The Brave Report: Market Commentary for November 2017

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

The market needs a nap. With the great run, the market has been on over the past year, it is not surprising that the market is showing some signs of tiring.  Stocks need a chance to catch their breath and give us all a chance to confirm that these lofty valuations are justified. This consolidation is normal and healthy for the markets and should set the stage for continued growth thru the New Year.

With that said, risks still exist. Tax reform, Brexit talks, uncertainty over leadership changes in Germany and other geopolitical events could all prove to be major headwinds for this bull market. We are also seeing continued rhetoric from various pundits and money managers that the market is reaching a top. However, even with these prognostications, we are not seeing the euphoria that usually proceeds a topping market.  While valuations still seem a bit stretched there may be some continued follow through before we experience a pullback of any significance.

Market Overview

Over the past month, the Dow Jones Industrial Average and the S&P500 have eked out small gains of around 0.7%. The NASDAQ, on the other hand, continues to keep flying along gaining around 3.1%.  This performance was driven primarily by strong tech earnings, with the technology ETF, XLK, gaining over 4.4% in the same time period.

Even with the slight monthly gains the S&P500 and Dow have both been down in each of the last 2 weeks. This marks the first back to back down weeks since August. This two-week pause seems to just be some healthy consolidation, as both indices still sit just below their all-time highs. The pause could also be due to additional money flowing into tech names that announced stellar earnings and away from utilities and telecoms who announce subpar results. Once earnings are fully digested I wouldn’t be surprised to see some profit taking in tech after New Years.

After surging to a 6-month high yield of 2.45 near the end of October the yield pulled back to spend most of the month bouncing between 2.30 and 2.40. So even though yields broke out briefly they settled back to trend line we have seen for the past few months. There is an expectation that the fed will raise rates again at their December meeting so we will have to see how much of that increase has already been priced in.

Earnings Justification: By most measures, this earnings season has been very strong. With the reporting season winding down 74% of stocks have beaten their earnings estimates and 66% have beaten revenue estimates.  The tech sector has had an even more successful quarter with more than 90% of tech companies beating their earnings estimates.

The market, however, has had an interesting reaction to these strong results. In most quarters earnings beats result in stock price appreciation as analysts adjust their earnings projections and price targets to account for the new earnings and revenue numbers.  With the run the market has been on over the last year plus it seems much of this appreciation has already been priced into the stock prices so rather than earnings beats propelling stocks forward, these beats have just been a justification of current prices. On a number of occasions, we have seen even the best earnings results lead to a pause or even a pullback in some stock prices.  For short-term traders, this is always quite frustrating but for long-term investors, these earnings justifications are a good thing.  They mean that these companies and the economy are growing and although the short term price reaction may have been muted the long-term growth projections that are currently being priced into the markets are relatively accurate. Additionally, it helps dispel concerns that the market is in a bubble.

Market Fatigue: The concept of market fatigue seems like just something that pundits say to explain a flat markets or markets that don’t seem to be doing much. But I think they it is an apt description of what we are experiencing right now.  The market has run up quite considerably over the past 12 months and as we approach year-end many investors and money managers would be happy to finish the year with these gains. We are sitting at stretched valuations and it seems no one wants to do anything to rock the boat too much. Earnings seem to have a good job at not ruffling too many feathers and have helped to justify the year to date market growth but everyone seems content to allow these earnings results to digest while we wait for some clarity around tax reform.

I’m not contending that we won’t see a year-end pullback or a Santa Clause rally but I wouldn’t be surprised if status quo wins the day.  Much of the market action headed into year-end could also be driven by tax planning as investors and money managers decide how to handle the unrealized capital gains that many investors are holding.

Tax Reform: The gorilla in the room is still the tax reform bill.  We have seen some progress but also a lot of pushback.  I think until we see some real progress on this issue everything we discuss is just speculation.  It is also important to point out that while getting a bill passed will probably be a positive catalyst for the markets in the short term, getting a watered-down bill or weak bill passed could actually have a negative impact on the economy and the markets in the long run. It would be viewed by many as Congress not living up to their promises and potentially seen as them just kicking the can down the road. I understand that passing such an important piece of legislation is not an easy task, especially in today’s political climate, but passing a bill that tries to make everyone happy could be worse for the economy than not passing anything at all.

Strategy Commentary

I continue to maintain a slightly reduced equity allocation. This earnings season has helped to dispel some fears over concerns that valuations were getting a little bloated. However, the uncertainties around tax reform of geo-political events still weigh on the overall risk profile of the markets.  If we can see some progress on the tax front I will be looking to add to these equity positions, especially if we continue to see some consolidation or a pullback.  The earnings season has convinced me that overall, company fundamentals are strong and this bull markets could still have some legs.

Domestically, I have maintained the same allocation from last month. This includes overweights to technology, healthcare and basic materials.  Technology continues to outperform and the strong earnings season from the sector only strengthens my conviction in the sector.  Healthcare, on the other hand, has shown some weakness and I will probably look to rotate out of it in the coming weeks.

Internationally, emerging markets still continue to drive forward.  The data coming out of China has been positive and the President’s trip there over the past few weeks doesn’t seem done much to move the markets in either direction. I am maintaining this overweight. Last month I also discussed reentering my position in Germany. However, with the uncertainty around Angela Merkel ability to form a coalition has cast some doubt on the country.  I think the economy is still the strongest in the EU block but I may wait to see if we can get some clarity before adding to the position.

I am still negative on the fixed-income space. Rates seem to be trending higher and we have seen some pullback in the high yield space as well.  I am maintaining my underweight to the space and again am more comfortable holding cash as a replacement.