Heading into March, it was beginning to feel as if the markets might revisit the correction lows plumbed in Early February amid still choppy trade. The S&P500 gave back more than -3.5% of its rebound over between February 27 and March 1 with sentiment eroding fast on the back of protectionist and trade-war rhetoric emanating from the Trump administration. That may still occur, but interestingly while the fury over trade-related tension remained elevated throughout last week and is still top of mind for many, financial markets began behaving better. In fact, the S&P500 managed to stage several mid-day reversals and close appreciably higher in 4 of the 5 days last week; the full-week experience was actually one of the best so far in 2018. The S&P500 climbed a strong +3.5% with half of that gain occurring on Friday, the 9th birthday of the current bull market (3/9) in concert with what can only be described as a blowout strong employment report for February.
Agitation Overdone – Commentary for March
Early in February the S&P500 and other indexes fell into correction territory. Recall, a correction in the financial markets is a 10% or greater decline from recent highs, which occurred on January 26th. Pullbacks, even in strong uptrends, are historically considered normal. But this was the first drawdown of -5% or more in 404 trading days running since February 11, 2016. Is the correction overdone? Perhaps, but it was probably overdue. Market agitation was brought on by 3 occurrences – feelings that valuation was stretched; a big jump in volatility; and uncertainty about inflation (more below). Also, many investors remain concerned that valuations are stretched, and they became shocked by increased volatility following 23 months of calm and steadily rising stock prices.
Rebound Continues Helping Narrow Early-February Drawdown – Week Ended 2/23/18
Following what was easily the sharpest and most stressful drawdown the markets experienced in the last two years, foreign and domestic equity markets are managing to fight their way back in recent weeks, dramatically narrowing the loss that was built in early-February. Volatility, remains more elevated than witnessed during virtually all of 2017 due to bond yields that have risen materially on the worry about rising inflation. But since February 9, the S&P500 is up almost +5%. With the rebound so sharp though and the pullback relatively short-lived, the biggest questions in our mind are: was that really the extent of the correction (seemed too short, even if it was panicky and nerve wracking); and secondly, will the market actually manage to finish roughly flat for the month? Writing today with the markets again notably higher, it seems the race is on, but barring a sharp selling between here and Wednesday it would seem the market has achieved a highly unexpected and HUGE moral victory and seeming credibility to participants such as us who believe the pullback was largely an overdue technical correction rather than a meaningful change to the positive underlying economic fundamentals.
Stocks Cross Technical Threshold of Correction – Week Ended 2/9/18
As bad as the prior week felt, the 5 trading days ending Friday February 9 were even worse with the S&P500 experiencing two selloffs approaching of around -4% each on Monday and Thursday; the 2nd brought the peak-to-trough giveback from January 26 to more than -10% and crossed the threshold for what is technically defined as a correction. It is crazy to think it was just Jan 26 when the major US indexes and client portfolios hit fresh all-time highs and retail investors seemed to be charging head-first into equities for apparent fear of missing out. How different the mood suddenly feels. Still, we are not in any way surprised to be seeing the market finally experiencing pressure. It was overdue and arguably healthy; weve been de-risking client portfolios in anticipation of such via some tactical adjustments and rebalancing efforts; those adjustments are helping as client portfolios are off nowhere near as much as the major indexes.
As We Now In a Good News is Bad News Market? – Week Ended 2/2/18
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.
Great Rotation Finally Upon Us? – Week Ended 1/26/18
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.
Racing Higher, But Pace Seems Impossible to Sustain – Week Ended 1/19/18
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.
The Climb Continues in Early 2018 – Week Ended 1/12/17
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.
S&P Logs First Perfect Year Ever – Week and Year Ended 12/29/17
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.
With 9 Days Remaining, Will Santa Give This Market Even More – Week Ended 12/15/17
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!