Q3 2017 Market Perspective
On behalf of the Altium Investment Committee;
Stocks once again made all-time highs during the third quarter and the Bull market continues on. Investors appear willing to push stocks even higher, despite increasing valuations, as corporate profits continue to improve, inflation remains low and economic growth remains steady. Stock market volatility is also low and the domestic business cycle continues to stay away from contraction territory.
The short term outlook is more difficult to predict and is further complicated by the simple fact that the economy has been recession free for almost 10 years now. The current Bull market has lasted now for 102 months. The longest Bull market in modern history began in 1990 and lasted 113 months.
The end of a Bull market is typically accompanied by an economic recession and in this communication we will discuss in greater detail our thoughts on why we are not concerned about a recession anytime soon.
KEY HEADLINES DURING Q3 2017
Stocks continue to rally & bonds are stable
Large Cap U.S. stocks rose 4% in the quarter (up 12.5% YTD) while international developed market stocks rose 5% (up 18.5% YTD) and emerging market stocks rose 8.3% (up 28% YTD) *.
Bonds continue to provide stability to portfolios. The 10yr U.S. Treasury yield was relatively unchanged in the quarter and the Barclays Aggregate Bond Index was up 0.86% in quarter (up 3.14% for the year).
Fed continues to unwind its quantitative easing policy
The U.S. Fed has maintained expectations for another rate hike in 2017, most likely December.
It also announced plans to reduce the size of its balance sheet through the end of this year and into 2018.
Indicators discussed below point to continuation of the current late stage economic expansion
The U.S. Treasury yield curve remains positive, despite flattening slightly during the quarter.**
Consumer Confidence remains at historically high levels.***
Inflation remains below the Fed’s 2% target and continues to perplex Fed Chair Yellen.****
Expected market volatility (as measured by the VIX index) is near its lowest point of the year.
President Trump will continue to push for his pro-growth initiatives, focused now on tax reform (after failing at Health Care reform).
WHAT WE ARE WATCHING NOW
STOCK MARKET VALUATIONS
Stock market analysts and investors alike often rely on valuation ratios to help determine the attractiveness of an individual investment or broad markets. Price to Earnings ratio (P/E) is one valuation method which looks at the price of an investment relative to its actual or estimated earnings per share. A closely-watched measure of overall stock market value is the CAPE (cyclically adjusted P/E) ratio, which was created by Nobel Prize winner Robert Shiller. The current CAPE ratio of around 30x (see chart below) is substantially above its long-term average of about 15x. The concern that some market analysts have is that the ratio is nearing its historic highs that occurred in 1929 and 2000, just prior to major market corrections. However, the 25-year average CAPE ratio is 26.3x, signaling that prices are not as “overvalued” as commonly believed. In our opinion, stock market valuations should not be used as a standalone indicator of an impending correction. Moreover, a common misconception of the CAPE ratio is that it is a leading indicator of short term stock volatility when in fact the ratio is intended to predict long term average returns. Robert Shiller was recently quoted in a New York Times article saying this about the CAPE ratio, “There is no clear message from all of this. Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether.”+ We agree with this comment and our view is that while the CAPE ratio does indicate more subdued future market returns, it does not cause us to disrupt our long term strategic allocations.
Source: Robert Shiller CAPE Data, Yale.edu
FLATTENING TREASURY YIELD CURVE
We continue to watch the yield curve for “inversion” (i.e. long term interest rates turn lower than short term rates). An inverted yield curve would normally indicate that the economy is nearing a recession (red shaded area in the chart below) and historically a curve inversion has preceded Bear markets (the purple line in the chart below tracks the S&P500 index). As measured by the spread between the rate on 2yr. Treasuries and the rate on 10yr. Treasuries, the yield curve has continued to “flatten” throughout the year, but remains in positive territory. Currently the spread is positive 86.68 basis points (versus positive 125 basis points at the beginning of the year). In other words, the difference between rates on longer term bonds and shorter term bonds is narrowing. The yield curve would become inverted when some longer term rates are below short term rates.
Taking into consideration the potential for 3 or more Fed rate hikes between now and the end of 2018, it is possible that we continue to trend towards “inverted” yield territory sometime next year. We introduced the following chart in last quarter’s commentary, but have updated it for the most recent quarter. Please refer to our Q2 commentary for additional details. (Altium Q2 Commentary). The most important takeaway from this analysis is that the yield curve remains in positive territory (above the yellow line below) and it could be many more months before we reach an “inverted” curve, if at all. Therefore, we remain confident that we are not near an impending economic recession.
Source: Bloomberg; U.S. Treasury Yield Curve Spread between 2yr and 10yr Treasury rates
DOMESTIC POLICY AND GEOPOLITICAL TENSION
President Trump’s pro-growth initiatives would suffer a severe setback if he is unable to pass through his comprehensive tax overhaul plan. The plan, if passed, would aim to cut personal and business tax rates and simplify the overall tax code. Enacting tax reform could provide additional fuel for further “slow and steady” U.S. economic growth and prolong this current period of recovery. Failure to pass even a “lightened” version of this plan, however, could be one catalyst towards reaching a peak in stock prices. As it relates to stock prices it is important to recognize that a more favorable tax environment for corporations would provide a boost to after-tax profits which would in turn indicate increasing stock prices when applying P/E multiples.
While it can be argued that the “markets” have consistently withstood a constant barrage of terrorist activity and devastating natural disasters over the last couple of decades, we must remain aware of geopolitical risks and exogenous shocks. One such example is the rising tension with North Korea. While a conflict with North Korea may not be a catalyst itself for a market correction, it could surely magnify a correction should it occur while we are already in a Bear market. Therefore, the looming North Korea risk should not be dismissed.
You have heard us say in the last few commentaries that we do not fear a recession. We know that they are normal as part of economic and business cycles. The current recovery phase of this cycle is the second longest recovery in modern history and the indicators that we have discussed in this communication lead us to believe that the Bull market in stocks can continue in the near-term. When a recession occurs and a market correction follows, we strongly believe that sticking to our stated investment strategy is the appropriate course of action.
With everything going on in the world today it is easy to allow emotions to impact investment decisions. Our job is to assess the situation, provide you with our analysis and ultimately be steadfast in the execution of the specific strategies related to your plan.
At the core of our investment philosophy is the belief that investment allocation decisions are the most important determinant of long term results. Therefore, it is critical that we manage to your specific plan and appropriate risk tolerance at all times. We firmly believe that if we stay invested within your individual risk budgets we have a greater chance of achieving your long term goals. This is especially true during periods of uncertainty, including both positive and negative market cycles.
Gregory Slater, CFA, CFP®
Chief Investment Officer
* LC US stocks = S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
** Yield curve; spread between the rate on 2yr. Treasuries and the rate on 10yr. Treasuries
*** Consumer Confidence: Conference Board Consumer Confidence
**** Inflation: Core PCE
+ https://www.nytimes.com/2017/03/31/upshot/trump-bull-market-stocks.html?mcubz=0; Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies
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