MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

A Milestone and Turkey Talk

It’s been a long-running bull market. Born in the depths of the Great Recession, the current bull market, as measured by the S&P 500 Index, has sidestepped a bear market since bottoming on March 9, 2009 at 676.53 (St. Louis Federal Reserve). A bear market is generally defined as a 20% drop or more. The widely followed index closed August 31 at 2,901.52 (WSJ).

On August 22, the current bull market extended its run to 3,453 calendar days (CNBC), taking the crown away from the previous champion, the run-up of the 1990s – see Figure 1. In some respects, it’s just a date. But it’s also a milestone.

As Figure 1 illustrates, lengthiest doesn’t necessarily mean best performing. That title still resides with the October 1990 – March 2000 bull market. It’s trough-to-peak return totaled 417% vs today’s run, which through August 31, has amounted to 329%.

More importantly, investors who have adhered to a disciplined approach that includes a diversified stock portfolio have been rewarded.

Sure, there have been times when the bulls have been knocked off balance. Greece, European financial woes, China anxieties, and the collapse in oil prices forced corrections of at least 10% since 2009.

An uptick in Treasury bond yields earlier this year pushed investors to the sidelines. What may have been a modest dip turned into a 10% correction when products tied to market volatility exacerbated selling.

While some sectors have suffered, trade frictions also caused jitters but have yet to trigger a significant slowdown in the U.S. Given strong profit and economic growth, low interest rates, and low inflation, investors have once again focused on the medium- and long-term drivers of stock prices – the favorable economic fundamentals.

Let’s talk Turkey

From time to time, a tremor from an overseas incident reaches our shores and impacts our markets. In most cases, when we look back at the event, it barely creates a ripple at home. It’s a footnote in market history few remember.

Russia’s invasion of Ukraine four years ago was a one-day market event. The U.K.’s Brexit vote in 2016 jarred investors for a couple of days, but that was about it. Europe’s financial turmoil in 2011 created waves. But in each case, none of these incidents caused significant harm to the U.S. economy.

In each case, cooler heads prevailed, and longer-term investors, those who stuck with a disciplined approach and avoided the temptation of an emotional response, were rewarded.

That leads us to the nation of Turkey. Problems have been simmering for a long time in Turkey. Last month, U.S. investors reacted when President Trump tweeted he wanted to double steel and aluminum tariffs on the struggling nation. It was like lighting a match in an already parched forest.

The lira, which has already begun to sag, quickly extended losses – see Figure 2. The Financial Times reported the European Union was concerned that some banks might have too much exposure to Turkey, and shorter-term investors were quick to react – at least for one day.

It’s not that a currency crisis can’t lead to what’s called “contagion,” when a financial crisis in one corner of the globe spreads. We saw that in 1998 when Russia defaulted. But odds of such an event are low.

Turkey’s problems have been in the making for years. It has borrowed too much money – much in dollars – to grow its economy. If borrowed in dollars, interest accrues in dollars, and loans must be repaid in dollars. Rising U.S. interest rates and rising inflation in Turkey conspired against the lira.

A lower lira means it’s costlier to convert lira into dollars, i.e., the debt level effectively rises, making repayment more difficult. In turn, a crisis of confidence develops, encouraging foreign investors to dump the lira, and a vicious downward cycle ensues.

Issues in other troubled areas also bear watching. Argentina comes to mind. But bottom line, it was a one-day selloff that amounted to less than one percent, and attention quickly returned to the positive economic fundamentals.

As we approached the end of August, the S&P 500 Index, the NASDAQ Composite, and a number of other key indexes rose to record highs (MarketWatch, various sources).

Given the negative headlines generated by trade frictions and emerging market woes, economic growth + profit growth + low interest rates have gone a long way in underpinning stocks.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Entering the Second Half of the Year with Momentum

The U.S. economy just recorded its best quarter in nearly four years. Gross Domestic Product (GDP), which is the broadest measure of the value of a country’s economy, grew at an annual pace of 4.1%, according to the U.S. Bureau of Economic Analysis – see Figure 1.

We’ll get two more revisions over the next couple of months, but the early read is encouraging.

Without trying to minimize the good news, it’s important to point out that the GDP report is old data. It’s a snapshot of April – June. We’re entering August, which leads us to the next question. Was Q2 a one-time event, or are we entering a higher orbit of growth?

We’ve had false starts before – bursts of activity followed by a slowdown. And the trade war with U.S. trading partners is creating uncertainty.

Figure 2 illustrates that GDP, when measured on a year-over-year basis, has consistently and gradually accelerated for eight-consecutive quarters. It points to momentum.

Consumer and business confidence remains strong, and tax cuts, fiscal stimulus, and regulatory relief are likely to encourage economic activity.

While growth in Q3 and Q4 may not match Q2’s 4.1% pace, there are reasons for cautious optimism as we push into the second half of the year.

The big picture

Economic growth is beneficial in many ways. It creates jobs and new opportunities. While wage growth hasn’t been robust, a growing economy is necessary for wages to rise.

For savers, the expansion has finally started to lift interest rates, albeit at a gradual pace. For investors, economic growth is the engine of profit growth. And profit growth is the biggest factor that drives stocks higher over the longer term.

Q2 earnings season has been marked by several themes. Some companies have fretted about higher raw material costs, higher freight costs, and the negative impact of tariffs.

A couple of high-profile disappointments in the social media space generated recent volatility in the NASDAQ Composite, which for much of the year has been the beneficiary of tech outperformance. But these misses were mostly company-specific and not tied to economic weaknesses.

Thanks to the cut in the corporate tax rate, from 35% last year to 21% this year, Q2 earnings growth is very strong – see Figure 3. But let’s not discount U.S. economic growth either. By and large, forecasts being issued by companies for the rest of the year have generally been upbeat (Thomson Reuters).

Given the negative headlines generated by trade tensions, economic growth + profit growth + interest rates that remain near historic lows have gone a long way in propping up stocks.

It suggests that investors aren’t experiencing too much anguish over the ongoing trade war. Or, it’s possible investors are underestimating the economic impact. Possibly, they expect the U.S. to prevail, or they simply don’t believe a trade war, even if extended in length, will have that much of an economic impact.

It has created some day-to-day volatility, and additional choppy action can never be ruled out. But the economic fundamentals continue to lend support.

As July came to a close, the S&P 500 was up 5.34% since the end of last year. It’s not earth-shattering, and it almost feels puny compared to last year’s exceptional performance. But if it were possible to extend the year-to-date gain through December, the S&P 500’s return would end up near its long-term annual average.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Nine Years Old

The economic recovery began in July 2009 – that according to the National Bureau of Economic Research, the official arbiter of recessions and economic expansions. A quick review of the math, and it means the current expansion just turned nine years old, or 108 months.

Let’s put that into perspective. We’ve surpassed the long-running expansion of the 1960s by two months. We’re within striking distance of the all-time longest expansion, which ran through the 1990s and lasted exactly ten years – see Figure 1.

It has not been an impressive economic recovery – see Figure 2. The graphic illustrates it has been the weakest since at least 1950 (the U.S. government began collecting quarterly data in 1947). But it’s probably one reason for its longevity.

You see, fast growth can sometimes force the Fed to quickly hike interest rates, which can stifle the economy. Or, it can create speculative excesses – economic booms – that sow the seeds of the next recession. We experienced that in the late 1990s.

Besides the general slowdown in growth post WWII, two things stand out.

First, recessions are typically short interruptions in what otherwise has been a long-term upward trajectory for the economy. Second, the 2001 recession was so shallow, it failed to produce a year-over-year (y/y) decline in GDP. In fact, the U.S. economy generated an uninterrupted period of y/y GDP growth that lasted nearly 17 years!

Still, growth stalled in 2001, the jobless rate rose, and the shallow recession was enough to prick the bubble in stocks, which had become extremely overvalued.

The current cycle is no longer young, and it generally leads to concerns that a recession could be lurking. Importance to investors: recessions and bear markets historically go hand in hand.

But is a recession in the next year inevitable? Not necessarily. Optimists, led by Byron Wien, the respected vice chairman of Blackstone, said in his July commentary be believes the current cycle “has at least several more years left to run.”

Bolstering his case, inflation is gradually moving higher but remains low, and wages are up but aren’t accelerating at a fast clip. Both factors are keeping the Federal Reserve from hiking interest rates too quickly. Moreover, fiscal stimulus, including the recently enacted tax cuts, is in the pipeline.

While Mr. Wien’s confidence isn’t shared by all analysts, most short-term leading economic indicators aren’t suggesting a recession will ensue this year or early next year.

Looking ahead and the upcoming election

Last year’s strong rally carried over into 2018 but quickly ran into a brick wall when longer-term Treasury yields tracked higher. The Dow Jones Industrials and the S&P 500 Index have failed to recapture January highs, but the tech-heavy NASDAQ Composite and closely followed measures of mid-sized and smaller-sized companies did set new highs in June (MarketWatch data).

As the month came to a close, escalating trade tensions have hampered sentiment, especially as it relates to large multinationals, whose reach extends around the globe.

An all-out global trade war would constitute a threat to U.S. and global economic growth and counter the economic stimulus from the tax cuts. So far, however, retaliatory actions have been measured.

While difficult to quantify the direct impact, the upcoming midterm elections may be creating headwinds. Yes, economic growth and corporate profits are a big factor in the longer-term direction of stocks, but political uncertainty can sometimes translate into shorter-term investor angst.

A recent study published in the Wall Street Journal found that since the creation of the Dow Jones Industrials in the late 1890s, the oldest and best known of the market indexes has produced “an annualized gain of just 1.4% in the six months before midterm elections, in contrast to a 21.8% annualized return in the six months thereafter.”

The study noted the pattern was not as pronounced during presidential elections. It didn’t repeat itself during non-election years. Of course, these are just averages. Economic and international factors may come into play, and each cycle has its own unique features.

We enter the second half of the year with a modest pullback in global economic momentum, but growth at home remains strong. Corporate profit growth is likely to remain strong this year and moderate in 2019, while low interest rates, and a low level of inflation – at least for now, have helped counter the headwinds created by the ongoing spat in trade.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

The Shifting Winds of Sentiment

Market sentiment can be fragile. There are times when there is unbridled enthusiasm. Then, we may get a change in a key metric, and it’s as if everyone who was on one side of the boat runs to the other side.

In a way, that’s what happened when investor sentiment shifted between January, when shares were hitting new highs, and early February, when investors turned the tables.

If we look to the economy, nothing much has really changed. Sure, the winds of protectionism whipsawed sentiment earlier in the year, and tensions haven’t dissipated. But first quarter profits came in much better than expected (Thomson Reuters), and the jobless rate fell to 3.8% in May (U.S. BLS).

If we’re basing the outlook on the economy and profit growth, the fundamentals are sound.

Over the last month, larger company stocks have stabilized and moved away from recent lows. It’s another shift in sentiment.

It’s been even brighter for smaller-company stocks, with a key index hitting an all-time high in late May, according to MarketWatch.

There are times when it’s difficult to pinpoint the exact reason why shares drift in a particular direction. When investors implement buy or sell decisions, there isn’t a space on the ticket entitled, “reason for stock transaction.” But we can scan the investment landscape for signs.

Like a detective solving a riddle, we can gather clues and reach a reasonable hypothesis. For starters, investors appear to be adapting to the idea of a 10-year Treasury yield around 3%. The growing economy, which supports corporate profits, helps to offset any headwinds from higher rates.

