Q3 2017 Economic / Market Recap
The Energizer Bunny
Many folks remember from the late 1980s, when the battery manufacturer, Eveready/Energizer, began their commercials featuring the Energizer Bunny with his flip-flops, drum and sunglasses. These commercials originally began as a parody of Eveready/Energizer’s main competitor, Duracell, which also had commercials that featured a bunny. The message was simple: the Energizer Bunny could outperform the Duracell bunny because of its superior battery. Thus, the well-known tagline of “He just keeps going and going and going…” was born.
We can’t help but to have a similar thought as we contemplate the financial markets since last year’s election. There has been a multitude of opportunities for financial markets to throw a relatively short-term temper tantrum. However, markets have mostly ignored or brushed those events aside without much reaction.
On March 22, 2017, a terrorist ran over more than 50 people along the Westminster Bridge in London. Over the next 5 trading days, the S&P 500 actually increased. London experienced another attack in June, when a terrorist group ran over pedestrians, then jumped out, and began stabbing people. Over the next 5 trading days, the S&P 500 essentially remained flat. There was a time over the last decade or so when a terrorist attack in a major metropolitan environment would have at least caused markets to produce a momentary pullback.
Markets have not just ignored terrorist attacks, they have paid little attention to geopolitical events. 2017 has seen North Korea’s Kim Jong-un repeatedly test missiles, nuclear weapons, and make threats. On July 4, 2017, North Korea fired an ICBM with an effective range of at least 4,000 miles. Again, over the next 5 trading days, the S&P 500 barely budged. On September 3rd, North Korea conducted a nuclear weapons test that produced a magnitude 6.3 earthquake. During the next 5 trading days, the S&P 500 increased.
In spite of these events and several others, financial markets, at least in the present, have become The Energizer Bunny, “they just keep going and going and going…”
Through the end of the 3rd Quarter, the US and international stock markets (as measured by the S&P 500 and EAFA) are up double digits. YTD, the US Bond Market (Bloomberg Barclays US Aggregate Bond) is up 3%.
Q4 2017 Outlook
Economic/Market Conditions
As stated above, there have been numerous of opportunities in 2017 for markets to take a short-term breather. So, why haven’t they?
First, we need to consider the current, actual economic fundamentals. We suggest that economic conditions over the last year have slowly improved and have built a solid foundation. In late September, the US GDP for the 2nd Quarter was revised from to an annualized rate of 3.1%. The current estimate from the Atlanta Federal Reserve is that the 3rd Quarter GDP will come in around 2.7%. This is not the robust growth that the US experienced in the 1990s, but these numbers are very solid and slowly improving. As we have discussed at length on multiple occasions, historically there is a low probability of a Bear Market (a market drop of at least 20% from a recent high) forming when the economy is not in, or close to, a recession. The likelihood of a recession over the next year looks very low.
Second, companies are profitable and corporate earnings growth has been good. You may remember that a couple of years ago the US dollar was very strong. Currently, the US Dollar has descended to an almost three-year low. A weaker dollar may sound counterintuitive to market gains, but a strong US dollar hurts US companies that trade their goods and services in the global marketplace. Large US companies have reported consistently positive earnings and revenue reports over the past few quarters.
In spite of both the economy and earnings, we do believe that US stocks look expensive compared to their historical norms. One measure that we often reference is Robert Shiller’s PE Ratio. Currently, Shiller’s PE ratio is at 30.93. To provide some context, according to Robert Shiller’s work the only time over the last 137 years that his PE ratio has been higher is before the Tech Bubble in the late 1990s. Said more plainly, according to this measurement, stocks are at their second most expensive point ever. Due to these historically elevated valuations, we continue to preach that a short-term correction (in the 5% to 10% range) would be healthy and an opportunity to increase stock allocations.
