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The Brave Report: Market Commentary for September 2017

Click here for PDF version of this report: The Brave Report-Sept 2017

And the train keeps rolling on. As I sit here and write this I just assume the market is reaching another all-time high. That is the story for the past month, and few years, for that matter. Whatever the risks are that exist, from the do nothing folks in Washington and the continued threats from various hurricanes to the missile tests in North Korea, the markets don’t seem to care one bit. They just keep marching along, only pausing briefly to take a breath before powering ahead into uncharted territory.

The questions that these new highs keep bringing up are: Is this market overvalued? Has the bull market run for too long? When will the market finally see a substantial correction? And how bad of a correction will it be?  Pundits have run out of breath trying to make sense of these questions in hopes of being able to proclaim that they were the ones that were right and that they predicted the downturn.  But while these folks continue to argue and talk, the markets themselves just shrug and keep humming along.  The best prediction I can make is that these markets will just continue to march higher until they don’t. Then the pundits will be right, but not yet.

Market Overview

Over the past month, all the major indices took a major step higher.  It wasn’t a straight line up but it did seem that way with the S&P only experiencing five down days during the time frame. Further, only one of those down days saw a drop greater than 0.35%, and those can be primarily attributed to the fear about Hurricane Irma. In total, the Dow and the S&P gained around 3.1%.  While the NASDAQ again was the outperformer, gaining just shy of 4%. This performance was punctuated by the best day since March when the Dow gained more than 1.2% on September 11th. This was also the best performing month since February.

Much of the weakness and increased volatility I discussed in last month’s commentary seems to be a thing of the past. For what is normally one of the most volatile months, the last 30 days have been anything but volatile and many of the names we saw taking a pause or losing momentum have reversed course and moved higher.

In the fixed income space, we saw little month to month movement with the yield on the 10-year rising from 2.18 to 2.23. However, we did see a mid-month drop in rates as markets prepared for Hurricane Irma, sinking as low as 2.06 on September 8th.

Fed Meeting: The FOMC met this week and presented their economic projections along with a press conference from chair Janet Yellen.  The expectation going in was that a rate hike at this time was unlikely but what many were looking for was any hint at a future rate hike at the December meeting. The message we got was pretty much in line with expectations.  They left a December rate hike on the table, with 12 of the 16 voting members calling for a December hike. They also confirmed that they would begin reducing their balance sheet starting in October.  This was already discussed in previous meetings so was right in line with expectations. The Fed was also careful, as always, to leave the door open to reversing course if economic fundamentals change.

We have seen over the past few Fed statements that the market reaction to the statement has been relatively mute. This month’s reaction followed suit. This is due to a few factors.  One, they have laid out their long-term roadmap and, to date, have not veered from it much, meaning most information being presented is already priced into the market.  Second, the market seems to have confidence in the Fed that they will not make any major policy mistakes or rash moves and if they plan to change course this will be communicated to us well in advance.

All-time Highs: I wrote about this topic in more length in a blog post last week, but feel like it is worth discussing here as well. There seems to be fear throughout the investing world that all these new highs we continue to see are signaling an imminent correction. Many feel this bull market has gone on for too long (the 2nd longest in history) so it must reverse. As someone that tries to look at the markets from a fundamental basis and value stocks and the markets based on the underlying business performance I do not put much credence in the length of a bull or bear market being a determining factor in when it reverses course.  If the underlying economic conditions are right and businesses continue to grow and innovate than there is no reason a bull market can’t go on for many, many years. Now the key caveats here are that economic conditions need to be right and businesses need to continue to grow and innovate.  These are the variables that we should be debating to determine when this bull market is finally over.

To that point, economic growth has been strong, with GDP growth being revised upward to 3% last quarter. Unemployment is low and, even with the rate hikes we have seen, borrowing is still historically cheap.  These conditions set the table for companies to grow and helps to provide capital for these companies to continue to innovate, all recipes for the bull market to continue.  With that said though, there are still a number of risks in the market that could derail this market but the simple fact that we continue to hit all-time highs is not one of them. Investors must look much deeper to determine if a stock or the market as a whole is over-valued and whether these all-time highs are justified.

Strategy Commentary

The slight reduction in my equity exposure last month seems to have been for not.  I still think there are a number of risks in the market that are not being fully priced in but I expect to opportunistically reenter some of those equity positions in the coming weeks. I may have missed out on a little of the upside but, as I have discussed in the past, I am comfortable with that tradeoff if I think risks are too high.

 

Domestically I did some slight rebalancing. I shifted my allocation out of Industrials and into Materials.  This doesn’t represent a major adjustment since these sectors tend to be relatively correlated but I think there is more upside in the Materials sector. I am still maintaining my overweights to Technology and healthcare. These have been the two best performing sectors over the past six months and I expect their outperformance to continue.

