Mega-Cap Tech Aids New Index Highs – Week Ended 10/27/17

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.

Unfazed by Media Attempts to Draw Parallels to 30th Anniversary of Black Monday – Week Ended 10/20/17

US equities, as viewed through the lens of the S&P500, added another +86 bps last week bringing month-to-date performance to +2.3%. If US equities are roughly flat or better through the balance of the month, October will conclude as the second strongest month this year. That is a noteworthy accomplishment when considering that US equities are now up more than +15% YTD and there are unsurprisingly a number of other very strong monthly advances already on the books, not to mention that September and October have often proved troublesome. In fact, last week was the 30th anniversary of the stock market crash in 1987 referred to as Black Monday, wherein the stock market plummeted more than 30% in just two trading days.

Historical seasonal context aside, from an economic perspective, the market action (rise) last week makes sense when built on the theme of synchronized global acceleration. The market did briefly take note of some elevated geopolitical tensions mid-week; but globally conditions remain indicative of improvement. In the US, we are witnessing corporate surveys that continue to reflect upbeat business and consumer confidence; at the same time unemployment claims returned back to pre-hurricane levels more quickly than expected and manufacturing appears robust. Outside the US, indicators reveal the second largest economy in the world, China, is again growing very rapidly; that provides a tailwind to global demand. Sales are also running at an attractive pace in Europe, and leaders in Japan responsible for the pro-growth economic reforms of recent years were affirmed through a snap-election that essentially keeps the green light lit on Abenomics priorities. Of added bonus, US investors also received the headline US tax reform actually occurring might be better amid congress making swift and encouraging progress on budget-related items and a tax framework are advancing. Of course tax reform remains highly uncertain and final efforts are likely to remain highly partisan (making almost any supporter defections potentially catastrophic to passage), but early indications suggest the probability for meaningful reform is much higher than investors broadly believe.

As encouraging as this extended period of favorable market appreciation and low volatility is, it is hard not to ponder how investors and markets might be getting at least somewhat complacent. Severe down-days are virtually non-existent over the last 20 months and the market has now gone more than 340 trading days without a correction of 5% or more. Of course we are not rooting against continued advance, but we suspect the perception of calm amid ongoing worry might actually result in outsized negative reaction if/when any unforeseen shocks present themselves to the system. Investors are becoming conditioned to markets that seemingly only go up and pullbacks that are promptly viewed as benign entry points. Economic data continues to support the view that the economy is on sound expansionary footing with risk of near-term recession highly remote, but monetary policy here in the US as well as in Europe looks increasingly likely to continue tightening and prone to departing from the very cautious pursuit of normalization that characterizes this cycle. Here in the US, the yield curve is now the flattest it has been since 2009; without an uptick in inflation expectations and/or economic growth, it looks set to flatten further. This is significant in that many believe the yield curve (if inverted) has been the most reliable forward indicator of market turbulence and warning of recession. We remain watchful of how the yield curve will evolve from here; we expect the current cycle still has more fuel in the tank amid short-term money costs still reside firmly below that of expected inflation (a condition indicative of still easy money). But a change in the composition of the Fed or liquidity abroad, has the potential to restrict monetary policy beyond what the economy can support, ushering in the end of this economic and market cycle.

No Bad Luck Seen on Friday the 13th as Market Chugs On – Week Ended 10/13/17

Domestic markets managed to broadly rise in the week ending on spooky Friday the 13th with the S&P500 notching progress of +0.2%; so far in October the benchmark is up nearly +1.4% on top of what was a strong 3Q and another quarterly earnings season now upon us. US financial markets are now moving into the portion of the calendar where performance is often most favorable, and out of the season where it historically is weakest. This poses an interesting question: can the recent pace enjoyed over virtually all of 2017 continue or get even better over 4Q and 1Q, or was the seasonal benefit pulled forward to a degree that year-end will be uninspiring?

From an economic perspective and recent soft headline from the hurricane-influenced September employment report aside, data continues to support the view that the Fed will hike short-term interest rates one more time before 2017 sunsets. The strongest of themes is that we are witnessing synchronized global growth and that it seems to be accelerating. Surveys of US companies reflect continued supportive sentiment; industrial production in Germany surged +4.5% over the year-ago level while Taiwan exports and Japan machine tool orders accelerated 21% and +46% from same periods last year, respectively. The MSCI world reflects an +18% increase in the trailing 12 months. Those are crazy big numbers when thinking about economic activity occurring around the globe and go at least some distance toward explaining how the market continues to advance despite persistent negative and worrisome media headlines and providing a valid justification for why valuations appear at the higher-end of their historical ranges. But what these numbers also suggest is that inflation may be spooling up to quickly rise. And indeed, wages (a key ingredient to broad-based price pressure) appear to finally be showing a more meaningful increase via the Atlanta Fed wage tracker.

