Mid-Year Market Update

“How in the world can the market be doing so well when everything in Washington seems to be a disaster?”  I’ve been asked this question many times in the past few months, and I think there are two parts to the answer:

  1. With regards to the economy and the markets, things in Washington are better than the alarmist media want you to believe.
  2. Though government policies – fiscal, tax, regulatory, and monetary – are certainly very important to the financial markets, they are not the be-all and end-all.

        Better Than the Media Wants You to Know – I’ve said this many times before: bad news pays.  The media is in the business of selling advertising, and what drives eyeballs to TV and computer screens is the threat of disaster.  It is also overwhelmingly liberal, and absolutely loathes the Trump administration.   Consequently, the media has a financial and emotional interest in portraying almost everything coming out of Washington as the end of days.

In reality, I believe one of the reasons the market has been rallying since the day after the election is that many of the policies that the new administration has proposed could have beneficial effects on the financial markets.  Though attempts to repeal and replace Obamacare are garnering all the headlines right now, the promise of tax and regulatory reform is one of the drivers of this bull market.  Keep in mind that before the election almost everyone believed that Hillary would win, and we would have more of the same constricting policies that led President Obama to be the first president in history to not have at least 1 year of 3%+ GDP growth during his administration.  This has been an almost 9 month relief rally.

 

        The Economy Is an Ecosystem — We frequently hear economists talk about the economy as if it’s a machine: it’s overheating, running out of gas, stalling, etc.  But it’s not an internal combustion engine; it’s an ecosystem.  That is, it’s a complex, dynamic web of billions of people interacting with each to produce profits for themselves and their companies.  And when tsunamis like the mortgage disaster of 2008-09 hit, people adjust.  Bad D.C. policies hurt, but economies recover because people work at it.

 

Future Outlook

 

        Pessimism Is Good – Wall St. legend John Templeton once said “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”  Building on Templeton’s observation, Ray Devoe has broken secular bull markets into 6 phases 1) Aftershock/Rebuilding;  2) Guarded Optimism; 3) Enthusiasm; 4) Exuberance; 5) Unreality; 6) Cold water (the bubble bursts).   Our Chief Investment Strategist Jeff Saut believes we are still just in the “Guarded Optimism” phase. [1]  Leon Tuey, formerly of BMO Nesbitt Burns and RBC Capital Markets, concurs:

 

        Although long retired, many fund managers in Europe, Asia, and North America still call me and seek my view of the market.  I can report to you that worldwide, investors are skeptical and fearful.  Most are sitting on a mountain of cash.  As you know, that is very bullish.[2]

 

Scott Grannis at Calafia Beach Pundit has more details on the same theme:

 

        If you want bad news and arguments for why the market is due to collapse any day now, just spend a few hours reading Zero Hedge or browsing the media and punditry. Very few observers these days are willing to pound the table for stocks, considering they have been rising for more than 8 years and are hitting new highs almost every day. Is there anyone who isn’t dismayed that Trump and the Repubs haven’t been able to repeal and replace Obamacare after years of trying? Is there anyone who is confident that Trump and the Repubs will succeed in massively lowering tax rates? I don’t see any evidence that the market is pricing in a stronger economy: 5-yr real yields on TIPS are a mere 0.15%, a level that suggests the market is priced to sluggish growth for as far as the eye can see. Investors are on the horns of a dilemma: it’s tough to be bullish, but it’s also expensive to be bearish. The earnings yield on stocks is still quite high relative to the yield on cash and bond market alternatives; so hiding out in cash means giving up a lot of precious yield. But almost $9 trillion in bank savings deposits paying almost nothing says that there are lots of people who are reluctant to take on market risk. Indeed, when I look at the market, I see more evidence of caution than I do of exuberance. Bill Miller, a long-time friend and former colleague, maintains that the market is still in a “safety bubble” after the shock of 2008. I’ve long observed that real yields on TIPS are miserably low, and for that matter nominal yields on sovereign bond markets nearly everywhere are very low. So it’s not at all obvious that the market is running on fumes.[3]

 

This doesn’t sound like the “irrational exuberance” of Devoe’s Stage 6 .

 

        An Earnings Driven Bull – Warren Buffet’s mentor Ben Graham often stated, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.”  What he meant was that in the short term the fear and greed of “voters” (investors) drive the market, but in the long run the heavy and ever-increasing accumulation of earnings determines the market’s price.  Leon Tuey believes that this great bull market is only in the early stages of the second leg.[4]  The first leg was from October 10, 2008 and ended in May, 2015, which was driven by an easy/accommodative monetary policy.  The second leg started in February, 2016 which is always the longest and strongest as it is driven by improving economic conditions (due to the monetary stimulation of the past eight years) and accelerating earnings momentum which is what investors are seeing.[5]

 

So far this quarter, 65% of companies reporting earnings have bettered estimates and 67.1% have beaten revenue projections.[6]  For the year, earnings for the S&P 500 are expected to be up 6-8%.[7]

 

        Some Leading Indicators – Credit Default Swaps are one of the better indicators of the health of corporations.  They are not showing stress and trending upwards as they did before the last recession.

The prices of industrial metals are moving up.  Usually they are in decline before a recession.

 

        In each of the past 5 recessions, new home sales have dropped significantly before the recession started; they have now been in a steady uptrend since 2011.

Finally, how does my favorite indicator – “The Fed Indicator” – look?  As you can see, though the Real Fed Funds rate (the difference the Federal Funds rate and the rate of inflation) and the 1-10 Slope (the difference between the yield on 1-Year and 10-Year Treasury securities) are both moving in the wrong direction, they are nowhere near the levels that have preceded previous recessions.

 

In spite of all the sturm und drang in the media, it looks like we are in the early to middle stage of a long term, secular bull market, with no apparent storm clouds on the horizon.

 

[1] Raymond James Gleanings, 6/23/17

[2] Raymond James Investment Strategy 7/17/17 click here

[3] Calafia Beach Pundit, 7/20/17

[4] He is referring to the “second leg” of this “secular bull market.”  For a better understanding of this type of bull market, see my blog post of 4/6/17 Stay Rational My Friends.

[5] Raymond James Investment Strategy, 7/17/17 click here

[6] Raymond James Investment Strategy, 7/24/17 click here

[7] Raymond James Investment Strategy, 7/17/17 click here

The information contained in this report does not purport to be a complete description of the markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Don Harrison, and are not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice.

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