Now that the Dow and S&P 500 have set record highs without corresponding records in corporate earnings or GDP growth, where do we go from here? That is a great question. Let’s dig a little deeper to see what is going on.
Our thinking is that over the next 6 to 12 months, we will continue to remain cautious even as equities rally to new highs. The shorter term (2 to 4 months) could see equities pull back, perhaps significantly; not like in 2000 - 2002, but a pullback nonetheless.
What's Propelling the Market
So, what is driving this rally to new highs? This is a logical question, since earnings and GDP are still muted, historically speaking. Let’s look at what could be propelling this market higher for now:
- Falling bond yields from the low to mid-2% area to 1.37% in early July. The yield has now increased to 1.52% (as of late July) but is still very much below 2%.
- Rising forward looking earnings. Earnings and GDP are looked at as year-over-year when trying to determine if the economy is getting better or not. The latter half of 2015 saw the dollar moving higher, which hurt multinationals’ profits and put downward pressure on their earnings. Today, the dollar is lower, although modestly rising, so multinational companies have an easier time beating their earnings from this time last year.
- BREXIT has come and gone without too much disruption from capital markets. Maybe BREXIT won’t end up being such a big economic deal to our markets. Europe, including the U.K., only represents about 7% of the S&P 500’s profits. (The EM markets, including China, represent roughly 16% of the S&P 500’s profits and Japan only represents about 1%).
- There is ample liquidity; more so with consumers than corporations, and consumers are starting to “loosen their wallets” a bit more.
- The barometers of financial and economic deflationary “tail risk” that we follow are improving. We monitor high-yield spreads over Treasuries, spreads between emerging market sovereign debt and corporate bonds (they have continued to narrow), oil prices, which are up, and the dollar, which is strengthening again, just to name a few things. As a result, we are seeing a minimal possibility of a deflationary scare.
- The risks of financial contagion spreading from BREXIT in other EU countries appear low. As long as all of these issues continue to improve, we could see risk assets move a little higher, with some pullbacks along the way.
Of all of the issues mentioned above, the most important one would be the earnings outlook. So, the question becomes…are we past the worst of reported earnings? We think that Q2 earnings will continue to decline, but only because of the energy sector. Beyond the next several quarters, we expect profit growth to be in the 3% - 5% range with energy even contributing modestly to this outlook. According to the Bank Credit Analyst (BCA) “top line growth excluding sectors impacted by plunging commodity prices (energy, materials and utilities) already has been in the 3% - 5% range since 2012, which is roughly in line with nominal GDP growth.”
We must keep in mind that the BCA also says that “domestic revenue growth is accelerating with rising margins, while foreign revenues and margins are declining. Any future stimulus from the European Central Bank will not reverse these trends anytime soon.” On the negative side, or a headwind to the above, is valuation. While the market - the S&P 500 - is nowhere near where it was in 1999/early 2000 (valuation wise), it is above what we would consider to be fair value. This doesn’t mean that it can’t get even more overvalued.
The good news is that back in 1999/early 2000, we had declining breadth (fewer and fewer stocks were making new highs) and increased volatility. Back at the turn of the century the VIX Index, a measure of volatility, was in the 40s. Today it is in the low teens - around 13. Volatility is a way of telling how nervous and edgy the investment community is at a specific point in time. Today, investors are reasonably complacent.
With all of the above being said, our Investment Department has made some portfolio changes since the markets went to new highs, but on the margin only. We have done the following:
- We continue to maintain a significant overweight to domestic equities versus foreign equities.
- We reduced the cash position from 11% - 12% to around 6%. The proceeds went into a new equity position.
- We reduced our equity underweight from about 10% to 5%.
- We established an initial position in a preferred stock portfolio in an effort to raise our portfolio’s overall yield.
- We initiated a small position in an emerging market fund; one that we have owned in the past.
- We initiated a small position in gold.
- We are contemplating slightly reducing our exposure in the market neutral fund we currently own and adding a second market neutral fund that behaves somewhat differently from the current fund.
Please contact us at (972) 684-5923 if you have any questions.
NOT SURE WHERE TO START?
Request your FREE Final Approach retirement planning guide.
This guide is designed to help you understand the decisions you will need to make as you approach retirement and the factors that go into a comprehensive retirement plan. It includes:
- A checklist for transitioning into retirement
- Common investor pitfalls
- An outline of your retirement benefits
- A retirement timeline to help you know what to expect
- Key topics to consider in your estate plan
- The importance of survivor assistance
Request the Final Approach to find out how prepared you are for retirement.
Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.