In spite of both the economy and earnings, we do believe that US stocks look expensive compared to their historical norms. One measure that we often reference is Robert Shiller’s PE Ratio. Currently, Shiller’s PE ratio is at 30.93. To provide some context, according to Robert Shiller’s work the only time over the last 137 years that his PE ratio has been higher is before the Tech Bubble in the late 1990s. Said more plainly, according to this measurement, stocks are at their second most expensive point ever. Due to these historically elevated valuations, we continue to preach that a short-term correction (in the 5% to 10% range) would be healthy and an opportunity to increase stock allocations.
Our recommendation to clients that are willing to take some amount of risk is that they should generally maintain their existing stock allocations. We would not advocate dramatically reducing stock exposure at this time. Likewise, we would not suggest dramatically increasing stock exposure. In our view, slowly increasing stock exposure over time is a much more prudent strategy—if there is a short-term correction, we would look to accelerate that strategy.
Federal Reserve Actions
The Federal Reserve has helped keep bond interest rates near all-time lows by continuing to be very conservative in increasing interest rates. The Fed has done its best to clearly telegraph any anticipated rate hikes. Markets do not like surprises. Markets do not like uncertainty. The Federal Reserve is trying to accommodate both.
The Federal Reserve has increased interest rates twice in 2017. There is a solid probability that they will increase rates again in December. Markets are viewing these increases as healthy. Increasing interest rates allows the Federal Reserve to replenish some of their “ammunition” from fighting the 2008-2009 Financial Crisis.
Washington, DC Legislation (Or Lack Thereof)
The boondoggle that is Washington, D.C. appears to have no end in sight. In fact, it can be easily argued that Washington is more dysfunctional now than before the 2016 election. Republicans and Democrats still can’t get along for the good of the country, but now many Republicans can’t even get along with fellow Republicans.
This phenomenon has played out publically through the failed attempts to reform or repeal the Affordable Care Act (commonly known as Obamacare). The inability to decisively reach an agreement on ACA when the Republicans hold a majority may provide a glimpse into the next target for Republicans: tax reform. From a market and economic perspective, we would suggest that tax reform would have a more significant impact on the economy than repealing the ACA. The Kiplinger Letter, seems to agree, “If Washington can find a way to lower tax rates and induce firms to bring some of the money home, it would boost the economy.” Currently, US corporations have stashed away around $2.6 trillion in profits overseas—allowing them a favorable way to bring that money back to the US could be huge.
At this point, the details of the Republican tax overhaul plan are still vague and fluid. If current attempts to get something done fail, we would look for it to happen before the Summer of 2018, when most representatives and senators will begin to switch their focus on being reelected.
Markets have largely ignored debt-ceiling debates since 2011, when several agencies reduced the US’ credit rating. In September, President Trump agreed to increase the debt ceiling until early December. Currently, the balance of the US debt is in excess of $20 trillion. Many Republicans view debt-ceiling debates as opportunities to have more wide-ranging discussions on government spending.
A key point up for debate later this year will be the elimination of the debt ceiling. As farfetched as that may sound, President Trump has not ruled out that possibility. In September, President Trump stated, “For many years, people have been talking about getting rid of the debt ceiling altogether, and there are a lot of good reasons to do that. It complicates things, it’s really not necessary. So certainly that’s something that will be discussed.” It will be interesting to see if this twist will rile markets or, as with many other events so far in 2017, it will largely be ignored.
Summary
If 2017 ends without a market decline of at least 7%, it will mark only the second time (2013 being the other) over the last 20+ years that there has not been a meaningful correction at some point during the year. From where we sit, it looks like there is a decent probability that a correction in 2017 will not occur.
We suggest to clients that they enjoy this Energizer Bunny market. We feel confident in saying that good times will not last forever. Chaos will return. What will be the spark to start the next round of chaos? It’s impossible to know with certainty.
As always, we will continue to monitor the market landscape and economic conditions. As we see opportunities develop, we will look to take advantage. As we see storm clouds brewing, we will look to defend and manage risk.
Thank you for your continued trust! We hope that you have an excellent Fall!
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