Company stock buybacks, or companies that repurchase their shares on the open market, jumped to a record pace in Q1 (Figure 1). That’s expected continue in the current quarter (S&P Dow Jones Indices).

Additionally, legendary investor Warren Buffett said in a CNBC interview in early May that he was actively buying stocks in the first quarter.

It’s not that Mr. Buffett can’t make a mistake. He can as no one is infallible. Buffett has repeatedly said he doesn’t try to time the market, but an investor of his stature, and one whose long-term record of success speaks for itself, provided a degree of comfort and soothed anxious nerves.

Meanwhile, smaller companies don’t have as much international exposure, reducing potential damage from rising tariffs. Reduced exposure overseas limits any headwinds from the recent rise in the dollar.

As the winds of sentiment shift, it’s a good reminder that longer-term investors should be careful about being bounced around by short-term changes in investor psychology. Market timing is rarely a successful strategy.

Italy stirs

As the end of the month approached, a hiccup in Italy created tremors that reverberated through global markets.

First, a little bit of background – Europe has been dealing with various banking and financial problems since the beginning of the decade. We’ve seen flare-ups in Greece, Spain, Portugal and Cyprus. A couple of years ago, markets grappled with the short-term fall out when U.K. voters decided to exit the European Union, i.e., Brexit. Over the last year, faster growth in Europe has pushed anxieties to the backburner.

Over the Memorial Day weekend, the president of Italy rejected the appointment of the finance minister from the newly elected coalition government because of a perceived bias against Italy’s use of the euro as its currency. The newly chosen prime minister (not to be confused with the president) abruptly resigned.

While attempts are being made to salvage the current coalition, new elections can’t be ruled out.

The reaction in Italian bonds was swift, with yields surging (Bloomberg), while global markets temporarily took it on the chin. The overriding concern – Italy could dump the euro.

Unlike Greece, Italy is the eurozone’s third-largest economy. Though its debt is high, it’s not in need of a bailout as was the case with Greece. But a rejection of the euro would have huge ramifications in Italy. Cash would likely flee the country, collapsing Italian banks and roiling the European financial system.

It’s an unpleasant prospect, but rejection of the common currency is not something voters in Italy have been clamoring for. Cooler heads quickly prevailed.

The economic consequences strongly suggest that odds Italy will reject the euro are low. But the latest drama is a reminder that Europe’s financial struggles are simmering near the surface. At times, tensions in Europe can create volatility in U.S. markets.

Housing reclaims a prior peak

For some cities, home prices have been in record territory for quite a while. But this marks the first time a key measure of U.S. prices has surpassed the 2006 peak – see Figure 2 blue line. It took almost 12 years.

Unlike the prior decade, when speculators and easy lending standards helped create a buying frenzy that fueled price increases and home building, conditions are different today.

Underwriting standards are stricter and home builders have been reluctant to build smaller, starter homes. In some locales, bidding wars have broken out, especially at lower price points. Additionally, price increases (red line, Figure 2) have been reasonably steady. Gone are the days when prices were marching up at unsustainable, double-digit rates.

While rising mortgage rates could slow the housing market, today it is more about the lack of supply, as noted by statistics from the National Association of Realtors.

The lack of supply has created a challenge for buyers and has impeded sales in some markets. But overbuilding, which has historically been a prerequisite for a bubble, isn’t a problem right now. The problem in many markets is a lack of available homes for sale.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Competing Forces

Since stocks rolled over near the end of January, there has been a sharp pickup in volatility – big gains on some days and big losses on others. But the selloff since the January 26th peak has been modest. Index April Return* 2018 YTD Return %

The Dow Jones Industrial Average®, which is the oldest and best known of the market averages (made of 30 large, well-known firms), is down 9.2% from its closing high as of April 30 (St. Louis Federal Reserve).

The S&P 500 Index®, which as its name implies consists of 500 larger companies, is down 7.8%. In both cases, the declines have been modest by historical standards. While markets trend higher over the longer term, we recognize that bumps in the road are normal.

Last year’s big advance left some investors with a false sense of security. Throw in very low volatility and it’s easy to forget that temporary pullbacks are the norm.

Successfully timing such selloffs – getting out at the top and back in at the bottom – is next to impossible.

We can mitigate risk, but not eliminate it. I understand that dips can sometimes be unpleasant, but they are incorporated into a long-term investment plan designed to reach your financial goals.

While shares aren’t far from all-time highs, we have, as noted above, experienced a much greater degree of volatility compared to 2017. Figure 1 highlights such volatility.

Through all of 2017 and the first month of 2018, the S&P 500 Index registered a daily change of 1% or more just 10 times. Over the next three months, the number of plus/minus daily changes accelerated to 29.

It’s another tangible measure that illustrates we’re seeing wider price swings.

China and the uptick in rates

Trade tensions subsided after China’s president gave a conciliatory speech last month. He didn’t offer much in the way of concessions, but his tone was designed to ratchet down the rhetoric. Still, the issue isn’t going away, and protectionism and the potential hit to U.S. exports remains a concern as deadlines loom.

Unlike the steel and aluminum tariffs, even free traders agree China’s trade practices, which include forced technology transfers and restricted access to Chinese markets, are undermining the trading system (Wall Street Journal).

Some will agree with Trump’s approach and others will not, but both agree on the desired outcome.

Stocks have also run into modest resistance amid an increase in interest rates, including the yield on the 10- year Treasury bond.

The yield on the benchmark Treasury breached 3% for the first time since late 2013 – see Figure 2. Most analysts point to forecasts of faster U.S. growth, forecasts that inflation may tick higher, and the belief the Fed will continue to gradually hike the fed funds rate. Projections that point to higher budget deficits may also be playing a role.

At about 3%, the 10-year bond remains at an historically low rate, but the recent rise has injected some uncertainty into the shorter-term outlook.

There is no shortage of academic theory to explain how rates may impact stocks. While an improving economy aids earnings and support shares, let’s avoid the academic weeds and keep things simple: rates that rise too quickly could slow economic growth and compete with stocks for the investors’ dollar.

The big winner – Q1 earnings…so why doesn’t it matter

Q1 S&P 500 profits are forecast to rise an astounding 25.0% from a year ago (Thomson Reuters I/B/E/S as of 5.1.18, with 60% for companies having reported). This compares with a forecast of a still-strong 18.5% on April 1. That’s a significant upward revision.

More firms are beating analyst expectations than ever before (Bloomberg) and are beating by a wider-than-average margin. While strong earnings growth is an underlying support, it’s not fueling further gains.

Trade tensions and rates may be creating some headwinds, but it appears the very strong profit season may have already been priced in. Further, Q1’s upbeat numbers aren’t sustainable into 2019.

For starters, we won’t be getting another reduction in the corporate rate next year. However, earnings growth going forward will be compounded from a higher base.

How that is being priced into shares is unclear, but it is likely supportive of stocks longer term. Still, as we head into May, competing forces are creating volatility and have been keeping shares in a range.

If you any questions or have any items you would like to discuss, please feel free to reach out to me.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

A Tale of Two Cities

The first quarter of 2018 can be placed into two distinctive camps. Market action in January was a continuation of 2017, with investors pricing in sharp upward revisions to 2018 profit estimates (Thomson Reuters). But the tide shifted in February and March, with volatility replacing relative tranquility.

Did you know the S&P 500 Index snapped its longest streak without a back-to-back daily 0.5% decline at the end of January? That’s right – 310 trading days without two consecutive pullbacks of at least 0.5%, according to the research firm Bespoke Group. It was nearly double the prior streak.

The lack of volatility, which can create complacency, was nearly unprecedented. Yes, volatility sometimes leads to uneasiness. I get it. We take various precautions to reduce risk, but the return required to reach your financial goals requires some risk, or what might be called a calculated risk.

Figure 1 highlights the path of the broad-based S&P 500 Index since the bull market began. It has been a profitable trend for a diversified investor, but one that has included five market corrections of at least 10%.

That 10% pullback from the record-closing peak on January 26 took just nine trading days, the shortest such peak to 10% correction on record (LPL Research) – see Figure 1.

The initial selloff was sparked by a rise in the yield on the 10-year Treasury bond. The drop was exacerbated by investment products tied to market volatility. Without getting into all the minutia, too many speculators piled into a trade that bet the lack of market volatility would continue.

When stocks swooned in early February, the unwinding of the “volatility trade” aggravated what likely would have been a very modest decline. That trade eventually unwound, but we were treated to another round of instability when President Donald Trump surprised investors by announcing steep tariffs on steel and aluminum imports – tariffs designed to pry open foreign markets to U.S. goods.

Protectionism has always been a risk that could create instability, as Trump had campaigned on the issue. New barriers to imports had been placed on the backburner in 2017. That has changed.

The reason for worries—steel and aluminum tariffs raise U.S. manufacturing costs, hinder new projects, and may encourage some firms to move production offshore. Newly erected barriers can also spark a tit-for-tat trade war as other countries retaliate against U.S. exports, slowing economic and profit growth.

It’s a scenario that creates heightened uncertainty and has added to the volatile daily market swings.

The ebb and flow of risk

Stocks have a long-term upward bias that will be interrupted from time to time by various issues.

Early in the economic recovery, investors fretted about Greece, the expanding debt crisis in Europe, and the loss of the USA’s triple-A credit rating by Standard & Poor’s. During late 2015 and early 2016, a slowdown in China’s growth, an unexpected devaluation of China’s currency, and the collapse in oil prices threw investors a short-term curveball.

Volatility reentered the investment landscape in February after an unusually quiet period in 2017. Table 1 highlights the daily percentage changes in the S&P 500 Index over various periods.

In the 13 months that ended in January, the daily percentage change in the S&P 500 (up or down) was just 0.31%. That compares to a daily percentage change of 0.55% over the last five years.

Note the much larger average move in February and March. For comparison purposes, I’ve also included 2011, when stocks last experienced an extended period of volatility.

Final thoughts

Volatility can be unnerving, but recent action illustrates it is not unusual. The economic fundamentals remain solid, including economic growth, profit growth, still-low interest rates, and recent announcements of large stock buybacks by various firms (Wall Street Journal).

Stock market corrections of at least 10% are inevitable. But the fundamentals have helped to cushion the decline.

As a note by LPL Research recently pointed out, “Corrections (10% or greater declines) are never fun, but they also aren’t new territory for investors. Prior to the most recent example, we have experienced 36 corrections since 1980, and the S&P 500 fell by an average of 15.6% from peak to trough during these periods.

“Twelve months later, the index made up some ground, rising an average of 16.0% from the low, and after 24 months, the S&P 500 had climbed by an average of 28.0%, reinforcing the need for long-term investors to maintain their diversified strategies.”

Please feel free to reach out to me if you any questions or have any items you would like to discuss.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

The Super Bowl and the Stock Market

Did you watch the Super Bowl last month? If you did, you were treated to a thrilling offensive contest that left the winner in doubt until the final seconds had ticked off the clock.

What may have been the deciding play in the game – a late fourth quarter assault by a Philadelphia Eagles defensive lineman, who managed to strip the ball from New England quarterback Tom Brady. In a game practically devoid of sacks, it proved to be a costly turnover, and one that came without warning.

