It is time to celebrate as the Dow approaches a multi-year target of 23,000. On October 5th, the Dow reached 22,775, effectively achieving our long-term target (Figure 1). Through the third quarter of 2017 the Dow has gained 14.1%, paced by growth stocks which have increased over 20.4%. Sectors that have lagged include value stocks, up 9.4%, small caps, up 8.5%, and intermediate-term bonds which have gained 3.4%. It has clearly been a growth-stock year led by Apple, Amazon, Microsoft, Facebook, Google (now Alphabet) and biotechnology.
After several years of disappointing performance, foreign stock markets have charged ahead on the back of improved economic performance, greater political stability and a weaker dollar. Foreign large-cap stocks are up 20.3% year to date and foreign emerging-market stocks have gained 26.2%. Leading the emerging-markets advance have been Latin America, China and India markets.
Typically, when stocks go up we would expect bonds to go down in price, but this has not been the case in 2017. Broad-based bond indexes have increased 3.4%, slightly more than the coupon rate. Foreign bonds have performed even better due to a stronger dollar and have gained 6.1%. Overall, 2017 has been a year to celebrate portfolio performance as most all investment strategies worked.
Figure 1 – The Dow Jones Index Has Almost Reached its 23,000 Target
What Next? Or Where do we go from here?
We approach the market as a balancing act between technical and fundamental forces. On the technical-side, the market will have achieved a key level when the Dow reaches 23,000. Many technicians expect the market to either consolidate broadly sideways for several months before resuming the rally or reverse downwards and test key levels of support. These support levels would be Dow 21,200 or a decline of 6.9% and then Dow 18,300 which indicates a drop of 19.6%. It has been well over a year without a moderate correction and certain sectors of the market remain overvalued. On the other hand, some believe that the market could spike higher to Dow 25,000. Where do we go from here?
The 30-year long term chart of the Dow Jones Index depicts a three-leg rally since 2009, often an indication of the end of a major move (Figure 2). While the market may extend the rally further, a sideways move is more likely. Yet, there is always the risk of a significant downside move. Despite decent U.S. economic fundamentals, stock valuation levels do not favor U.S. stocks. International markets and bonds may be a better alternative.
Figure 2 – The 30 Year Chart of the Dow Jones Index Seems Too Good to be True
The U.S. Economic Story Remains Resilient
Fundamentally, the U.S. economic outlook remains moderately positive and is acting like a fully mature economy. The economic data shows resilience and depicts a modest growth path for the past 8 years. While recent economic data has been slowing, particularly employment growth in retail, technology and healthcare, it is hard to distinguish the trend from the effect of three hurricanes. With e-commerce leading the way, we expect a rebound in growth as holiday spending is expected to be strong with a projected increase of 3.6% to 4.0%. Recent natural disasters have created an unintended form of infrastructure spending, with a likely total exceeding $200 billion. Construction spending and auto replacements will ultimately lead to more growth in 2018. With potential tax reform and financial deregulation dangling in front of the economy, the U.S. fundamental outlook remains constructive.
Global Growth Continues to Outperform in 2017
The global economy improved substantially in 2017 as Eurozone and Japanese economic growth and business confidence accelerated. European economic sentiment is at a 10-year high and German unemployment at an all-time low. European government and central bank policy is starting to shift from fiscal austerity and low interest rates to higher rates and more economic stimulus. Eurozone growth is expected to stay in the 2.0% range. European stock markets have underperformed the U.S. by a cumulative 40% over the last 3 years, but have outperformed in 2017 as confidence in the E.U. improves.
The strong dollar of 2015-2016 reversed course this year, adding to the performance of non-U.S. stock markets. Low interest rates created by central bank buying programs in Europe, the U.K. and Japan are likely to reverse in 2018. The dollar may find a new trading range that balances expected interest rate moves among the global central banks.
Emerging market stocks have enjoyed a spectacular stock market year, up close to 25%, as growth improved in the China region, Latin America and Eastern Europe. As global economic growth improved, resource-supplying companies in emerging economies have enjoyed a modest rebound in commodity demand. If the global economy remains on track, one could expect a resurgence in commodity prices. Overall, emerging economies are enjoying the benefits of a strong world economy and improved internal consumer demand. Our bet is that emerging markets continue to outperform the U.S. market for the near future.
Figure 3 depicts the large performance differential of the U.S. stock market versus international markets. Looking back over time they generally correlate well with one market moving in a similar direction as the other. Over the past few years however, U.S. stocks have significantly outpaced the international markets. Going forward we may continue to see international stocks outperform until they reach a more equitable level of valuation.
