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The Brave Report: Market Commentary for January 2018

Click here for the PDF version of this report: The Brave Report – Jan 2018

We don’t really need the government anyway. Over the weekend the government shut down for around 70 hours and the markets just laughed. So far this year the markets have been on a tear, logging one of the best starts to a year in decades. This rally continues to gain steam. The uncertainty of tax reform has been lifted. Economic data continues to be stellar and earnings reports seem to echo this sentiment. We have also seen the retail investor get more optimistic and start to move some of their cash from the sidelines as they feel they have missed out on this bull- run and are scrambling to get involved before there is a correction. This euphoria is often seen in the last innings of a bull run but how long those innings lasts is still yet to be determined.  In the meantime, the markets show very few signs of slowing down.

Market Overview

Over the past month, all three major indices moved in lockstep again making swift moves higher.  The NASDAQ was the biggest winner after underperforming last month, gaining around 7.5%. The DOW and the S&P followed suit with both gaining just shy of 6%. These gains represent one of the best starts to the year we have seen. We saw money flood into equities starting on the first trading day of the year and it has only continued as we enter earnings season.

Big technology companies have been the biggest winners recently but it seems that we are in an environment where almost all ships are rising. While there is some outperformance in areas over the past 3 months only one major sector, utilities, has gained less than 6%, with 4 sectors gaining more than 12%.

The fixed income side finally saw a break from the norm.  The 10-year, which has been very range bound since the election finally broke out of this range and reached a yield we haven’t seen since the end of 2014. It is still hovering right on the edge of the previous range so the big question remains, will it finish its breakout or settle back into the range? The other dynamic we have seen recently is a flattening of the yield curve. With the 10-year breaking out higher, the 30 years still remains below 3%. It will be important to continue to monitor this yield curve dynamic, especially as the Fed continues along its path of rate increases.

Earnings: We are just at the very beginning of earnings season but as we move into some of the bigger names, especially on the tech side, I wonder if this will be a quarter when earnings propel stocks or if, similar to last quarter, earnings just justify the runs that many stocks have been on over the past month. In the environment, we are currently in a number of stocks have run up in anticipation of their earnings and not because of their earnings. Last quarter many reports did justify these runs but it will be interesting to see if this same dynamic exists over the next few weeks.

The other interesting dynamic in these earnings is these will be the first quarterly reports since the tax reform bill got passed.  Up until now, any mention of tax reform was just speculation.  With the reforms now signed into law, we will now get to see how companies are factoring these tax cuts into their forward guidance and business plans.  We have seen a number of companies preemptively announce one-time employee bonuses but these earnings reports and conference calls will give us a taste of how these tax savings will be spent.  Will it be passed along to shareholders in the form of dividend increases or share buybacks or will it lead to more capital investment?

Investor Euphoria: I’ve talked a bit in the past about investor behavior and how it changes during the different stages of a bull market. One interesting thing I have seen in recent months, and especially since the start of the year is an increased excitement by retail investors and a rush to chase returns.  Many investors stayed on the sidelines last year thinking the market had to finally pull back and missed out on over 20% returns. Now they seem to be flooding back trying to make up for it.  This type of investor euphoria is typically reserved for the later stages of a bull run. Now I still don’t think we have reached such a euphoric state that it is time to worry and these last few innings of a bull market can sometimes last for years and can represent some very significant gains. This type of euphoria can add some fuel to these gains before an eventual correction. However, I do think it is something to keep an eye on to make sure the market isn’t getting too far ahead of itself. If it does, any pullback could be exacerbated.

Yield Curve:  As I mentioned above, the yield on the 10-year treasury finally broke out of a range it has been stuck in since 2014 and traded above 2.61%. This has brought into question whether the bull run we have seen in bonds over the past 30 years is finally coming to an end.  The expectation is for continued increases in the fed funds rate and while these moves don’t directly impact the 10-year bond they definitely have an influence on yields across the curve.  A rise in the 10-year is significant because it is widely used as a benchmark to prices loans and mortgages so an increase in yield can have a direct impact on consumers.  I don’t expect the yield to rise rapidly but under current economic conditions, I wouldn’t be surprised to see it creep toward 3% over the coming year.

Strategy Commentary

As I alluded to last month, I increased my equity exposure back above normal levels at the beginning of the month. With tax reform complete, a continued flow of positive economic data and strong corporate earnings I feel that many of the potentially negative uncertainties have been removed from the market. I also don’t think the full impact of the corporate tax cuts has been priced into the equity markets yet. As I mentioned above, it will be interesting to hear how companies are going to utilize the benefits of these tax cuts but in my opinion, it can only be a positive for equity markets over the next few months.

Domestically, I still continue to be overweight the same sectors.  Although technology has been on quite a tear I still think it has legs and has the biggest opportunity for growth. I wouldn’t be surprised if we saw a brief pause as many of the big tech names consolidate after earnings but I expect the rally in the sector to continue.  I am also maintaining my positions in financials and materials.  Materials have underperformed in the past month or two so I may shift some of these assets back to industrials but these two sectors stand to win if anything gets done on the infrastructure side of things.

Internationally, I continue to maintain my overweight to emerging markets. I see it as the best place for growth moving forward. China, in particular, has been outperforming and even with Trump’s trade rhetoric, I don’t see China’s economy slowing down anytime soon. There is still uncertainty surrounding the European Union and the plan for Brexit and I would rather stay on the sidelines for now.

I am still negative on the fixed income space. Rates continue to trend higher and with three rate hikes expected next year, I would rather stay underweight at this time. With the small amount of exposure I do have I am staying on the shorter side of the yield curve.