With commodity prices rising (attributable at least in part to rebuilding efforts following recent catastrophic weather) and wage-data also suggesting upward bias, inflation may be transitioning from sub-target to more concerning. This comes just as the term on current Fed chairwoman Janet Yellen looks set to end and the possibility of a more hawkish replacement is not remote. To the extent that price pressure rises too swiftly, the Fed would likely adjust its very metered rate normalization process into something more robust than markets have seen in over a decade. Hastening wage pressure would also put downward bias on corporate profit margins. Both of these factors would start the clock on how much longer the current business and market cycle can endure before a short-circuit occurs. As noted frequently, we believe there is more time this cycle and pent-up demand persists; but the long age of this bull market and economic expansion, coupled with what seems to be a growing complacency or calm over the markets has us on the watch for the streak without a correction to come to an end. The market has now went more than 335 trading days without so much as even a 5% correction; a long period of tranquility by most any measure. At the same time, a recent survey of the most bearish investors shows that even they are throwing in the towel on waiting for a meaningful pullback, which in itself may be one of the most troubling aspects of this current backdrop. A lack of bearishness, even in the absence of euphoria, suggests that market expectations may be too high and ripe for short-run disappointment.

Against Seemingly Long Odds, Winning Streak Continued in September and 3Q Week Ended 9/29/17

Despite what going in appeared to be a brewing cocktail of worries for investors set against a backdrop of above-average valuations and historic-low volatility, September 2017 will be one for the history books. It concluded as the least volatile September in 66 years. The month also saw the S&P log its 41st record high of the year (10 of which occurred during September alone). These amazing highlights stand in stark contrast to what is historically an average loss of -0.5% during the month of September AND the seemingly stacked worries of straining North Korea relations, destructive hurricanes clobbering the south, and ongoing Washington dysfunction including a looming debt ceiling and Federal budget resolution to name the most obvious. The point of all this however comes back to a question theme we increasingly hear from clients and financial colleagues alike: how is the market managing to seemingly ignore and become detached from what appears to be an anything-but-rosy rosy backdrop?

The question is valid; but perhaps misses the other side of the story. Admittedly, the headlines over the last 18 months have been nothing shy of discouraging and full of worry-worthy potential. But they are also detached from what is supposed to drive asset prices over time: fundamentals. In that regard, it needs to be acknowledged how much is actually going right. One research group recently adopted the phrase that while the US growth backdrop is certainly not the strongest in memory, it is one of the clearest in terms of the supporting message and direction. This includes that global growth has become synchronized, inflation is restrained, monetary policies remain stimulative, deregulation is a focus, consumer net worth is markedly rising, credit spreads remain accommodative of corporate America, a weakening US dollar is helping companies with foreign sales, and tax cuts are still possible. All of these should probably be viewed as at least partly responsible for why the market manages to continue establishing new highs even as monetary policy looks destined to continue normalizing and tightening at what is intended to be a boring pace. Worth noting: 3Q dividends were up +8.4% over last year; its often been said that profits are an opinion, but dividends are a fact and in this regard it seems most logical that financial markets are continuing to rise and business confidence supportive.

Listing the fundamental reasons for why the economic and fundamental picture is not to suggest that risks do not exist. But it also continues to be the case that perhaps the best reason to be bearish is there is no reason to be bearish. Also, while historical averages for both time and magnitude of market cycles are not on the side of this current market being able to continue (bull market is both longer and bigger than average) age alone does not have the power to change the fundamentals supporting it. Rather, some exogenous factor will ultimately be the cause for the current cycle ending. With an eye toward the 4Q, historical precedent suggests that as long as corporate earnings continue to advance, a recession is of low probability. And, the 4Q is often the strongest from a seasonal perspective, especially when September was positive. Taken together, while valuations feel high and a modest pullback called for by skeptics remains elusive and probably overdue, it would seem ones best bet is to remain disciplined and invested. Be on watch for our quarterly newsletter to publish on these pages and/or arrive in your inbox in the coming days. We hope you find it helpful.