The same can be said of the drop in the S&P 500 Index, which accumulated in a 10% decline in just nine-short trading days (St. Louis Federal Reserve). We know volatility is always possible. It’s something I explicitly alluded to in last month’s update—

Since 1950, the average intra-year pullback in the S&P 500 has been 13.6%, with 91% of intra-year declines of at least 5%, and 54% of at least 10%, according to LPL Research.

Like Brady’s fumble, timing such an event is practically impossible.

The initial selloff can likely be tied to an uptick in Treasury bond yields. But the selloff was exacerbated by computer-program trading AND complex trades that were highly leveraged and tied to investment products, which rise when market volatility is low.

Few understand the intricacies of these products (and risks), but regulators are reportedly investigating them, according to Bloomberg News.

The so-called “volatility trade” appears to have unwound, but, against the backdrop of economic momentum and modest inflation concerns, investors are turning their attention to interest rates and bond yields. Note: interest rates tend to rise when economic growth is stronger and/or inflation worries surface.

Stock performance in rising rate environments – an historical perspective

Past performance is not a guarantee of future performance, but what has occurred is the past is worthy of review as it may be used as an educational guide.

Conventional wisdom suggests rising interest rates are bad for stocks, because it decreases the relative attractiveness of equities. In other words, a rise in interest rates may siphon some funds away from stocks.

As Figure 1 highlights, on average, stocks have risen in both rising and falling rate environments, but rising yields on the 10-year Treasury bond have, on average, reduced gains.

Longer term, growth in corporate profits is a strong underlying support for stocks, helping to offset headwinds from rising yields, at least in most cases – see Figure 2.

So, let’s take our example one step further and break rising yields into four categories: big declines in rates, modest decline in rates, modest increases in rates, and big increases in rates.

As Figure 2 illustrates, stocks faced the stiffest headwinds when the 10-year Treasury yield recorded its biggest average monthly increases.

But, let’s add one more wrinkle to the empirical data. S&P Dow Jones Indices also pointed out, “Between 1954 and 1997, falling rates accompanied rising stock markets 80% of the time. Between 1998 and 2012, falling rates were associated with rising stocks only 27% of the time.”

In recent years, historically low interest rates have sometimes been associated with heightened uncertainty. And periods of heightened uncertainty created stronger headwinds for shares.

While we can never discount the possibility that rising rates, or other factors, might fuel shorter-term volatility, with the exception of steep rate increases, 60 years of data suggest that, on average, rising yields have not prevented longer-term stock market gains, as economic growth lent support to profit growth.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Stock Roar in January

January came in like a lion. The broad-based S&P 500 Index registered 14 new closing highs while the Dow racked up 11 (St. Louis Federal Reserve). It’s an impressive start to the new year, but I believe it’s fair to say that the current pace is not sustainable.

Many of the factors that have supported stocks over the last year remain in place, including solid economic growth at home and overseas, an acceleration in profit growth (Thomson Reuters), still low interest rates, and low inflation as measured by the Consumer Price Index.

A remark in last month’s newsletter…

“Might we see a selloff early in the new year? It’s possible, if investors book 2017 stock profits in tax year 2018. Following 2013’s outsized 30% gain in the S&P 500 (St. Louis Federal Reserve), shares went sideways in the first three weeks of 2014, then slid 6% over the next couple of weeks.”

… did not materialize in January.

But the upward lurch in stocks was primarily driven by the dramatic reduction in the corporate rate from 35% in 2017 to 21% this year and beyond, in my view.

The chart below illustrates the almost unprecedented rise in quarterly profit estimates by analysts – Figure 1.

I’ll explain. Analysts were estimating an already-strong 12.2% increase in Q1 2018 S&P 500 profits on January 1 (Thomson Reuters). By month’s end, analysts had raised their forecast to 17.2%. That’s an astounding 5-percentage point increase in earnings estimates in just one month.

And we’re not simply witnessing the increase in Q1. It’s across the board.

With analysts sharply hiking profit forecasts, investors quickly priced in a much rosier earnings outlook. Hence, the sizable gains in stocks we saw as the year began.

Legendary investor Warren Buffett summed it up this way in a CNBC interview in the middle of last month. He called it the equivalent to a “silent shareholder,” in this case the U.S. government, giving up a claim to profits to other shareholders.

“You had this major change in the silent stockholder in American business, who has been content with 35%…and now instead of getting a 35% interest in the earnings (he noted foreign earnings from U.S. firms are more complicated) they get 21% and that makes the remaining stock more valuable,” he said.

Of course, one could ask – are analysts overestimating the impact from tax reform? Probably not, but it’s an open question because we haven’t had business tax reform of this magnitude in over 30 years.

One cloud on the horizon

Stocks may not be priced for perfection, but they are priced for many positive events. It leaves less room for disappointment.

As stocks have surged in January, we’ve experienced an upward creep in bond yields.

In particular, the 10-year Treasury bond is reacting to the possibility that inflation will gradually accelerate this year, economic growth will continue at a solid pace, and global central banks may become less accommodative. Note: Treasury bonds have historically performed well in low-inflationary, low-growth environments (bond prices and bond yields move in opposite directions).

A rise in the 10-year yield to its highest level in almost four years created modest jitters in shares as the month ended – see Figure 2.

It’s a reminder of something we already know—markets can experience bouts of volatility. Since 1950, the average intra-year pullback in the S&P 500 has been 13.6%, with 91% of intra-year declines of at least 5%, and 54% of at least 10%, according to LPL Research.

It’s simply a reminder that markets, which have a longer-term upward bias, do experience turbulence.

If you have any questions or concerns, I’d be happy to discuss them with you. I’m just an email or phone call away.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Running of the Bulls

The bulls took charge the day after election day, keeping the bears on the defensive throughout 2017. A GOP that controlled all three branches of government ignited early optimism among investors, who had expected easy passage of economic-friendly policies. But instead, gridlock kept investors on pins and needles until year-end, when Congress enacted a dramatic cut in the corporate tax rate and modestly shaved tax brackets for individuals.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC

Whatever your thoughts are about the president, investors are bipartisan. The long-term focus is on the economy and profits, i.e. the fundamentals. Investors really don’t care which party supports investor- friendly policies. Yes, there are important issues beyond the markets, and elections have consequences. But purely through the narrow prism of the market, it’s the economic fundamentals that matter.

For much of the year, improving economic fundamentals fueled bullish sentiment, sparking 71 closing daily highs for the Dow – a record (MarketWatch). Let’s review—

1. Profit growth accelerated (Thomson Reuters).
2. A synchronized global expansion created additional tailwinds for corporate profits.
3. Global growth has accelerated, as noted by the IMF’s October outlook.
4. Consumer confidence (the Conference Board) hit its best reading since late 2000.
5. Small business confidence recorded its second-best reading in over 30 years (NFIB).
6. The Unemployment Rate fell to 4.1% (U.S. BLS).
7. Gross Domestic Product in the U.S. recorded two-straight quarters above 3.0% (U.S. BEA).
8. Inflation in the U.S. remains low (Consumer Price Index—U.S. BLS).
9. U.S. interest rates remain low, and are currently expected to rise gradually.
10. Leading indicators put odds on a near-term recession at a low level.

Put another way, it’s the perfect receipt for last year’s impressive advance.

One more interesting aspect of last year’s rally: there was little volatility. The biggest dip of the year for the S&P 500 totaled 2.8%, the smallest since 1995’s 2.5% (LPL Research). Since 1950, the average intra-year pullback has been 13.6%. It’s a timely reminder that a modest pullback in 2018 can’t be ruled out.

A look ahead

The economic outlook heading into 2018 hasn’t been this upbeat in years, as the U.S economy finished 2017 with momentum.

Moreover, the synchronized upturn in global growth not only aids the U.S. economy, it has been a big support for earnings of U.S. multinationals, according to FactSet Research. A reduction in the corporate tax rate is set to support earnings longer term, but it’s unclear how much has been priced in by investors.

I’m never one to throw caution to the wind and perspective is in order. Figure 1 illustrates annual winning streaks for the broad-based S&P 500 Index. We’re one year away from tying the record for consecutive annual advances going back to 1947 – see Figure 1.

Figure 2 offers another comparison. It highlights the six longest bull markets since WWII and their respective advances.

The current bull market is the second longest in both longevity and performance.

By itself, the second longest bull market since WWII creates an air of caution, but bull markets don’t die of old age or enter a danger zone based only on past performance. The end of a bull market has historically correlated with the onset of a recession. Since the late 1960s, only one bear market – the 1987 Crash – did not align itself with a recession – see Figure 3.

Still, any number of events not directly tied to the economic fundamentals could spark a bout of volatility.

Might we see a selloff early in the new year? It’s possible, if investors book 2017 stock profits in tax year 2018. Following 2013’s outsized 30% gain in the S&P 500 (St. Louis Federal Reserve), shares went sideways in the first three weeks of 2014, then slid 6% over the next couple of weeks. Yet, the year finished higher.

Bigger concerns would surround the fundamentals. If inflation were to unexpectedly heat up, we could see a more aggressive Federal Reserve, one that deviates from its currently stated path of gradual rate increases. Odds of an unexpected jump in inflation are low, but keep an eye on oil prices, which have topped $60 per barrel for the first since June 2015 (St. Louis Federal Reserve).

However, a Fed that turns more aggressive in response to a spurt in economic growth is less of a concern, in my view, since a robust economy would lend added support to corporate profits. Of course, any unexpected economic slowdown would likely create a stiffer headwind for earnings and stocks.

For those who enjoy looking at probabilities, a 20%+ advance in the S&P 500 in one year does not necessarily mean we’ll see a pullback the following year.

Excluding 2017 (up 21.83% including dividends reinvested—S&P Dow Jones Indices), there have been 24 years in which the S&P 500’s annual performance has exceeded 20% (including dividends reinvested, New York School of Business S&P 500 data). The following year saw the S&P 500 rise 18 times and decline five times.

For long-term investors, it boils down to an investment plan that is rooted in a number of factors, including the economic fundamentals. Shorter term, the fundamentals may not always be positive. But discipline, patience, and investment decisions that don’t spring from an emotional response to disconcerting events have historically been the most efficient path to one’s goals.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Around the World

Last month’s commentary opened with a summary of the number of daily all-time highs recorded by the S&P 500 Index3 – 50 closing all-time highs this year (LPL Research, St. Louis Federal Reserve) through October 31. We can add seven more now that November has come to a close.

Shorter term, improved odds the GOP tax bill will squeak through the Senate fueled gains at month end. But let me quickly add the bill still has hurdles that must be cleared before becoming law. Longer term, it’s still all about the economic fundamentals.

November’s commentary also highlighted more upbeat prospects for the U.S. economy. But that is only part of the narrative. To paraphrase the late Paul Harvey, “Now it’s time for the rest of the story.” And one that has an international flair.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC, London Bullion Market Assoc
* Monthly: October 31, 2017 – November 30, 2017

“Growth in Global Economy is Robust,” said a November 29th story in the Wall Street Journal.

The Journal referenced the latest economic outlook provided by the Organization for Economic Cooperation
and Development (OECD) – an international group made up of 35 countries, including the U.S.

This year we’re seeing growth accelerate in the U.S., Europe, China and Japan, according to OECD data. While challenges remain, “Global growth is projected to improve slightly in 2018, but remain below the pace of previous recoveries,” the OECD said.

The October 2017 World Economic Outlook from the International Monetary Fund (IMF) concurs, adding that emerging and developing economies should see economic growth accelerate from 4.6% this year to 4.9% in 2018. Emerging and developing economies expanded by 4.3% last year. It’s an encouraging trend.

