QUARTERLY MARKET UPDATE as of January 2018
In the fourth quarter the surprisingly resilient bull market continued its upward march. Most sectors were up with the strongest performance coming from Consumer Discretionary, and Technology, which gained 10% in the quarter, while Utilities were down 1.0%. Overall the market was up 6.7% as measured by the S & P 500. Small cap stocks gained 3.4%, while the MSCI International stock index was up 3.9%. Treasury bond yields stayed about the same for the quarter with the 10-year rate up a nominal amount to 2.40%.
As expected, in December the Federal Reserve announced a ¼ point increase in the range of the benchmark federal funds rate to 1.25% to 1.50%, the third increase last year. The Fed’s economic forecast suggests it will increase short-term rates three more times this year. With short term rates rising and interest rates at the longer end of the yield curve remaining about the same over the last year, we now have the flattest yield curve in 10 years. In the past that has been a harbinger for a recession.
The current economic expansion is the third longest on record. Past expansions ended after the economy overheated or valuations entered extreme levels, and that has not yet occurred. Inflation has been under control and growth as measured by GDP while recently increasing, has been slow and steady. While debt levels on automobiles and credit cards have hit new record levels, mortgage debt which represents a much larger percentage of overall debt is still below its past peak. The level of corporate debt is also below its prior peak.
U.S. stock market valuations are at above average levels, but are well below the highs from past cycles. The forward P/E using this year’s consensus earnings forecast has actually dropped to 18.3 as corporate earnings are expected to increase 12% this year. Using next year’s earnings that value is even lower. We would be more concerned about a bubble when that value comes close to past peaks and moves up into the mid 20’s.
Inflation remains low. The core personal consumption expenditures index only increased 0.1% month over month, and was up only 1.5% over the last year. The unemployment rate remains at 4.1%, the lowest level since February 2001. Expectations of low unemployment levels leading to a surge in wages has yet to materialize. The year over year increase in hourly earnings was only 2.5%, which is an improvement but not enough to impact inflation.
Consumer confidence is high after hitting 17-year highs, and business investment saw an upturn last year with the largest increase in five years. We expect a strong rebound in residential investment after the rebuilding efforts from last summer’s hurricanes. Adding up all of these positives along with new tax legislation providing additional stimulus measures supports our scenario for continued steady growth this year. Growth as measured by GDP is expected to increase to 3.3% in the fourth quarter and increase this year by 2.4% versus 2.2% in 2017.
The most surprising aspect of the stock market over the last year was the lack of volatility and the absence of a meaningful correction. This happened despite ongoing geopolitical tensions, turbulence in Washington D.C., hurricanes, fires, and a tighter monetary policy. On a quarterly basis, we are now on a string of nine consecutive quarters with positive returns. Even with a positive economic backdrop within a bull market, investors should expect to see a period of retracement.
The steady upward climb has been achieved despite an overriding element of caution. There are still many individuals on the sideline or underinvested. Weekly mutual fund flow data in late December as tracked by EPFR Global showed a sharp outflow from U.S. equities, the most in over two years. That goes counter to what is normally seen at the end of a bull market. Typically, mutual fund investors are late entrants and finally feel comfortable with the sustainability of the market after a final surge in prices as the market reaches a peak. We are not at that level yet.
Valuation disparities carried over to this year will continue to impact market movement and sector rotation. We expect to see profit taking in the stocks that achieved oversize returns last year and trade above their fair values. Investors will continue to move towards the sectors and stocks that have been underperforming over the past year and represent a more reasonable valuation than the overall market.