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Connect the Dots

The S&P 500, the popular measure of U.S. stock behavior, remains firmly in bull territory. The month of May saw a total return of 1.4%, and the market is now up 8.6% year to date. Stoic stock investors have been rewarded. It is remarkable we have seen only two days this year when the prices swung down more than 1%.   This highly complacent market has a lot of investors shaking their heads in some bewilderment, unable to make sense of the behavior of stock prices in relation to the often hard to fathom events taking place around the world.

On the positive side of the ledger, the fundamental backdrop is reasonably strong. The powerful earnings recovery we observed in 1Q 2017 will likely continue. Corporate America is on fire and this has been driving stock prices. Earnings have been bolstered by robust manufacturing data at home and surprisingly strong business conditions from around the world, Europe in particular. The US$ has been falling relative to other currencies, and is now back below its pre-election levels. This improves demand for U.S. goods and services. The Federal Reserve is on track to raise the Fed Funds rate, its messaging has been clear, and at the moment the stock market is ok with that.

The stocks behaving the best in this market are in our wheelhouse. Generally referred to as growth stocks, these are stocks showing consistent improvements in revenues, margins and profits. Large cap growth stocks (measured by the ETF IVW) are up 14.9% year to date, head and shoulders above large cap value stocks (measured by the ETF IVE), which are up 3.7% year to date. To a certain extent, large cap technology stocks have been driving the parade. Stocks like Apple, Amazon and Facebook are all up over 30%. Market cap and a high percentage of international revenue have been positive factors. Also, typical of a momentum market, stocks that have been doing well are continuing to do well. Valuation, measured by P/E ratio, has fallen due to robust earnings, leaving the door open to further appreciation.

On the flip side, interest rates and energy prices may be flashing warning signs. Short term rates will rise with the anticipated increase in the Federal Funds Rate. On the long end, the benchmark US 10-year Treasury note is currently yielding 2.1%, its lowest level since the post-election bump. The drop in rates may be signaling a declining growth outlook for corporate America. It is not clear, yet. Worse, a flattening yield curve can precurse an inverted yield curve, which investors typically link with a recession and often a bear market. The energy patch is also worrisome. The horrendous drop in energy prices starting in 2014 led to utter havoc in multiple areas of the market. After largely stabilizing in the $50 bbl range, prices are falling again. Rising rig counts, discord in traditional oil producing countries, and the economic disruption caused by the US fracking industry are all at work here.

Possibly most difficult to read, and interpret in any meaningful way is the narrative. The news flow out of Washington is unsettling. This creates a musical chairs sense of mistrust. Importantly, it also causes greater mistrust among our traditional partners around the world, with respect to economics (trade), defense sharing arrangements, and most importantly, the environment. Wall Street continues to look through the noise. My concern is that when the troubled times inevitably arrive, as they always do, we do not have the strength in leadership required to reassure nervous markets and allow them to re-set.

Though the path forward is never clear, I have the feeling we are tap tapping along like a blind man with a long cane, principally concerned with identifying where not to step. This makes for cautious progress, at best. Defending against the arrival of a black swan is expensive, in money terms, and is purely a guessing game. I suggest the logical way to proceed is to watch for the beginnings of a change in trend, and to pro-actively take profits (sell) if the market begins to trend down. While we take this on, I would like to catch up with you if we have not spoken recently.

Bruce Hotaling, CFA

Managing Partner

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