But let’s take a moment to dive a little bit deeper. Yes, it’s a brief dive into the weeds, but it illustrates an important point.

Figure 1 offers a great summary of what’s transpiring globally. Figure 1 illustrates whether fixed investment is rising or falling in 45 countries. A quick side note is in order: Fixed investment is a wonky term that primarily refers to spending by businesses on buildings and equipment.

The expansion or contraction in spending by businesses is significant because it is an important driver of economic growth. We see that spending plummeted during the 2009 recession. That’s not a surprise.

We also see a rebound as the global economy exited the recession. But heightened uncertainty following the financial crisis limited the economic upside, that is, until late last year (IMF data).

Currently, all but one country is expected to exhibit growth in 2017 and 2018. That’s impressive.

Put it in terms I understand

Okay, I get it. That was a wonky way of saying that prospects around the world are improving, but I felt it was important to use an obscure piece of economic data to graphically demonstrate the big picture.

From a more practical standpoint, faster global growth is translating into faster revenue and profit growth for U.S. companies that have more worldwide exposure – see Figure 2.

Figure 2 also offers us two takeaways. First, a thriving global economy creates a tailwind for earnings, which supports stocks. Second, the synchronized acceleration in activity around the world is a major factor in the upbeat performance of international stocks this year.

While we should never forget that unforeseen events have the potential to inject volatility into the market, including failure of tax reform, the economic fundamentals, both at home and abroad, have lent support to shares.

If you have any questions or concerns, I’d be happy to discuss them with you. I’m just an email or phone call away.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Melt-Up

The Dow Jones Industrial Average1 ended October near a record high. The same can be said of the broader-based S&P 500 Index3, which is a measure of 500 large publicly-traded U.S. companies.

Failing to end the month at a new high isn’t material. You see, through 10.31.17, the S&P 500 Index has recorded 50 closing all-time highs (LPL Research, St. Louis Federal Reserve). Notably, 20 have occurred since September 11, and eleven occurred in the month of October. It’s an impressive run.

Statistically speaking, September is the market’s weakest month (St. Louis Federal Reserve), while October has historically had a ghoulish reputation. Well, that didn’t happen this year.

Simply put, the fundamentals that have driven the rally remain in place – modest/moderate economic growth which is supporting corporate profit growth.

At the end of October, the U.S. BEA reported Gross Domestic Product (GDP), which is the largest measure of economic activity, grew at a 3.0% annualized pace in Q3. It was the second-straight quarter growth has met or exceeded 3%. It’s something we haven’t seen since 2014 – see Figure 1.

Just as important, we’re witnessing a synchronized acceleration in global economic growth. China is expanding at a brisk pace, while activity in Europe and emerging markets have accelerated. Even Japan’s much-maligned economy has been experiencing more consistent economic activity.

Why should U.S. centric investors care about the overseas economy? S&P Dow Jones Indices estimates that S&P 500 companies gathered 43.2% of sales from overseas in 2016.

S&P is quick to point out this is only an estimate because not all entities break out sales based on geography. Still, an estimate north of 40% is significant. So, it almost goes without saying that a brighter outlook overseas is a big benefit to U.S. multinationals, as we’ve seen from several Q3 earnings reports (CNBC, Bloomberg, various sources).

Need more convincing? FactSet Research estimated last month that companies with more than half of sales outside the U.S. were expected to post significantly higher Q3 profit growth than those that secure more than half their sales at home.

But North Korea hasn’t gone away

It hasn’t. But lately, headlines that might impact shares have been lacking. For that matter, missiles tests have had only a very limited and short-term effect on stocks. We don’t know when an alarming headline may surface, but investors have been discounting anything short of a crisis at the current time.

Discord in Washington? It’s failed to blunt bullish enthusiasm, as investors are rightfully keeping their eyes on the economic fundamentals.

About those new highs

That brings us back to the string of new highs we’ve experienced. One question that typically arises, “Is a new high the time to sell?” By itself, the short answer is “no.”

Nearly four years ago, Josh Brown, writing in the Reformed Broker, posted an inciteful piece that summed it up well. On January 15, 2014, he wrote—

“Just reading or hearing the term (new highs) itself engenders a certain kind of hysteria in people. It suggests that things are about to tip the other way any second, as we all carry within ourselves a cognitive defect known as the Gambler’s Fallacy. We innately believe that random occurrences are meant to balance out over short periods of time. That ten straight coin flips landing on heads virtually assures that a tails flip will be next – despite the fact that the next flip is its own event and nothing that came before it matters.”

The CNBC commentator added, “While our DNA and 100,000 years of evolutionary programming may lead us to believe that a new all-time high is a precarious perch and presages an imminent turn in the other direction, it isn’t ever quite that simple.”

That year, the S&P 500 Index went on to record 53 new, all-time closing highs – see Figure 2.

So, selling the day the market reaches a new high simply means you will probably receive a slightly higher price than if you had sold the day prior. But it doesn’t tell us about tomorrow – or, for that matter, a week, month, or year later.

In reality, anyone who shares his or her thoughts on where stocks are headed next month or next year is only offering a guess. No one owns a crystal ball. Many factors, both known and unknown, will determine share prices next year. The economic fundamentals and corporate profits play a big role, but emotions can sometimes sway sentiment in the shorter term.

A disciplined approach based upon a time-tested investment plan may not completely remove the anxiety we might experience, but historically it has been the best approach to reaching one’s financial goals.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Climbing a Wall of Worries to New Highs

The S&P 500 Index has risen 12.53% since the beginning of the year – pretty impressive. The S&P 500 not only ended the quarter at a record high, it extended its quarterly winning streak to eight-straight quarters (MarketWatch data). As far as September’s reputation for being a weak month, it didn’t happen.

It’s not uncommon to hear some folks credit this year’s runup to the performance of a few large stocks. You see, the S&P 500 Index is what is called a “market-capitalization” weighted index. That simply means that the larger stocks in the 500-company index have a greater influence than the smaller ones. So, strong gains by some large companies are driving most of the returns. Right?

Well, not exactly.

I recently came across a mid-September commentary by Blackstone that pointed out an equal-weighted version of the S&P 500 is up over 8% (at quarter-end, it’s up 10.38% year-to-date, per S&P Dow Jones Indices).

(The equal-weighted S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly. The index includes the same firms as the capitalization-weighted S&P 500, but each company is allocated a fixed weight of 0.2% of the index at each quarterly rebalance. Past performance does not guarantee future results.)

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Quarterly: June 30, 2017 – September 29, 2017

In other words, the good cheer from this year’s bull market isn’t concentrated in just a few large stocks.

Washington, North Korea and hurricanes

What’s interesting, and is surprising to some, is the continued lack of volatility in the market. Political gridlock in Washington hasn’t had much of an impact on investor psychology. The same holds true of rising tensions with North Korea and the devastating hurricanes that slammed into Texas, Florida and Puerto Rico.

Recall the jump in shares immediately following the election. Republicans controlled the White House and Congress.

Investors quickly seized the bullish reins amid expectations that tax cuts were a given, infrastructure spending and a ramp-up in defense spending would soon be in the pipeline, and pro-growth deregulation would be forthcoming. Think of it as a sugar and caffeine cocktail for economic activity.

Trump acted on the deregulation front, but the rest of his agenda seems to be mired in a quicksand known as Capitol Hill.

The rhetorical volley between North Korea and the U.S. has been unsettling, and more is likely forthcoming.

Prepare yourself for that. But it hasn’t had an impact on the U.S. economy.

Moreover, investors are beginning to price in the unpredictability of North Korea’s rogue leader. Taken together, a more meaningful market reaction has been lacking. Without a significant increase in tensions, recent history suggests market impact will likely remain limited.

Lastly, Hurricanes Harvey, Irma and Maria have devastated local communities. While relief efforts are under way and I encourage you to consider donating, the longer-term effect on the U.S. economy is likely to be minimal. Shorter term, it is affecting the data and gasoline prices are up, but rebuilding efforts are likely to lend support in the months ahead.

That said, Republican Congressional leaders and Trump released a blueprint for tax reform at the end of September, but it must wind its way around many Congressional hurdles before it can be enacted into law.

Keep an eye on the fundamentals

Longer term, I can’t put too much emphasis on what drives stock prices – corporate profits and expectations of how corporate profits will perform.

What’s been happening in Washington and North Korea has been barely more than a distraction for investors, as faster economic growth at home and overseas has lifted earnings.

In addition, interest rates remain near historic lows, which reduces competition with stocks. It’s been a powerful tonic that has kept volatility and the bears at bay.

Tax Reform

As September came to a close, the Trump administration unveiled its long-awaited plan to reform the tax code.

The plan is simply an outline, a blueprint that was the byproduct of negotiations between Trump officials and key Republican Senate and House leaders. It’s a framework that is likely to undergo several iterations as it winds its way through the House and the Senate.

With Congress tied to a tight schedule, details may not be finalized until early 2018, if then.

From an investment perspective, the outline was silent in regards to how it will treat dividends and capital gains. In addition, no mention was made of the 3.8% surtax on investment income that hits high-income Americans.

Retirement accounts could undergo changes. There has been some chatter about shifting retirement vehicles toward “Roth-style” accounts, which would eliminate the upfront deduction to income. But at this juncture, anything beyond that is simply speculation.

From a business perspective, the outline lowers the top corporate rate from 35% to 20%, which has been highly coveted by investors. It also allows for a top rate of 25% on business income. But specific language has yet to be written.

Simply put, tax planning becomes extremely tenuous given the high degree of uncertainty. If you have any questions or concerns, I’d be happy to discuss them with you. I’m just an email or phone call away.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

The Stock Market and Earnings

For much of the year, the overall stock market has exhibited an unusual lack of volatility. In fact, one must go all the way back to the week ended September 9, 2016 before finding a Friday-to-Friday period in which the S&P 500 Index fell by more than 2% (MarketWatch closing data for the S&P 500).

At times, the upward climb in stocks has been exciting. At other times, it’s been pretty dull. And maybe that helps explain some of the shrill headlines that have been popping up on financial websites – websites that thrive on clicks and ad dollars.

Those who adhere to a disciplined investment plan, one that focuses on long-term performance, shouldn’t be too concerned.

But we did witness a little bit of volatility creep back into the major indices last month, even as many of these same indices finished the month near record highs.

A heated rhetorical exchange between President Donald Trump and North Korea’s rogue leader created a modest degree of instability earlier in August. But it was short-lived. Uncertainty emanating from Washington may have also rattled a few short-term traders.

What was noticeably absent was the lack of a meaningful market response when North Korea tested a missile that flew over Japan during the last week of August.

Two observations—
First, absent a serious crisis, investors appear to be pricing in North Korea’s unpredictable missile tests. Hence, we saw a muted reaction to what was a very provocative act of aggression.

Second, at least in the shorter term, investors don’t believe the situation will spiral out of control.

In no way am I trying to downplay the seriousness of what is going on. But from a short-term investment perspective viewed through the narrow lens of the market, geopolitical uncertainties just haven’t had much effect on shares.Yes, stocks opened lower the following day but quickly rallied to finish in positive territory.

Earnings, earnings, earnings

Any real estate agent will tell you it’s location, location, location. While short-term market sentiment can be swayed by any number of factors – both positive or negative – longer-term, it’s earnings, earnings, earnings for stock prices.

