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The Brave Report: Market Commentary for October 2017

Click here for the pdf version of this report: The Brave Report-Oct 2017

Don’t screw this up congress. With market tailwinds still seemingly going strong, we are waiting for the catalyst that finally reverses the trend. Right now the major variable hanging over the markets and whether it still has legs into next year is the prospect of wide-ranging tax reform.  The President has outlined his vision for this reform and it is now up to Congress to actually do something. Will they defy their recent record and actually figure out a way to do their jobs? Or will this major campaign promise be added to the list of their failings?

The markets haven’t seemed too concerned, yet, but if we continue to see the can being kicked down the road the uncertainty could start spilling over to the markets. Until that point, it seems that we are entering earnings season with quite a bit of optimism and without any news from Washington that will be the main focus in the weeks to come.

Market Overview

This was another very strong month across the board with all major indices making considerable gains. The Dow Jones Industrial Average was the big winner, gaining around 3.6% with the NASDAQ and S&P500 close behind gaining 2.8% and 2.5% respectively.  This puts the Dow up more than 27% in the past year.

It was a pretty consistent march higher throughout the month with very few down days.  For a month that is normally the most volatile, we saw very few hiccups. The Dow was also able to break through the 23,000 mark for the first time.  This marks the 6th round number breakthrough over the past 12 months. While these levels have very little importance from a fundamental standpoint they do represent psychological barriers for many investors, especially on the retail side.

On the fixed income side, we had a relatively active month. The yield on the 10-year treasury hit a low of 2.22 and a high of 2.37.  If you look more broadly at the last few months we are definitely starting to see an uptrend in rates developing. However, for about the last 6 months every uptrend has seemed capped around the 2.4 range.  It will be interesting to see if the 10-year breaks through this resistance level or we continue to see this range hold.

Tax Reform: While the market continues to reach new highs there is one major market moving variable that seems to be hanging over the entire market right now. The run-up in the markets that we have seen since the election last year have been driven, in part, by the promises and expectations of the new administration and not necessarily what has been actually accomplished. One of these promises was an overhaul of the current tax code.  This included reforming and simplifying income tax while also reducing corporate tax rates.  The prospect of such widespread changes was seen as a potential growth engine for the economy.  The difficult position we are now in is that a lot of this tax reform is being priced into the market. I fear that passage of tax reform will only have a minimal impact on the continued upside of the market, however, the failure to get these reform passed could have a major short-term negative impact on markets. Treasury Secretary Steven Mnuchen even went as far as to warn Congress this week that if they don’t pass tax cuts then they will be saddled with a correction in equities.

With such an important job to do it seems congress still cannot get their act together.  What started as a promise of the passage of tax reform by year end is looking more like an early 2018 agenda item.  So far we have received a basic outline from the Trump administration but this was a very high-level look. And just yesterday the Senate passed a budget measure which means they will only need a simple majority to pass a tax bill instead of needing any help from the Democrats. It is now up to Congress to work with the President’s outline to create a much more specific piece of legislation. Now I understand that changing the tax code is not just a simple reform, especially in the current political climate, but companies and investors are beginning to grow restless.  A lack of progress will only be tolerated for a little while longer before the uncertainty starts to become a drag on the markets.

Earnings: With other catalysts seemingly put on hold we are entering an earnings season where earnings results could be the key driver for the next market move. And expectations are quite high.  Last quarter’s results were strong but with valuations stretched in a number of sectors another knockout quarter is needed to justify continued market growth.  The fundamentals of the economy are there for another good quarter. We are at almost full employment and the economy continues to grow at a rate above most expectations.  Whether this translates into strong quarterly numbers is the real question.

We have already heard results from a number of the large banks and so far these results seem positive. We are only in the early stages of this story and by this time next month, we should have a much more clear picture of how most companies have been performing.

Strategy Commentary

Over the past month, I continued to maintain a slightly reduced equity exposure. I am still looking for a reentry point for some of those positions and I expect this earnings season to shed some light on the current valuation risk in the market. There is still an overhang from the North Korea situation. Add to that the uncertainty around tax reform and I am comfortable maintaining this cautiously optimistic stance. I have definitely missed out a portion of the run-up in the market over the past two months but I am comfortable sacrificing a little upside with these uncertainties still hanging over the market.

Domestically I have maintained the same allocation from last month. This includes overweights to Technology, Healthcare and Basic materials.  I have been overweight technology for quite some time now.  With valuations stretched in a lot of sectors, the growth potential in the technology space helps to justify current valuations, especially in relative terms to other sectors.

Internationally I continue to maintain my overweight to Emerging Markets.  The economic growth numbers released by China this week and the promises that came out of the Communist Congress set the table for continued strong growth in that region and I see no reason that emerging markets, as a whole, can continue to outperform.  As I discussed last month, I may have been a little premature in reducing my exposure to Germany. It has been the best performing developed international market over the past 3 months and I may look to re-enter the position in the next few weeks.

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.