QUARTERLY MARKET UPDATE as of October 2017
Stocks moved higher once again and have now advanced for eight consecutive quarters. The S & P 500 gained 4.5% with the strongest performance in the Technology and Energy sectors, while the historically safe Consumer Staples sector was down for the quarter. International and small cap stocks were also up, gaining by a similar amount to the S & P. The Federal Reserve left the target range for the Federal Funds rate unchanged for the quarter at 1% to 1.25%. The ten year Treasury yield which had been declining for most of the quarter, bounced back to finish just above its starting point at 2.33%. The dollar continued to weaken against the currencies of U.S.’ major trading partners.
The recurring gains in the stock market with little volatility have been a pleasant surprise. We do have several supporting factors for a bull market such as very low interest rates, benign inflation, and steady growth, which have historically been very positive for the market. While overall valuations remain at above average levels with the latest one year forward P/E at 18.6, it is about the same value as last quarter, and not yet at peak levels seen in past bull markets. Corporate earnings growth has been good, keeping valuations from becoming more expensive; and no domestic or geopolitical events seem to sway the market for more than a few days.
The market inherently forecasts the economy several months out and it is pricing in stability and growth to continue. Tax reform legislation may provide an added boost, but if nothing is passed it is not likely in itself to be a catalyst for a major correction. Changes in the current driving factors behind the market: interest rates, inflation, and growth should continue to dominate and determine the market’s direction going forward. Corrections can and do occur, but without new economic factors we believe a pullback should serve as a buying opportunity.
The Fed is expected to continue its gradual course of interest rate hikes with a high probability for the next hike to occur in December, and three more in 2018. Inflation remains benign, with the latest annual core PCE rate remaining below the Fed’s 2% threshold. Nevertheless, a December rate increase is a proactive step to stay ahead of the inflation curve. The unemployment rate has dropped to a very low historical level. Combined with strong job creation it now raises the likelihood of higher future wages.
Estimating the level of unemployment that will trigger inflation has been a very inexact science of late. Economists have had a range over the years from 6% down to 5%. Yet inflation remains low. The unemployment rate is now at 4.4% and is expected to decline further as new job openings are exceeding the number of available workers. The Fed expects this to drive wages higher as corporations compete for the limited supply of workers. But they don’t have a high degree of confidence that this will in fact occur. Hence the tenuous and gradual approach to interest rate increases, on the road back to a new normal fed funds rate level near 2%.
This month the Fed is also expected to start reducing its $4.5 trillion balance sheet created from its past bond buying program, known as Quantitative Easing. Reversing this program by selling bonds will also take a gradual and cautious approach, as it has the potential of sharply increasing interest rates. It will be another unprecedented action with difficulty in predicting the outcome. We expect the Fed will closely monitor its impact on economic growth and adjust or cease sales if there are any adverse impacts to the economy. About 1/3 of the holdings have terms that are less than five years which could be held to maturity to alleviate selling pressure and causing a spike up in interest rates.
The rate of growth as measured by GDP has been steadily increasing. The latest Economist poll has an expected increase this year of 2.1% followed by 2.3% in 2018. Both are down fractionally from last quarter’s poll, but still higher than the 1.85% increase in 2016. The rough hurricane season will take away a portion of the third quarter’s growth rate, but the rebuilding efforts should add to growth in the fourth quarter.
The argument can be made that the current economic expansion is long by historical standards and we should expect a recession / bear market in the not too distant future. On the other hand, the rate of growth of this expansion has been less than those in the past, making the case for the expansion to continue. This is another example of the delicate balancing act required to forecast the market. What we have seen and expect to continue to act on this quarter is a migration away from stocks that have advanced beyond their fair values. Stocks that trade far above their historical normal valuation levels are being sold off. This past quarter’s poor performance in the consumer staples sector is an example of this and recently has become a source of funds. It is a sector with few bargains and many overpriced stocks. We expect investors will now migrate towards the sectors and stocks that have been underperforming over the past year and represent a more reasonable valuation than the overall market.