Sure, interest rates, corporate stock buybacks, the level of inflation, and more play a role, but profits and expectations of future profits are the biggest variable.

With Q2 earnings season set to conclude, companies posted sales and profits that were much better than analysts had expected, according to Thomson Reuters.

Thomson Reuters also reported that S&P 500 profits were up 12.1% from a year ago, the second consecutive double-digit increase. Profits were forecast to rise 8.0% as Q2 ended.

Notably, the four-quarter earnings (not to be confused with an economic recession) recession has ended.

Also, Figure 2 highlights the negative impact from the gyration in oil prices on S&P 500 earnings over the last two years. Still, even if energy is removed (the modest recovery in oil has aided earnings of energy companies), profit growth has been very respectable in recent quarters.

Bottom line – rising revenues and profits, in response to modest growth at home and an acceleration in economic growth around the world, has played a big role in supporting stocks. And it has occurred amid growing tensions with North Korea and dysfunction in Washington.

Simply put, investors have been focused on the fundamentals that drive stocks and have been looking past media-driven headlines.

Speaking of media headlines

Congress must pass and the president must sign a continuing resolution or pass a budget by September 30, or the government will shut down.

Of course, the government doesn’t completely shut down. Military, air traffic control, and other essential services continue, including checks for Social Security and Medicare. But non-essential government employees will stay at home and national parks would close.

Short-term traders get jittery, but the data going back to 1976 suggest any market impact is limited.

There have been 18 government shutdowns since 1976 (NBC News). The worst impact on the market: the S&P 500 Index fell 4.42% (1979). Number two and three, both in the 1970s, saw a drop of just over 3%.

One year following the shutdowns, the S&P 500 was up in 16 of the 18 closures. If we awaken to news on October 1 that we’ve entered the 19th government shutdown since 1976, my sympathies will go out to those who have planned October vacations to America’s beautiful monuments and national parks.

From a market perspective, historically it has had minimal short-term impact and virtually no long-term effect.

The debate over the debt ceiling is another matter. Congress must raise the debt ceiling or the Treasury could default. It’s something that has never happened before. Republican leaders in both the House and Senate have said the ceiling will be raised before the limit is breached, likely in early October.

Bottom line—both narratives could increase volatility in September. While history strongly suggests long-term investors would likely look past a government shutdown, a breach of the debt ceiling, which is unlikely, would send financial markets into uncharted waters.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

The Tortoise and the Hare

Most are familiar with the Aesop’s Fable, The Tortoise and the Hare. It’s a story that teaches that a slow, steady, and deliberate pace ultimately produces success. Without a doubt, the current economic expansion has been slow and steady. There are many drawbacks to its dull pace, but it has one silver lining – longevity.

That brings us to the National Bureau of Economic Research (NBER)? Repeat that name. Just saying it could end a sleepless night. But stay with me, I’m going somewhere with this.

The NBER is the official arbiter of economic recessions and economic recoveries (also called expansions). The organization bases its decision on complex models that take employment, manufacturing, income, and retail and business sales into account.

For investors, recessions and recoveries matter.

The current economic expansion just entered its ninth year. Put another way, it just turned eight years old. How do we know? The NBER marked the end of what we now call the Great Recession as of June 2009.

As Figure 1 highlights, the current expansion is the third longest since WWII, and we’re not far from moving into second place, which brings up a natural question. Is a recession lurking just around the corner?

It’s an impossible question to answer with certainty, as the brightest economic minds have historically done a poor job of calling turning points in the business cycle.

Still, expansions don’t die of old age. They usually come to an end because speculative excesses build up in the economy, such as the tech/telecom boom of the 1990s or the housing bubble in the 2000s.

Or, the Fed cuts off the expansion via rate hikes. The shortest recovery, which lasted only one year, experienced an early demise when then Fed Chairman Paul Volker hiked interest rates in an effort to end years of high inflation. His recipe worked, but the cost was steep – a lengthy and deep recession.

While accurately forecasting the next recession is problematic at best, we can look to leading economic indicators for clues. And most leading indicators aren’t flashing red, suggesting a near-term recession is unlikely.

It’s not that cracks in the economic foundation haven’t appeared, but the lackluster recovery has helped prevent most speculative excesses from building in the economy.

A long running bull

A bear market is typically defined as a 20% drop in a major market index, like the S&P 500 Index. While we came close to a 20% selloff in 2011, we haven’t had a full-fledged bear market since the last recession.

In fact, the current bull market is the second longest since WWII, second only to the bull market of the 1990s, which coincided with the longest expansion on record – see Figure 2.

Given the age of the current run in stocks, it’s fair to ask the same question that might be asked of the current expansion. Is a bear market lurking around the corner?

A recession and the bear market

Figure 3 speaks volumes. Recessions are closely tied to bear markets, or declines in excess of 20%. Why? Longer term, stocks march to the tune of corporate profit growth, and nothing stymies profit growth and expectations of profit growth more than a recession.

We have had only one bear market since the mid-1960s that was not tied to a recession – the one-day Crash of 1987. The 22% decline in the mid-1960s, mild by bear standards, correlated with a sharp slowdown in the economy, though a recession did not ensue.

Conclusions

We can conclude that a recession will inevitably ensue, and we can reasonably conclude the economy will exit that recession. It’s been a pattern we’ve witnessed for over 200 years. We can’t say with certainty we’ll sidestep a 20% selloff absent a recession, but over 50 years of data suggest the odds we’ll experience a bear market outside of a recession are low.

We do see 10%+ selloffs from time to time (four since the bull market began per St. Louis Federal Reserve data), but the belief economic growth would continue prevented a more serious decline.

Based on the historical data, we can say that a steady and deliberate plan, i.e., one that eschews short-term emotional reactions that inevitably envelope investor psychology, enables investors to more effectively reach their long-term investment goals.

Put another way, it’s an alternative version of the tortoise and the hare.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Like Watching the Paint Dry

Have you ever watched a movie or read a book that put you to sleep? One word – boring. It’s a rhetorical question, as all of us have been subject to a plot that failed to inspire.

Well, something similar has been happening to much of the stock market.

An end-of-June Wall Street Journal story started out this way. “Stock market volatility is near an all-time low…”

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC *Quarterly: March 31, 2017 – June 30, 2017

On June 9, CNBC.com reported that one key measure of volatility fell to its lowest reading since late 1993. That low came just after former FBI Director James Comey’s much-anticipated testimony before a Congressional committee. Viewed through the narrow lens of the market, investors just didn’t care.

But boring shouldn’t necessarily be viewed negatively. The Wall Street Journal also pointed out that several major global indexes had their best first-half performance since 2009.

We also see the lack of downside action in the weekly movements of the broad-based S&P 500 Index, which is a measure of 500 large U.S. companies.

Figure 1 highlights the percentage weekly change in the S&P 500 Index – Friday’s close to Friday’s close.

Since February 2016, the index recorded just one weekly decline of greater than 2%. That’s 72 of 73 weeks.

According to LPL Research, it’s the longest comparable streak since “61-straight weeks (all less than 2%) ended in early 1996. The year 1995 is also the last time a full year didn’t have a weekly 2% drop. Since 1950, the S&P 500 has averaged six 2% weekly drops per year.”

Chillin’

There have been several reasons for the complacency, including an economy that isn’t rocking the economic boat, an expanding global economy, a Federal Reserve that continues to signal gradual rates hikes, and global central banks that remain in a very accommodative mode (though the European Central Bank has hinted it may eventually shift gears).

One other reason—the lack of stress in the financial system.

Financial stresses became a big issue in the 2008 financial crisis, when credit market seized up and lending among banks and other institutions nearly broke down.

In the aftermath of the crisis, arguments arose over how to monitor developments in the financial markets.

One tool is the St. Louis Fed Financial Stress Index©. It’s hardly a household name, but it is designed to measure stresses that may be building in the financial system.

It is a compilation of 18 weekly data series, including those that measure lending in the credit markets, volatility of stock prices, and how investors view risky debt such as junk bonds.

As highlighted in Figure 2, conditions are quite easy and are near the lowest levels seen since the recession ended.

There are a number of contributors to today’s “relaxed” mood in the credit markets.

Few leading indicators point to a recession at home, corporate profits are rising, and the Federal Reserve is boosting rates at a gradual pace.

In addition, investors aren’t very concerned about weak spots overseas, including some of the troubled economies in Europe and emerging markets.

Some will argue that complacency precedes volatility, and a more serious downturn in stocks is eventually inevitable.

We have experienced four downturns in the S&P 500 that were greater than 10% since 2010 per St. Louis Fed data. However, in the context of an expanding economy, stock market corrections have historically been viewed as temporary and healthy for the market. That has been the case for such downturns since 2010.

Some will say valuations may be a bit extended, especially in some high-flying tech stocks. However, successfully timing a selloff and re-entering shares near the bottom is a feat that is rarely successful.

Think of it this way. Predicting stock market turns is akin to predicting a fumble in a football game. You know it’s an inevitable part of the game but even a well-respected sports commentator would come up short trying to call such an occurrence.

Baseball great Casey Stengel’s comment, “Never make predictions, especially about the future,” seems quite fitting.

Long-term investment plans, i.e., a financial roadmap, take unexpected detours into account. Markets never move up in a straight line, but those who try to successfully time the ups and down in stocks rarely find such moves to be profitable over the longer run.

If you have any questions or thoughts, please feel free to reach out to me.

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Missing Mojo – Bond Yields Remain Low

The Federal Reserve has hiked the fed funds rate three times since it first raised its key lending rate over a year ago. And a closely watched gauge from the CME Group that measures rate-hike sentiment puts odds of a June increase at 95% as of the last day of May.

Sure, we’ve seen T-bill rates rise modestly and some money funds and CDs have ticked higher, but savers aren’t seeing rates anywhere near where they were before the 2008 financial crisis.

Notably, longer-term bond yields have actually dipped from recent highs – see Figure 1.

There are several reasons why yields haven’t risen much, and we can lay the blame on domestic as well as global markets.

Let’s start with the major central banks

The Federal Reserve has lifted rates but remains very cautious and continues to promote a gradual rate-hike trajectory.

But it isn’t just the Fed. While the U.S. central bank has begun to tighten, major banks such as the European Central Bank and the Bank of Japan continue hold their key rates at or below zero for short-term loans.

Further, neither bank signaled it may soon shift policy.

You see, central banks play an important role in what happens to rates, both in their own countries and in the U.S.

As the month ended, the 10-year German bond yielded just 0.30%, and the yield on Japan’s 10-year bond came in at a scant 0.05% (Bloomberg).

With the U.S. 10-year Treasury above 2%, investors overseas looking for a safe place to park cash can easily boost their yield by buying U.S. bonds, which helps keep a soft lid on U.S. yields (bond prices and yields move in the opposite direction).

U.S. inflation

Long-term bondholders are wary of any whiff of inflation. If the rate of price hikes were to jump, they could easily be stuck in a low-yielding bond whose annual payout doesn’t keep pace with inflation.

But inflation, as measured by the Consumer Price Index and the lesser-known PCE Price Index, remains very low.

The left-hand side of Figure 1 illustrates the 10-year yield is off last year’s low, but it has dropped about one-third of a percentage point from its recent high.

Also, note the recent decline in inflation expectations.

Expectation for inflation is based on the 10-year breakeven rate of inflation, or the 10-year Treasury yield minus the 10-year TIPs yield. It offers a rough forecast for the annual rate of inflation over a 10-year period, as the difference in yield on a TIPs security and a 10-year Treasury represents the yield an investor is willing to give up for protection against inflation.

