We saw a bit of a correction in the domestic equity markets this week, but international stocks posted gains, due in part to a weak dollar. The S&P dipped a fraction (-0.02%) while the small-cap Russell 2000 slipped -0.5. The NASDAQ closed -0.2% lower. The international markets bucked the trend with the EAFE up +0.4% and emerging +0.3%. The advance in equities over the last few months has been relentless. It was only a few days ago that tech stocks, for example, hit their highest level since the dot-com bubble peak (as you can see below).
Markets hitting all-time highs naturally make people nervous. But the truth is that all-time highs, by themselves, are signaling nothing other than a market that has been going up. Just because every bear market has started from an all-time high doesn’t mean that every all-time high is followed by a bear market. Far from it.
The top panel of the table below shows that the S&P 500 is at an all-time high roughly 8% of the time since 1928. The forward returns following all-time highs are actually slightly above average from 1-month through 5-years (exception: 3 years). The percentage of positive forward returns is above average from 1-month through 1-year and slightly below average at 3 years and 5 years forward. Basically hitting all-time highs says nothing about the future.
However, the NASDAQ back to bubble highs brings back some bad memories for a lot of us. But we shouldn’t forget how crazy the late 1990’s were. The chart below shows global tech stocks (blue line) against earnings (green line). In the last 1990’s tech stocks soared but earnings growth was lackluster, or at least not rapid enough to keep track with prices.
What is different this time (now those are dangerous words!!) is that prices and earnings are much more in line. Tech companies actually make money now. A lot of money. This doesn’t mean prices can’t correct, but simply that we are not seeing the massive distortions we saw in the last 90’s.
2017 – More about Earnings than Trump
Regardless of your political affiliation, you have to admit the political theater on Thursday was amazing. McCain, the Mooch….you couldn’t write this stuff. However, from a market perspective, what has mattered much more is the evolving earnings picture.
In the first quarter of 2017, earnings grew 17% year-over-year. That’s the highest reading since 2010. A full 75% of companies announced earnings that matched or exceeded expectations, led by tech stocks, health care, and financials. Not bad.
However, the early numbers for the second quarter are looking even better. As you can see below, close to 80% of large-cap companies have beat expectations. The beat rate for mid-cap companies has also picked up.
Just as impressive is the fact that over the past 12-months revenue per share has risen 3.8% (chart below). Early numbers for Q2 points to growth over 4%.
All in all this is a constructive backdrop for equities for the next few months. But……
Complacency and Corrections
If you want to worry about something then the worry de jour is that no one is worrying. As the Wall Street Journal reported yesterday:
“Stock markets go up and down: It is a fact of life. Except in 2017. Three major stock-market benchmarks in the U.S., Europe and Asia have avoided pullbacks this year, commonly defined as 5% declines from recent highs. Never in at least the past 30 years have all three indexes – the S&P 500, MSCI Europe and MSCI Asia-Pacific ex-Japan – gone a calendar year without falling at some point by at least 5%.
In good years and bad, markets tend to fluctuate wildly, with stock indexes often falling by double-digit percentages before bouncing back. That hasn’t been the case this year, another reflection of the historically low volatility that has gripped the world. The CBOE Volatility Index, or VIX, finished Wednesday at its lowest since 1993.”
The VIX is a measure of volatility priced into the options market. This so-called “fear gauge” actually pushed to an all time lows before bouncing modestly.
This is a sign (to some) that no one is worried. Insuring against a market correction is unusually cheap. This is an unique state of affairs that is making many scratch their heads. Why are vol levels so low? Surely this can’t last, right? Jeff Gundlach, for one, is betting on a reverse. He was quoted on Friday buying short-term volatility:
“We are in a seasonally weak period for stocks but more importantly, we think the VIX was really, really low. So the S&P puts are going long volatility.”
It wouldn’t take much to pop the VIX up to 15, but as long as the earnings growth story persists, any spike could be similar to the spikes we’ve seen this year – fleeting.
The Fed, their Balance Sheet, and the Dollar
The Fed met on Tuesday and Wednesday and it was pretty much a snoozefest. Interest rates were left unchanged and the Fed kept the door open for balance sheet reduction ‘relatively soon.’ This probably means September because the Fed holds a press conference that month after the meeting. There is every reason to expect another rate hike this year, probably in December.
The balance sheet reduction plan will be slow. If they start in September it will entail allowing $10 billion per month of securities to mature. This cap will be raised by $10 billion each quarter until it hits $50 billion. The chart below from Capital Economics shows that the balance sheet is projected to fall from roughly $4.5 trillion to $2.5 trillion by the end of 2020. In essence this will unwind QE 3 and leaves QE 1 and 2 in place.
Will this derail the economy and the markets? We suspect this news is pretty well priced in given the Fed has been publicizing the idea for a few months.
If there was a surprise from the Fed it was the fact that they sounded a note of caution on the recent weak inflation readings. As you can see below, short-term inflation measures (black line) have fallen to basically 0%.
We talked extensively about this in our quarterly letter. There is a case to be made that some of the softening is transitory, but there is a good chance that today’s economy has changed and that deflationary pressures are just as strong as they were a few years ago. Regardless, the note of caution from the Fed caught currency investors a bit by surprise. The dollar fell after the release and the euro, for example, rallied above 1.17 for the first time in two years, as you can see below.
Consensus has been wrong on a couple big things this year. First is the bet that inflation would increase. Second is a continuation of the dollar bull market. Coming into this year, several investment houses had called for the euro to sink to parity against the buck, with the Trump administration expected to unleash pro-growth measures and the Federal Reserve forecast to tighten policy against a still-dovish European Central Bank.
But 2017 has unfolded in a way that has surprised many observers, with the euro up close to 11 percent.
For one, Donald Trump has found himself lodged in a series of scandals that have curbed expectations for a large fiscal stimulus program and tax cuts that were expected to boost the growth rate.
The eurozone economy has also brightened up significantly. The annualized growth rate came in at 2.4 per cent in the first three months of 2017, the highest level in two years, according to Eurostat data. In turn, the ECB has signaled that its concerns over the potential for deflation have receded, leading economists to reckon that the central bank will disclose plans towards the end of this year to begin tapering its bond buying.
“A lower risk of deflation will likely be presented as the main motivation behind a gradual slowing in the pace of growth of the ECB’s balance sheet during the course of next year,” said Francesco Garzarelli, co-head of European macro research at Goldman Sachs.
A more hawkish ECB, along with better growth, has already begun to squish the gap between core eurozone rates and higher-yielding Treasuries, notes Kit Juckes of Société Générale.
Have a good weekend.
Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.