Internationally, Emerging Markets still continues to perform well, adding more than 15% since I increased exposure in April.  As expected, I reduced my Germany exposure earlier this month. So far this seems to be the wrong move but if I do add more developed international I will probably look to use a broader European position.

I am still negative on the fixed-income space.  I am maintaining my underweight to the space and again am more comfortable holding cash as a replacement.

Market Top or Room to Run?

It feels like we have been asking this question for a few years now.  Every time the market makes new highs, pauses or pulls back slightly every pundit comes out of the woodwork to proclaim the market has topped out or the bull market is over. And yet, the markets just continue to march higher. I have discussed this off and on in some of my commentaries and other blog posts and seem to continually get questions from clients and prospects about this issue. This bull market that started at the end of the financial crisis can’t just keep going, or can it?

Investor Sentiment: One of the many drivers behind most bull markets and one that eventually leads to its demise is investor sentiment.  Famed investor John Templeton once said in regards to investor sentiment “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” In a note to investors this week, Goldman’s chief US equity strategist David Kostin notes, “investors today are situated between skepticism and optimism,” he continued” because investor euphoria is nonexistent, an imminent start of a long decline seems unlikely.”

Looking back over the past 9 years it is safe to say that much of this axiom has held true but also the pattern doesn’t always happen in a straight line. It is safe to say that most investors are not euphoric about the current markets. However, throughout the current bull market we have gone thru the pessimism stage and then bounced back and forth between the skepticism and optimism stages a number of times, even occasionally touching on euphoria and pessimism sides of the spectrum but never once reaching the euphoric levels that we saw during the tech bubble or the run-up to the financial crisis. If this axiom continues to hold true we will need to see that before a longer term pullback materializes.

It is important to point out though that even without reaching a full euphoric market, short term pull backs of 5 or 10% still are very realistic.  The low volatility environment we are in has made us forget that these types of pullbacks are normal and should be expected.

Valuation: By almost all measures, valuations are quite stretched. Whether these stretched valuations are justified is a discussion for another blog but on the surface, it would seem that most of the market is overvalued.  Looking at the Shiller P/E below, which adjusts for inflation and helps to smooth out the earnings over a longer time frame, you can see that the Shiller PE currently stands at 30.54. That is almost double the long term average of 16.78. Additionally, we have only seen this metric reach this level on two other occasions in history, Black Tuesday just before the market crash of 1929 and during the Dotcom bubble in the late 90s.

Now, just because valuations seem quite high does not mean that the market does not still have room to run or that earnings growth can’t accelerate to justify these current valuations. It also doesn’t mean that the market is at a top. It simply means that historically speaking, the markets are factoring in a much larger earnings multiple than they have in the past. This increased multiple could be a factor of the low interest rate environment we have been in or simply a result of the back looking time frame that this metric uses in its calculation. The earnings number used in the calculation is an average of the previous 10 years of earnings. Which means this includes 2008 and 2009 when earnings dropped almost 90%. If those years are removed or just normalized then the markets still look stretched but the valuation situation doesn’t look nearly as dire.

Economic Data: From a fundamental standpoint the economy is running strong.  GDP for last quarter was recently revised up to 3%. Monthly job growth has averaged around 175,000 leading to one of the lowest unemployment rates in history. Even with this record low unemployment, the number of job openings in the US currently sits at an all-time high meaning the employment situation in this country looks like it will continue to be strong. Wages have been growing at around 2.7% and consumer confidence is also at its highest level since 2001.

With all of this positive economic data, it seems difficult to imagine that a recession is imminent. It is important to point out that market performance is not directly correlated to economic performance, but a relative correlation does exist.  This positive economic data won’t prevent a short term market pull back but could help buffer any longer term pullback and does create a great foundation for companies to continue to grow.

Uncertain Factors: There are other variables in the market that could also signal the end to this bull-run or at least slam on its breaks. I often discuss the many uncertainties in the market, especially around tail risk events.  These risks are not being fully priced into the markets and should one occur could lead to a major sell-off as people flee to safer assets.

On the flip side, other uncertain events could do the opposite and just add fuel to this market pushing it thru the optimistic stage.  If tax reform or regulatory reform becomes more of a certainty over the coming months than we could see a sharp leg up in the markets.  The general consensus is that we are far from any real legislation but such a positive surprise could add to investor optimism leading us closer to a market top. However, this would only be after a move higher.

So where does this leave us now? Investor sentiment and economic fundamentals are pointing to a continued run of the bulls.  Valuations and geopolitical risks are implying that we should proceed with caution. The real answer is to make sure you are positioned somewhere in the middle.  During these times a balanced portfolio can be your best friend.  It is also important to avoid panic selling if the market does correct at all. As we have seen recently these pullbacks will happen but the markets have been resilient.  If we do see a more pronounced correction of 10% just remember that these types of corrections are normal. If you can’t stomach a decline like that then you shouldn’t be as highly as invested as you are. You should reduce your equity exposure to a more comfortable risk tolerance.