A U.S. expansion that just can’t get out of second gear

Not only is weak economic growth a headwind to higher inflation, it acts like a magnet for U.S. Treasuries.

If growth were much faster, we’d likely see funds flow out of Treasuries and into more productive investments.

A flight of capital away from U.S. Treasury bonds would drive yields higher. Remember, the price of bonds and the yield move in the opposite direction.

Jump down to Figure 2. It tracks the growth of Gross Domestic Product (GDP), which is the broadest measure of activity for the economy, and compares it with the yield on the 10-year Treasury bond.

Nominal GDP calculates GDP based on current prices. Real GDP, which is how it is typically reported in the media, filters out inflation.

Figure 2 illustrates that the 10-year yield loosely tracks nominal GDP. Put another way, subpar GDP has been a headwind to higher yields.

Currently, nominal GDP might suggest the 10-year yield should rise. But remember, yields around the globe are low, central banks outside the U.S. are in no mood to raise interest rates, and the Fed continues to signal any rate hikes are expected to be gradual.

Bottom line—there are technical factors that also influence the daily inflows and outflows out of bonds.

While volatility in rates can’t be ruled out, the major influences on today’s low-rate environment have yet to abate.

If you have any questions or thoughts, please feel free to reach out to me.

Warmest Regards,

Christopher J. Carroll, CIMA®, CBC®
Founder, Portfolio Manager, and Managing Partner

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

It’s Not Just U.S. Stocks that Have Surged

U.S stocks haven’t been the only winners since election day. Stocks in Europe and around the global have performed admirably against a backdrop of faster economic growth and still-low interest rates.

Since the beginning of November, a major market index in Europe has outperformed the S&P 500 Index3, a key gauge of large U.S. firms – see Figure 1.

An important measure of emerging market stocks fell sharply in the wake of last year’s election. While U.S. markets jumped amid expectations of tax cuts and infrastructure spending, investors snubbed emerging markets, fearing that Trump’s trade policies would punish the economies of developing nations. As Figure 1 highlights, those fears have since subsided.

The Euro Stoxx 50 is an unmanaged index of major European companies which cannot be invested into directly. Past performance does not guarantee future results.

The MSCI Emerging Markets Index is an unmanaged index of companies in developing nations. The index cannot be invested into directly. Past performance does not guarantee future results.

What’s going on? For starters, major global central banks outside the U.S. continue to pour money into the financial system through the purchases of bonds and other financial assets. Two in particular are the European Central Bank and the Bank of Japan, which have yet to hint at increasing rates.

Of course, monetary policy alone doesn’t determine the direction of stocks. The Federal Reserve has lifted rates three times since its rate-hike cycle began, and U.S. shares are near or at record highs. Besides, ultra-low rates, coupled with non-existent growth, would not be a recipe of surging share prices.

More importantly, faster economic activity that fuels growth in corporate profits, is aiding stocks at home and around the globe.

In conjunction with Q1 earnings releases, a number of major U.S.-based industrials, which conduct a large portion of business overseas, have raised forecasts for 2017 (CNBC, firm-specific investor relations). This is important because simply maintaining guidance would have suggested growth might not be accelerating.

Moreover, FactSet reported last month that S&P 500 companies with greater global exposure are posting higher earnings than those with most of their sales at home.

You see, large U.S. industrials act like a global economic pinwheel. In the aggregate, they are akin to a “boots-on-the-ground” review of global economic conditions.

Key data points

The Organization for Economic Cooperation and Development (OECD)’s Composite Leading Indicator, which covers its 35 members (plus 6 major non-members), has been positive for 13 of the last 14 months.

Data Source: OECD Last Date: March 2017

Markit Economics publishes its monthly purchasing manager (PMI) surveys for several major countries. The PMIs that survey nations in Europe just hit their best level in six years, signaling the growth in Europe is accelerating. Further, the threat of deflation in Europe has waned, aiding the more upbeat outlook.

While risks remain, China, which came under pressure last year, posted annual GDP growth in Q1 of 6.9%, the fastest increase since Q3 2015 (MarketWatch).

Emerging markets step on the gas

Emerging markets (EM) can be defined as a nation’s economy that is progressing toward becoming advanced. It is typically characterized by faster growth than developed nations, but is more subject to volatility, political instability, and external shocks.

China and India are the largest EM economies. Other nations include South Korea, Brazil, Taiwan, South Africa, and Poland.

Depending on your risk profile, we may recommend investments in these countries be included as a part of a well-diversified portfolio. But be aware they can exhibit a heavier degree of volatility than what might be associated with mature economies.

That said, investors shrugged off initial anxieties reflected in the key gauge that tracks EM economies shortly after Trump’s election and have narrowed the gap with Europe and the U.S. – Figure 1.

In addition to growth prospects, the softer dollar and the general belief the Fed will remain in a go-slow mode have also aided emerging markets.

Let me explain. A stronger dollar can hurt EM economies, as some nations issue debt denominated in U.S dollars. So, a rise in the dollar makes it costlier to repay loans. Plus, a more aggressive series of Fed rate hikes could boost the dollar as well as siphon cash away from EM economies and into the U.S.

Many EM nations are dependent on commodity prices, as raw materials are a key export. More recently, commodity prices have tiptoed higher following a long slide, per the CoreCommodity CRB Index, a broad- based basket of commodity prices. Furthermore, earnings expectations are up sharply in 2017 versus one year ago (Charles Schwab).

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
* Monthly: March 31, 2017 – April 28, 2017

Bottom line—it’s been a confluence of factors that have boosted the fortune of stocks around the globe. It’s also an important reminder that a long-term investment plan for most investors should include a diversified international component.

If you have any questions or thoughts, please feel free to reach out to me.

Warmest Regards,

Christopher J. Carroll, CIMA®, CBC®
Founder, Portfolio Manager, and Managing Partner

Monthly Financial Market Update

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Political Uncertainty as Viewed Through an Investment Lens

The overriding theme that has engulfed markets during the first quarter, particularly stocks, has been Donald Trump and the general belief that he will enact policies that will spur economic growth and boost corporate profits. Never mind any lingering anxieties that his more controversial positions might detract from economic growth.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Monthly: February 28, 2017 – March 31, 2017

Of course, Trump can’t cut taxes and boost outlays on infrastructure projects simply by decree. He’s half the equation. Congress must still enact measures that reach his desk.

So, what happens if Congress deadlocks and nothing gets passed? Worries abound that investors are front-running changes in fiscal policy that may not occur.

Washington does not work like a well-oiled machine and compromises must still be hammered out. Odds are low at this point, but if the gears get gummed up and Congress fails to implement reforms, volatility is likely to ensue. What type of short-term fallout we might experience is difficult to forecast.

It’s a remark that found its way into last month’s commentary.

Well, for better or worse, Washington isn’t a well-oiled machine. That was vividly demonstrated when Republican leaders in the House pulled their bill to repeal and replace Obamacare when the votes weren’t there.

Whether Obamacare should be repealed or whether the Republican replacement was the right prescription is not in the scope of this month’s summary. What impacts investors is.

More importantly, investors have been anticipating a sharp reduction in the corporate tax rate. The math is simple. A lower tax rate boosts after tax earnings, which is positive for stocks. It may also induce firms to invest in various tools to boost output and productivity, which would aid economic growth.

But the inability to pass the health care bill raises the odds we might not see tax reform, as it highlighted the deep divisions within the Republican Party.

Republicans share common tax goals, including lowering rates for individuals, eliminating the alternative minimum tax, and slashing the corporate tax rate. Still, passage isn’t guaranteed.

While political noise can create volatility, the standoff with the health care bill didn’t spark much of a selloff. In fact, the major indices ended the week higher following the bill’s apparent demise.

Partisanship may create uncertainty at the Capitol, but investors care most about economic and profit growth. It is the long-term driver of stocks.

The Fed engages

When the year began, it appeared the Fed was gearing up for a rate hike in June. It would be the first of three expected increases in the fed funds rate.

Data Source: St. Louis Federal Reserve, Economic Projections of Fed Officials, NBER

Shaded areas mark recessions – Last Date: March 2017

Inflation rate as determined by the core PCE Price Index (excludes food and energy) Broken line represents current forecast for the fed funds rate per the Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents under their Individual Assessments of Projected Appropriate Monetary Policy Fed funds rate median projection of 1.375% at year-end 2017 and 2.125% at year-end 2018. Forecasts are subject to change

That changed in late February, when several Federal Reserve officials, including Fed Chief Janet Yellen, strongly hinted that March was in play.

When the March 15 meeting concluded, the Fed surprised no one by announcing it was raising the fed funds rate by 1⁄4% to a range of 0.75 – 1.0%.

Despite chatter the Fed might tweak the needle in a slightly more hawkish direction by raising projections from three rate hikes this year to four, it chose to maintain guidance at three. If that occurs, we would have a fed funds rate of 1.25 – 1.50% by the end of the year – see Figure 1.

“We realize that waiting too long to scale back some of our support (low rates) could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession,” Yellen pointed out in early March.

While she was cautiously optimistic on the economic outlook, she said expected rate increases should be “gradual.”

Pumped up profits

Ultimately, it’s about corporate profits, and the outlook for the rest of the year is favorable.

As of March 31, Thomson Reuters estimates earnings for S&P 500 companies, which captures about 80% of the total U.S. market capitalization (Dow Jones Indices), are expected to rise 10.2% from a year ago. That’s down from an estimate of 13.8% made at the beginning of the quarter.

Data Soure: Thomson Reuters Last Date: 3.31.17
All forecasts are subject to change

Since the early days of the economic recovery, analysts have lowered their estimates in response to conservative forecasts issued by firms. It’s an under-promise, over-deliver strategy. If we follow the same pattern this time around, firms will post their first double-digit rise in profits since Q3 2014.

According to Thomson Reuters, expect the most support to come from financials, technology, and energy. Energy played a significant role in the earnings recession, thanks to the collapse in oil prices. While prices have been shaky as of late, they are up from a year ago.

Later in the year

Anything past Q2 gets dicey and depends on several factors. Foremost, how the economy performs.

The theme that is being driven home? Be careful reacting to news items or political noise that may create temporary volatility, but fails to shift the narrative that has driven stocks from the March 2009 low.

We’ve seen it before: economic and political uncertainty in Europe, political gridlock at home, Brexit, China, geopolitical anxieties, and more.

When new problems crop up, and they will, uncertainty can quickly affect short-term market sentiment. But if it fails to materially dent the U.S. economic outlook, it’s unlikely to have a longer lasting impact on stocks.

When might we get a more pronounced downturn? Historically, bear markets correlate closely with recessions. A recession will eventually set in, and stocks will turn down. But recessions have historically led to economic upturns and new highs for stocks. It’s a pattern that’s repeated itself for over 200 years.

Warmest Regards,

Christopher J. Carroll, CIMA®, CBC®
Founder, Portfolio Manager, and Managing Partner

Monthly Financial Market Update

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

Market Melt-Up

The Dow Jones Industrial Average1 ended February on a negative note, snapping a 12-day winning streak of record closing highs. Looking back at market history, the Dow came up one day short of tying a record of 13-closing new highs achieved in January 1987 (Gluskin Sheff/Business Insider).

