Oh what a month November turned out to be. After a rocky start to the month the major U.S. market indices caught a post-election bid, all ending the month with strong positive gains. Global markets were mixed. Bonds, the big loser for the month, gave back half of its yearly return during the month as the dollar moved up strong. Commodities were positive as well.
|U.S. & International Stock Index Returns|
|S&P 400 (Midcap)||8.39%||16.37%|
|S&P 600 (Small Cap)||13.31%||20.88%|
|Barclays Agg. Bond||2.51%|
|CRB Commodity Index||7.48%|
|U.S. Dollar Index||2.56%|
Source: Morning Outlook December 1, 2016
WOW! In case you missed it, the equity market indices had a pretty good month of November. For the first time since 1999 the Dow Industrials, the S&P 500 and the NASDAQ all hit new all-time highs on the same day. Small cap stocks outperformed everything else, producing returns for the month that would normally be considered a good year!!! Global stocks did not do nearly as well as the MSCI EAFE was negative in November and the MSCI World index printed slightly positive gains.
When we report on how “the market” is doing each month we inevitably discuss how the major market indices have performed. Reality, however, is that the “stock market” is a market of stocks, not an index. What we have observed since the rally began on November 9th is a shift in where money has been allocated by the larger market players. Flows into areas expected to perform well in a Trump administration have caught a bid – energy, defense, infrastructure, and biotech – as areas like utilities and hospital stocks have been subject to selling pressure. To us this feels quite logical.
Overall this move has been strong. Valuations, which some consider being above where they should be based on history and their own personal beliefs, on the surface do not appear cheap. Yet when one factor’s in a major corporate tax break expected in 2017 and the still historically low interest rate environment, an argument can be made for even higher equity prices. Truth be told we have no idea if valuations are above or below where “they should be.” Simple reason is that valuations are a function of market perception on the outlook for the economy and corporate America.
To make things more interesting , we are approaching the 20th anniversary of then-Federal Reserve Chairman Alan Greenspan’s famous irrational exuberance speech in which he voiced concerns about how overvalued equities were at the time (December 5, 1996). More than three years later the stock markets finally hit their peak of a bull market that started in August, 1982. At the beginning of the move the market traded at 6 times earnings. At the peak we traded at 27.
Our point isn’t to say that valuations do not matter. No. We bring up current valuations to make you a more skeptical observer of those who argue both extremes of the valuation argument. We are more positive today than we were a month ago not because of some fundamental change in corporate earnings. We have changed positions because market perceptions have changed.
What a difference a month can make. Last month we said that we believed a new uptrend in yields had started but it looked to be short-term in nature. A convincing move above the 2.00% level on the 10-year Treasury bond would make us reconsider our viewpoint. Well … what you see in chart #3 is a clear, convincing move above the 2.00% level – from around 1.8% to 2.4%. Something has changed.
What we are seeing now is a clear break of a long downtrend on both the short-term and the long term charts (Charts #3 & 4). The 2.00% resistance we discussed in October is now the support level we would look to now as a new support level for a longer-term move up in rates.
Post-election we had a move up above the sideways trend in the US Dollar Index for what looks like a break of the 18+ month consolidation. Just like we said for bonds last month, we have to wait and see if the move is a true break, not a “fake-out break-out,” and how serious of a move higher is likely. Another 20%+ move, like the one that ran from mid-2014 to April 2015 is much different than a slightly stronger currency. In either case, continued dollar strength vs. other currencies has consequences.
For equity investors, multi-national corporations will once again be facing an earnings headwind on off-shore earnings that will be converted back into a stronger U.S. dollar. When that move is small it tends to be manageable by most companies affected. When the move is strong and swift, earnings suffer.
Commodity prices, on the other hand, are priced in dollars and would have a positive headwind keeping prices lower relative to our trading partners. This is good for consumers as energy costs would be more likely to remain low. On the other hand, if prices get/remain too low it dampens new energy production within our boarders.
Consolidation continues for the time being, although we do expect for a move at some point in the coming months. With Saudi Arabia and Russia signing an oil pact in September designed to limit the output of oil produced in the future there is reason to think oil prices may be moving higher in the future, assuming this leads to a production cut. With crude oil making up 23% and energy 41% of the CRB index, it is worth keeping an eye on energy prices as they have an oversized impact on the overall level for the index.
On November 16, 2016 we published a piece The Financial Markets in a Post-Election World giving our perspective on what the election would mean for U.S. policy moving forward and how that would affect the financial markets. In the weeks since publication we have started to see who would be filling many key cabinet posts and received some clarification on a number of issues from key members of Congress. While we cannot and will not know how these appointments ultimately affect U.S. economic policy for some time, what we do know is that the economy right now is in pretty good shape.
The new jobs numbers remain strong as the weekly unemployment numbers remain historically low. Unemployment came in at 4.6%, which we concede coincides with a still low participation rate as well as a percentage of the population who have been out of the labor market for many, many years. But with the aging of the Baby Boomer generation it is unrealistic to expect the participation rate to substantially increase in the coming years. Reality is a large group of people are and will continue to retire from the workforce.
The economy appears to be picking up steam as well. GDP growth in the third quarter was 3.2%. According to the latest Beige Book report from the St. Louis Fed the growth has been across most all regions and positive forward outlooks. A majority of the economists asked believed the economy would continue on to expand with heightened global risks. Put more simplistically: game on.
With this positive background we have the Trump rally which is real and likely to continue. The markets have moved, and done so in convincing fashion, even as many remain skeptical. All rallies end at some point. But market strength is not a negative. Nor is it a rational reason to sell. In the short-term your perception of “underlying value” usually doesn’t matter all that much. And right now we are in the seasonally strong season for the markets.
If you are a skeptic and think that Trump and his team are going to screw things up you may ultimately be correct. Or not. At this point we do not know. What we do know is that, at least until January 20, 2017 there is no chance that the President-elect can screw things up. The current rally in the stock markets is more than likely going to continue on for some time.
In my opinion, I would expect to see the rally end not at some arbitrary level for a market index or market valuation. No. Given the belief that many good things are set to happen – tax cuts for corporations and individuals, massive infrastructure spending, repeal and replace of Obamacare, never a factory leaving the United States again – we believe the rally ends when something happens to change this perception. This could come in the form of a fumble by the new administration, a filibuster in the Senate, or something else. What we do know is this rally won’t go on forever.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
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