The stock market in January felt very much like an extension of December 2017 with both U.S. and global equity indices moving higher at an accelerated rate. The U.S. Dollar also continued its trend, weakening vs. global currencies for the month. In contrast commodities changed direction and look to be strengthening as rising U.S. Treasury yields turned the bond index we track lower for the month.
U.S. & International Stock Index Returns
|Index January 2018 Year-to-Date|
|Dow Industrials 5.79% 5.79%|
|S&P 500 5.62% 5.62%|
|S&P 400 (Midcap) 2.81% 2.81%|
|S&P 600 (Small Cap) 2.47% 2.47%|
|MSCI World 5.22% 5.22%|
|MSCI EAFE 4.99% 4.99%|
|Bloomberg Agg. Bond (1.15%)|
|CRB Commodity Index 1.81%|
|US Dollar Index (3.35%)|
All data as of 01/31/2018
The booming stock market of 2017 did not come to an end with the ringing in of the new year. January saw both international and US equity indices surge. At home the move up continued the series of new all-time highs in a very docile investment environment. As we enter February – a month that is never really great – the market is very overbought (the jargonish term for “it has moved too high too fast”), leading us to believe that a short-term correction is likely.
But please do not interpret our short-term concerns with long-term fear … at least not right now. The underlying fundamentals for equities was greatly enhanced with the corporate tax cuts enacted by the Federal government at the end of 2017. The talk has been about the one-time bonus’ being paid to some workers as well as factories “coming back” to the United States from overseas. There is truth to those storylines, yet much more to get a complete understanding.
CEOs of publicly traded corporations work for the shareholders as well as the corporate board of directors. The mandate they work under is not to maximize the gains for the employees or the United States. You give more money to employees when necessary. The mandate is to maximize shareholder value. You move capital to where it can best be used to maximum value to the firm; You maximize shareholder value through share buybacks and large dividends.
We feel earnings growth equals increase value. Maybe not today or tomorrow, but over time. It was Benjamin Graham who said that the stock market is a voting machine in the short run but a weighing machine in the long run. Regardless of what happens in the next 28 days, in our opinion greater earnings for publicly traded companies is good for the investor.
When we look back on the bond market years from now, January 2018 may be the defining moment of a new cyclical bear market. Or not. What we do know is that January was a very poor month for bonds as the Bloomberg Aggregate Bond Index lost 1.15% for the month. The 10 year U.S. Treasury bond, over the same 31 day timeframe, saw its yield move from 2.40% to 2.71% by month’s end.
While the 10%+ move higher in yields is significant, more noteworthy in our eyes is the yield ended January above what had been a technical resistance level of 2.60%. As we showed in our December 2017 Stock Market Report the move above resistance looks very much like a break of the multi-decades long bull market for bonds. On the other hand, it could just be a temporary move higher.
For a number of reasons Magellan Financial believes that the current move higher in yields is the beginning of a new bear market for the bond market. Confirmation of a bond bear market will happen with a strong move above the 2014 high of 3.03% for the 10 year Treasury bond. Currently the economy is in good shape in both the United States as well as globally. There is still great liquidity due to the continued quantitative easing efforts of the ECB and Bank of Japan. Further stimulus has been provided by the recently passed tax reform by Congress which lowered tax rates for both individuals and corporations. Lower tax revenues, of course, will lead to less income for the Federal Government and more debt that needs to be absorbed by the markets. The Treasury is expected to lift sales of 2- and 3-year notes, which will keep the interest expense lower will lead to larger funding needs as these notes mature and need to be rolled forward.
Finally, The Federal Reserve Board (The Fed) is expected to raise short-term rates three times in 2018, increase from 1.50% to 2.25% by year’s end. With a strong economic background, it is logical to conclude that longer rates will also adjust higher. Higher yields equate to lower values for bonds.
In January the US Dollar Index lost 3.35% for the month. The downtrend accelerated on January 25 when Treasury Secretary Mnuchin commented in at the World Economic Forum in Davos that a weakening dollar helps the United States and he wasn’t opposed to the lower valuations. A statement of fact that previous Treasury Secretaries have avoided, Mnuchin was forced to “clarify” his “true thoughts” and the desire for a strong dollar. Nobody was buying it.
In his initial statements the Treasury Secretary was indeed correct – a weak dollar makes our foreign exports more attractive. Of course, honesty isn’t necessarily the best policy when it comes to currencies so we weren’t surprised when he walked back these comments the very next day. Such happenings matter over a few days or weeks. In the coming months we see a trend that is clearly down. In our view 85 and then 80 are the two areas of support for the index.
The big gains for equities are what has been getting the headlines, but the apparent breakout of the commodities index deserves attention. After a long base period the index broke above 196 in mid-January. If this former area of resistance turns into support we would expect to see a new uptrend to commence. The action in the coming weeks should provide some direction of where the commodities are heading this year.
Let’s just get this out there from the get go: we see a normal market correction coming in the near future. And we say this for one very simple reason: markets don’t go straight up.
If you go back to Chart #1 above we point to a number of reasons for our short-term pessimism. First, there has been very little volatility for a long time. It has been two years since the last 10% correction and more than a year since we witnessed a 5% pullback in the S&P500. Such tepid markets feel good but that is not what not normal markets feel like or how they traditionally respond.
Investors are getting complacent. We have more questions about speculative investments like Bitcoin, cannabis stocks, tech stocks trading at 300 times earnings than worries about a market downturn. What our years of working with investors has taught us that when the average investor is more concerned with the return than they are the risk a correction is usually not far off.
Finally, according to the Stock Trader’s Almanac, February is not typically a very good month for equities.
What we have, in our opinion, is a setup for a price correction for the major stock market averages. This is just a correction, in our opinion, and not the end of the current bull market. And as we said at the beginning, our short-term worries should not be interpreted as long-term pessimism at this point in time. Corporate earnings and revenue growth remains strong. Corporate tax cuts will make them even stronger. So, in the short term we are likely to see emotions move the market down. Longer term, as long as earnings remain good they will lead the way higher.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
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