The latest run can be traced back to comments made earlier in February by President Donald Trump. Following a very restrained “affirmative” on tax reform during a pre-Super Bowl interview with Fox News’ Bill O’Reilly, Trump quickly shifted gears and said he expected a “phenomenal” tax reform proposal within two to three weeks. That remark occurred on February 9 (CNN, the Hill.com).

Data Source: St. Louis Federal Reserve Last Date: 2.28.17

Details were lacking but the stock market rally gained new momentum.

But what about his combative nature? Could that create problems with shares? Well, so far it hasn’t, as investors have focused on the positives—expectations that fiscal stimulus will unleash the “animal spirits” that have been dormant and drive economic growth into a higher gear.

Fed Chief Janet Yellen offered a similar suggestion a couple of weeks ago when she was asked during her semi-annual testimony before two Congressional committees what she thought was driving stocks. “I think market participants likely are anticipating shifts in fiscal policy that will stimulate (economic) growth and perhaps raise earnings,” Yellen opined. Fiscal policy is simply a wonky way of saying tax cuts and infrastructure spending.

Her response fit neatly into some of the recent themes we’ve covered.

So, what happens if Congress deadlocks and nothing gets passed? Worries abound that investors are front-running changes in fiscal policy that may not occur.

Washington does not work like a well-oiled machine and compromises must still be hammered out. Odds are low at this point, but if the gears get gummed up and Congress fails to implement reforms, volatility is likely to ensue. What type of short-term fallout we might experience is difficult to forecast.

But let’s always remember that investors look to the future, using their collective wisdom (via buy and sell decisions) to discount potential events. It may not be a clear path, but at this juncture, there is the expectation reforms will eventually make their way to the president’s desk for his signature.

The 800-pound gorilla

Politics and the victory of Donald Trump (and a Republican Congress) have dominated the narrative since election day. Hindsight is 20-20, and it seems obvious today that investors would warm to his pro-business stance. His more controversial positions have done little to derail shares.

But if we look back over the last several years, domestic political themes that have cropped up from time to time held only a short-term sway over shares. The “fiscal cliff” at the end of 2012 created headwinds, until a last-minute deal took the issue off the table. And a 2013 government shutdown, coupled with the possibility the federal debt ceiling might be breached, cast a temporary shadow over markets.

Eventually, I suspect the political story line will run its course and the longer-term driver of shares will once again take center stage. In fact, I’d venture to say it’s already playing a role.

Data Source: Econ-Yale-Online data Robert Shiller Last Date: Dec 2016

Longer term, it is profits and the expectation of profits that drive stocks. Figure 2 highlights the close relationship between S&P 500 earnings and the S&P 500 Index.

Sure, there are times when shares sell at a discount to earnings, as we saw in the 1970s. At that time, interest rates and inflation were soaring, reducing the attractiveness of stocks.

Then came the late 1990s, when investors piled into almost anything with a “.com” after the firm’s name.

But by and large, it’s earnings that drive shares. In fact, the correlation between S&P 500 profits and the S&P 500 Index is an incredibly high +0.94, where +1.0 would mean the two variables perfectly mirror each other, and -1.0 would mean the two variables move in exactly the opposite directions. A zero simply means there is absolutely no correlation between the two variables.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Monthly: January 31, 2017 – February 28, 2017

In other words, Figure 2 is a graphic illustration that demonstrates profits are the biggest long-term driver of stocks. Sure, other factors can come into play in the short term, but investors buy and hold shares for a firm’s earnings and expected earnings.

Warmest Regards,

Christopher J. Carroll, CIMA®, CBC®
Founder, Portfolio Manager, and Founding Partner

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

The Waiting Game

Much of the optimism over the last three months can be traced back to the themes that have been running since Election Day.

It’s a new administration that wants corporate tax cuts, individual tax reform, regulatory reform, higher defense spending, and a ramp-up in infrastructure spending. With the exception of new domestic outlays, the Trump administration is working with a sympathetic Congress.

Yet, it’s also an administration that has railed against globalism and has shunned large, multilateral trade deals. Markets like the former; they cast a wary eye on the latter.

For now, it’s not just investors that have warmed to the change in Washington and the perception that business-friendly legislation is just around the corner. First, let me state the obvious. The name Donald Trump elicits a myriad of reactions. Yet, surveys of consumer confidence have soared since the election, with the Consumer Confidence Index hitting its best reading in 15 years – see Figure 1.

Data Sources: Conference Board, Polling Report, NBER
Shaded areas mark recessions Last Date: Jan 2017

Moreover, a measure of small business confidence is at its highest level in over a decade (National Federation of Independent Businesses). One might say that the ‘animal spirits’ that drive economic activity are stirring.

Still, major proposals designed to create a more fertile ground for economic growth don’t happen overnight.

Washington moves slowly and competing interests can complicate matters. For example, talk of a “border adjustment tax” is a new wrinkle that just popped up on the horizon. But investors want a simple and clean cut in the corporate tax rate, dropping it from 35% to around 15-20%. In some respects, January has been an interim period – a waiting period. It’s one where investors have been trying to evaluate how the new administration will govern, what its priorities will be, and how it will move forward.

Following a strong finish to 2016, we saw the upward momentum in shares slow through much of the month. However, the Dow did top 20,000 for the first time when Trump got back on message (at least from a market perspective), meeting with business leaders and signing executive orders designed to speed energy pipeline construction and pare back on what he sees as burdensome regulation.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Monthly: December 30, 2016 – January, 31 2017

Remember, it’s the pro-growth message we heard in November that sparked the rally in shares.

Still, Trump was not a conventional candidate, which was part of his appeal in some corners. And he has yet to shed his unorthodox ways. He’s not shy about tweeting his opinion or ruffling feathers.

Some like the new style. Others abhor it. As your financial advisor and financial confidant, I’m not here to offer opinions on his leadership, or use this space as a political platform.

My goal is to discuss themes that are affecting shares in either a positive or negative fashion. It’s to view what’s happening through the narrow prism of an investor. I’ll leave it to you to form your own conclusions regarding the broader aspect of his policy initiatives.

President-elect to president

Investors crave a fair degree of certainty. They want quick enactment of pro-growth policies. The roll-out of his more controversial stances, including the restriction on immigration, created political uncertainty and some turbulence as the month came to a close.

It not only raises fears that Trump may get sidetracked, but there are rising concerns the pro-business message heard in November and the laser-liker focus on taxes may end up taking a back seat to other proposals and squabbling among Congressional leaders.

Given the impressive run-up since Election Day, short-term traders used the political uncertainty as an excuse to sell as the month came to a close.

Long-term focus – the fundamentals

Longer term, it’s really about profits and profit expectations, economic growth, and interest rates.

The four-quarter earnings recession has ended, and earnings growth is forecast to accelerate and run above 10% in 2017 – see Figure 2. You have to go all the way back to early 2011 to find four-straight quarters of double-digit profit growth (Thomson Reuters).

Data Source: Thomson Reuters Last Date: 1.30.17 Forecasts are subject to change.

Of course, earnings forecasts are subject to change given that there are plenty of moving parts in the earnings forecast equation, including U.S. and global economic performance and the dollar.

Moreover, firms are posting profit margins that are near record levels (S&P Dow Jones Indices). An acceleration in wage growth would be welcome. So would a rise in business investment, but it would likely whittle away at margins. Of course, that would likely occur in response to faster economic growth, which is a tailwind for profits.

As you can see with this simple example, forecasts rely on plenty of changing variables.

Meanwhile, the economy continues to expand, and the Fed currently believes that gradual rate hikes are the most likely path.

Volatility can’t be ruled out. It is a natural part of investing. Risk can be managed but not eliminated. For now, the fundamentals are generally supportive of shares.

Warmest Regards,

Christopher J. Carroll, CIMA®
Founder, Portfolio Manager, and Founding Partner

Annual Financial Market Update

The summary below is provided for educational purposes only. If you have any thoughts or would like to discuss any other matters, please feel free to contact me.

An Average Year

That’s right, 2016 turned out to be an average year for stocks if you use the large-company S&P 500 Index as your yardstick. Going back to 1928, the average annual return, including reinvested dividends, runs nearly 10% (NY Stern School of Business data). When the year had ended, the S&P 500 rose 9.54%. Throw in dividends and 2016 rose 11.96% (MorningStar). Mid-cap and smaller company shares topped 20%.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC

Of course, these are just averages and returns can vary widely from year to year. Since the bull market began in early 2009 (St. Louis Federal Reserve), we’ve been treated to eight-straight years of positive returns for the S&P 500 Index (dividends included), with six of those in double digits (NY School of Business).

That always leads to the next question – or we near a top? I’ll attempt to provide perspective later in the summary. Spoiler alert – it largely depends on whether the U.S. economy is headed toward a recession.

A look back at 2016

The year finished on a solid note, but 2016 didn’t start out that way.

Falling oil prices, worries about China, an upward lurch in junk bond yields, and overblown fears of a recession took a big toll on investor sentiment. CNNMoney pointed out that the first ten days of the year were the worst start for the Dow in its history – that’s going all the way back to 1897.

To compound the angst, comparisons to 2008 were rife. However, this wasn’t 2008, there wasn’t a subprime crisis that was brewing, and shares touched bottom in early February (St. Louis Federal Reserve).

At the time, stocks were closely tracking oil prices. When oil prices bottomed, so did the S&P 500 Index (St. Louis Federal Reserve, Energy Information Admin.). Not coincidentally, so did the peak in junk bond yields (St. Louis Federal Reserve, Energy Information Admin.).

While tumbling oil prices had raised worries over demand and led to fears a recession might take hold, the reality was quite different – it was about too much oil, not fading demand in the economy.

Shares eventually moved off lows, and the closely-watched S&P 500 Index eclipsed its May 2015 high in July, when the surprise Brexit vote in the U.K. failed to create much turbulence in Europe.

Trump train spurs new highs

New highs experienced by the major U.S. indexes came despite the unexpected victory by Donald Trump. Most analysts believed a brief but violent selloff would ensue if the outsider won the election. Instead, talk of corporate and individual tax cuts, new spending on infrastructure, the repeal of Obamacare, and regulatory reform all served to spark a late-year rally.

The late-year surge in stocks came at the expense of longer-term Treasury bonds and high grade corporate bonds (St. Louis Federal Reserve). Figure 1 highlights the spike in Treasury yields (bond prices and yields move in opposite directions).

Data Source: St. Louis Federal Reserve, NBER Last Date: 12.30.16 Shaded areas mark recessions

Yields have been at or near historically low levels for much of the economic recovery. Very accommodating monetary policies from the major global central banks, low rates of inflation around the globe, a lackluster economy, and yields hovering near or below zero in parts of Europe have all played a role. Still, on a historical basis, Figure 1 illustrates that yields remain low.

The long cycles in oil

Oil is an incredibly important component in our economy. Falling gas prices have been a boon for drivers, but severe cutbacks by oil-related firms have forced layoffs and sharp reductions in expenditures in the industry. Moreover, it has hampered S&P 500 profit growth (Thomson Reuters).

We are witnessing a modest bounce in prices thanks to a recent OPEC decision to cut production. But even at today’s prices, rig activity in the shale producing regions is rising, promising to bring new output.

I won’t venture a guess where prices will end up next year, but as Figure 2 highlights, oil has historically moved in very long cycles. If that holds true this time around, we could see prices remain at relatively low levels for quite a while.

