wages growing at a faster clip than they are and resulting in more normal inflation. But low inflation should be enough to help central bankers avoid the temptation to get too aggressive in their pursuit of normalizing monetary policy which could ultimately short-circuit what is now one of the longest economic cycles in US history.

In the coming day, we look to distribute our August commentary to clients (also made available on our website). In that note, we will survey what we believe is the front-and-center topic on investor minds: how much longer than the current market advance continue? In many respects, it is hard to argue with the growing chorus that a notable pullback should be coming amid financial markets that feel to be a bit departed from economic and corporate fundamentals. On the other side of the coin however, valuations while elevated slightly above historical average are getting some help from corporate earnings which grew double-digits again in the 2Q over the same period last year. And, as long as wage growth fails to accelerate meaningfully or provoke higher inflation, it is equally challenging to say that the economy (and financial markets as a derivative) will suddenly impair the current trend beyond a short-term bump or two. We encourage you to check back for our monthly commentary titled Dancing on the Ceiling in the coming days.