Figure 3 – International Stocks offer Greater Value than U.S. Equities
What Happened to Inflation?
To the surprise of many, U.S. inflation peaked in March 2017 and has been declining since then. This coincides with a drop in the energy price index caused by a continued glut of OPEC oil and ongoing expansion in the U.S. oil fracking industry. With unemployment below 4.5% and likely to trend lower, labor market conditions are poised for wage increases in 2017 especially for those with college degrees where the rate of unemployment remains well under 2.2%. During the 4th quarter, we anticipate that increases in wage rates, home prices and commodity prices may contribute to higher inflation. A 2% inflation target appears reasonable for the near future (Figure 4).
Figure 4 – A 2% Inflation Target appears Reasonable
One Additional Rate Increase Likely in December
In June 2017, The Federal Reserve increased the Federal Funds rate by 0.25% to 1.15%. Fed officials also indicated that, conditions permitting, they would raise rates one more time in 2017 followed by three hikes in 2018. The Fed announced that they will start to trim their $4.5 trillion balance sheet by letting bonds in inventory mature with fewer replacements. This would be the beginning of a gradual wind-down of Quantitative Easing.
In the big picture, the U.S. Federal Reserve is leading global central banks to tighten monetary policy. Recent comments from the European Union, Japan and Canada have indicated that the easy-money policies of the past 8 years are on the way out and interest rates have moved higher in those countries. Coordinated central bank actions are dependent on economic growth and the rising inflation that results. We believe that global rates will increase in 2018.
Bond Market Outlook
Fixed income investments have moved sideways so far in 2017 (Figure 5). If inflation reappears, interest rates should move to higher levels in conjunction with a stronger economy. As bond portfolios are used to balance equities in a portfolio, we remain in higher-quality corporate and government debt. Junk bond markets are more likely to be correlated with the stock market.
Floating-rate funds, foreign fixed income and short maturity bonds are also core components of our diversified bond portfolios.
Figure 5 – U.S. 10-Yr. Treasuries Remain in a 2.1% to 2.6% Trading Range
Concerns on the Horizon
My greatest concerns that could affect the market include:
- North Korea. The question is whether the U.S. should attack or isolate North Korea. Be assured that the stock market and economy would not like a shooting war.
- The markets have “priced in” a pro-growth fiscal policy for 2018. If the prospect of a tax cut was removed, the current market would be substantially lower. If Congress and the President are unable to come to terms, market disillusionment would be swift and decisive.
- Unified tightening of credit by global central banks. The markets have been spoiled by 8 years of exceptional central bank liquidity and resulting low interest rates. As this cycle appears to be turning, the bond market may get ahead of the central banks with rates increasing more than may be warranted. Higher interest rates would lead to compression of multiples for high-dividend stocks as well.
- The underfunded pension bubble. These outstanding liabilities continue to plague many governments, states, municipalities and some companies. As the baby boomer generation retires, the underfunded pension plans will either have to pay up and raise taxes to fund the obligation or reduce the payments to their retirees. At some point this problem is going to reach a boiling point which could result in problems for the municipal bond market.
- The protectionist mindset of the Trump administration could lead our trading partners to make alliances with other nations to the detriment of the U.S. This could lead to disadvantages for U.S. companies operating abroad.
- In April 2017, a group dumped a collection of NSA spy tools on the internet. These are now being converted to weapons to be used against global commerce. Many companies and governments are unprepared for a global cyber terrorist attack. Stock markets would not react well should one develop.
Overall, we are reducing our aggregate equity exposure from a max long position to a neutral allocation. We see better long-term return opportunities in international developed and emerging markets. As a hedge against inflation risk we like funds and ETF’s with positions in large money center banks that will benefit from loan growth accelerating and a steepening yield curve. We also like global multinationals that will benefit from accelerating volume, tight controls and substantial gains in profits. Another group we favor are industrial commodity stocks that benefit from rising demand and higher margins.
To balance out our equity exposure, we have made our bond exposure less risky with an eye on inflation protection. Our maturity profile is neutral with an emphasis on investment grade corporate bonds, floating rate instruments and some emerging market fixed income.
In general, we remain invested but wary that the U.S. rally may have run its course. Stock market performance in the U.S. is likely to be dependent upon the success of Republican pro-growth tax policies, avoiding major trade wars and approving constructive economic plans. One needs cash to buy on market setbacks. As we approach the Dow 23,000 technical target, it appears to be an excellent opportunity to raise cash.