What’s in store this year

As with oil prices, forecasting how stocks will perform this year is dicey. Simply put, there are too many moving parts to the stock price equation, and each of those moving parts can affect one of the other moving parts.

But we can take a stab at some of the tailwinds and risks.

Since WWII, the U.S. economy has had 11 economic expansions, which were interrupted by recessions (National Bureau of Economic Research). At 73 months, the current expansion is the fourth longest, with the longest being 120 months in the 1990s (NBER).

The current recovery isn’t young anymore, but risks for a near-term recession in the U.S. are low. That’s important for investors because Figure 3 reveals that most bear markets, defined as a 20% decline, since the late 1950s were associated with a recession. The one most recent exception – the Crash of 1987.

Data Source: St. Louis Federal Reserve, NBER Shaded areas mark recessions Last Date: 12.30.16

Thomson Reuters is forecasting a return to S&P 500 profit growth in 2017, which would provide a tailwind for stocks. A gradual upward path in interest rates by the Fed would probably be viewed as a plus, especially if it were in response to an expanding economy.

Trump’s election sparked enthusiasm, primarily because he has touted pro-growth policies and downplayed his more controversial ideas. For example, it’s unknown if his tough trade talk during the election will result in dramatic new barriers to free trade or whether his rhetoric is simply a negotiating ploy.

You see, the vast majority of economists would argue that free trade is a net benefit to the U.S. However, “net benefit” is a fancy way of saying that winners exceed losers, but there are still losers.

You and I stand to gain when we buy cheap imports like big screen TVs that would cost more to manufacture in the U.S. Exporters gain access to foreign markets. Since 1990, exports as a percent of GDP have risen from 6% to 13% (U.S. BEA). That creates jobs for Americans and profits for U.S. firms.

But jobs have been lost when firms relocate plants abroad or when U.S. manufacturers can’t compete against lower-cost imports. If Trump were to follow through with threats to raise tariffs, U.S. trading partners could quickly retaliate, sparking trade war. Any heightened uncertainty could create volatility in stocks.

Of course, there are other unknowns. Will simmering problems in Europe or China bubble to the surface, or will unexpected geopolitical issues surprise investors?

What we have seen during this cycle – problems abroad that have not had a material impact on the U.S. economy have created temporary angst but have not killed the current bull market.

Another way to view this – those who have adhered to a long-range view and side-stepped the inevitable gyrations have profited.

Warmest Regards,

Christopher J. Carroll, CIMA®
Founder, Portfolio Manager, and Founding Partner

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to talk about any other matters, please feel free to contact me.

Investors Play the Trump Card

It’s simply a formality at this point. On December 19, the Electoral College will convene and electors will cast their votes. Barring any surprises, Donald Trump will become the 45th president of the United States.
While December’s vote is expected to produce few surprises, the election day results that put Trump in the win column caught most professional pundits off guard. The subsequent reaction in the market came as quite a surprise, too, with the major U.S. indices claiming new highs.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Monthly: October 31, 2016 – November 30, 2016

Wasn’t a Trump win supposed to send shares lower, perhaps much lower? Weren’t we going to get a Brexit-like reaction in stocks? Didn’t investors prefer a win by Clinton because she represented continuity, even if her professed policies weren’t always business friendly? The answer to each question is yes. Yet, we’ll never know how stocks might have reacted to a victory speech by Clinton.

What we do know is that stocks briefly plummeted in overnight trading as it became clear The Donald was about to trump Hillary (Bloomberg). A gracious victory speech by Trump, which was followed by a conciliatory concession speech by Clinton seemed to soothe concerns.

Then, rational investors did what rational investors do – they turned their focus back to the fundamentals and liked what they saw.

Data Source: St. Louis Federal Reserve Last Date: 11.30.16

Missing from Trump’s victory speech were the more controversial policies he advocated during the campaign. What did dawn on investors was the simple fact that voters had just elected a Republican president and a Republican Congress that seems intent on passing pro-business/pro-growth policies.

A cut in the corporate tax rate will aid corporate profits, encourage capital spending, and discourage “tax inversions,” i.e., companies relocate overseas purely because other nations tax their firms at lower rates, sometimes substantially lower rates.

Then there is the prospect of tax reform that may simplify the filing process and reduce the tax burden, putting more spendable cash in the hands of consumers. In theory, that means additional consumer and business spending, which would fuel economic activity.

There has been no shortage of talk that more burdensome regulations may be pared back, including a more business-friendly environment for traditional forms of energy production.

Finally, Trump promises to pursue additional outlays for the nation’s aging infrastructure and for defense.

All in all, it was a remarkable shift in investor sentiment that had been very wary of a Trump presidency.

A Trumpnado hits the bond market

Tax cuts and higher spending would likely bring about faster economic growth. But it could also boost the federal deficit. Moreover, we could see an uptick in inflation.

All three acted like a perfect storm for the bond market, sending yields sharply higher, as investors bailed out of bonds (bond prices and bond yields move in opposite directions).

Data Source: St. Louis Federal Reserve Last Date: 11.30.16

The impact on investment grade corporate debt has also been significant, with yields rising substantially (St. Louis Federal Reserve). However, the reaction in the junk bond market has been far more muted (St. Louis Federal Reserve).

The potential for a more robust economy acts like a tailwind for the cash flow of firms that sport lower bond ratings. In other words, the prospect for easier debt repayments typically reduces the risk of holding low-grade corporate debt.

Where to from here

Of course, there are always risks to the outlook. We’re hearing plenty of talk of tax reform, higher government spending, and less regulation. But the devil is always in the details.

While the Republican majority is likely to make headway on lowering the corporate tax rate, plans put forth by Trump and House Republicans that cut individual tax rates differ in various aspects, and compromises will be needed.

Republicans in the Senate could use the reconciliation process (a simple majority is needed) to pass a bill and avoid a Democratic filibuster. Any moves to reach across the aisle, gather bipartisan support and pass a bill with 60 votes in the Senate will require additional give and take.

Tax cuts can have a more immediate impact on the economy, but major infrastructure projects have exceedingly long lead times. Additionally, Republicans and deficit hawks have historically cast a very wary eye on large domestic outlays.

How the market performs over the longer term will likely be tied to the economy, Federal Reserve policy, and the perception of valuations.

We’ve seen a number of events at home and abroad that have had a temporary impact on stocks since the bull market began in 2009. Yet, prospects for an expanding economy have proved to be a tailwind for the market.

We will eventually enter a recession. That’s inevitable. But the odds of one occurring in the near term are currently low.

Warmest Regards,

Christopher J. Carroll, CIMA®
Founder, Portfolio Manager, and Managing Partner

MONTHLY FINANCIAL MARKET UPDATE

The summary below is provided for educational purposes only. If you have any thoughts or would like to talk about any other matters, please feel free to contact me.

Modest Volatility, an Election, and a European Bank

The third quarter began on a very uneven footing. The U.K. had just surprised investors by voting to leave the European Union (E.U.), and markets were in the process of digesting an enormous amount of uncertainty and repricing shares in the face of that uncertainty. But hindsight has a way of offering clarity that’s difficult to grasp in the middle of the storm. While markets at home take their longer-term marching orders from profits and profit expectations, shorter term any number of variables such as the surprise vote in the U.K. can influence sentiment.

Sources: U.S. Treasury, MarketWatch, St. Louis Federal Reserve, CNBC
*Monthly: June 30, 2016 – September 30, 2016

In reality, Brexit led to a two-day selloff in shares (St. Louis Fed Reserve). When cooler heads prevailed, the selloff was quickly followed by new highs for the S&P 500 Index (see Figure 1) and the Dow.

Let me reiterate, when negative geopolitical or global events occur, they can create short-term selling pressures, as we’ve witnessed on several occasions. But if it does not impact the U.S. economic outlook, the event is usually discounted and investors tend to regain their composure.

It’s important to point out that we saw an unusual amount of complacency starting in mid-July. That complacency came to an end in September when talk surfaced of a potential rate increase at the Federal Reserve’s September 21 meeting.

However, this is a very cautious Fed. It’s in no mood to surprise financial markets. While it signaled a rate hike this year is still very much a possibility, the Fed also paired back rate hike expectations in 2017 and 2018 (Federal Reserve Economic Projections).

In other words, those patiently waiting for the day when safe investments will offer a more palatable return may have to wait even longer.

Still, let’s look past Fed policy and review the long-term driver of stocks – profits and profit expectations.

Figure 2 illustrates the earnings recession that began Q3 2015 may extend into the Q3 2016. But it also highlights a forecast of a much better fourth quarter, which has played a significant role in supporting shares.

Too big to fail

Let’s shift gears. Too big to fail isn’t just a topic here at home. It’s something European governments are also grappling with. While U.S. banks have done a much better job of raising capital, the same can’t be said of many of their European counterparts (CNBC, various sources).

At the end of June, the International Monetary Fund called Deutsche Bank (DB $13), Germany’s largest bank by assets and the fourth largest in Europe (Statista.com), the greatest risk to the global financial system (Wall Street Journal).

Without diving into the weeds, problems continue to bubble just under the surface with a bank that sports assets of just under $2 trillion.

As onerous as bank bailouts can be, Germany may find itself in the unenviable position of having to stand behind its largest bank. One thing we painfully learned from 2008: once confidence evaporates, a bank is in very big trouble.

I suspect this is not a “Lehman moment,” which is a reference to the disorderly 2008 failure of Lehman Brothers and the subsequent financial crisis. Knowing what we know today and knowing what happens when a large institution collapses, it seems hard to imagine that Germany would allow its largest bank to fold. The economic ramifications for Europe’s largest economy would be overwhelmingly negative.

Today, the European Central Bank has the tools to step in. While new E.U. rules limit taxpayer assistance, it’s not prohibited (Financial Times). That’s not to say that additional problems for Deutsche Bank won’t create short-term volatility at home. It could. But a Lehman moment that creates turmoil in Europe seems unlikely.

A barroom brawl

It’s a tongue-in-cheek way of describing the upcoming election, and I would be remiss if I didn’t address what’s going on. That said, I’ll cautiously tiptoe into a minefield of opinions.

So far, there’s been very little volatility inspired by the upcoming vote. In fact, markets reacted favorably to the first debate when a CNN poll suggested Hillary Clinton bested Donald Trump.

Yet, that remark seems to fly in the face of conventional wisdom. Wouldn’t Wall Street prefer a Republican? Aren’t Republicans the party that favors business and investors? Won’t Trump’s tax policies aid business?

Well, Wall Street also favors certainty over uncertainty, and professional investors see continuity with a Clinton win. Trump’s strong rhetoric fuels passions among his supporters, but it also sparks heightened uncertainty among professional investors. And heightened uncertainty can short-term volatility.

It’s analogous to the idiom, “Better the devil you know than the devil you don’t.”

As your financial advisor and financial confidant, it’s my job to view your investments and strategies through a financial lens, and not spout political ideals when it comes to your financial goals. That said, this is not to be viewed as an endorsement of Clinton or Trump.

Longer term, stocks will take their cues from what happens to the economy and corporate profits. Shorter term, many issues can crop up that either fuel an advance or hinder shares, including a presidential election.

In a nutshell, the long-term trajectory of the U.S. economy is positive, as has been the case for over 200 years. While either candidate may implement policies that help or hinder the economy, U.S. fundamentals remain intact.

Warmest Regards,

Christopher J. Carroll, CIMA®
Founder, Portfolio Manager, and Founding Partner

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