The market's underlying heat this summer

The domestic stock market has been range-bound for the past six months. Observers and participants continue to see spectacular earnings growth through the second quarter of 2018 and expectations are for close to 20% earnings growth for the year.[1] In fact, such growth has actually caused price-to-earnings (P/E) ratios to compress from high levels to start the year to moderately expensive levels today. However, the strong earnings numbers have been offset with uncertainty surrounding trade talks and protectionism. To date, we have witnessed two dips and a moderate correction (a correction is characterized as a drop of 10% from the peak). But, despite the volatility, the S&P 500 Index is up approximately 7.5% and very close to making new all-time highs. Going back to 1928, it is actually "normal" for the market to experience 3 dips (down 5% or more) on average per year. 2017 was an aberration with none, causing investors to prevision that environment and become complacent. If the stock market makes it to the end of August this year without a 20% correction (considered a bear market), this will be the longest bull market in history surpassing the 1990s. Overall, the domestic economy has been flourishing this year with solid fundamentals. Noteworthy, the consumer confidence index hit its highest level since 2000, the National Federation of Independent Business (NFIB) shows small business optimism highest since 1983, the U.S. unemployment rate just hit the lowest rate in 50 years at 3.8%, and the S&P 500 Index posted one of the largest quarterly earnings growths in the first and second quarter. Despite the favorable data, stocks have been volatile. Volatility has been prevalent for two primary reasons: (1) the U.S. Fed has increased short-term rates - tightening the reins on monetary policy; and (2) numerous rising trade tensions have evolved. That said, it is key to remember the stock market is typically six to 12 months ahead of the economy. Addressing the first of the two reasons, the U.S. Federal Reserve (Fed) has raised short rates seven times since the end of 2015 and from the extremely low levels due to quantitative easing. However, the Fed's preferred inflation gauge (core personal consumption deflator) has been running right at their targeted level of 2% for the past few quarters. If the economy overshoots, the result could be more hikes than the market expects. Secondly, trade talks have intensified between the U.S. and China, North American Free Trade (NAFTA) talks have deteriorated, and the U.S. and European Union have had battles over steel, aluminum and autos. For the latter, there have been some glimmers of hope after discussions between President Trump and European Commission President Juncker who have agreed to work toward reducing barriers. However, U.S. and China trade talks have not resulted in any agreement and have actually witnessed further retaliations from both sides. There are no indications a U.S. recession is imminent. However, late cycle pressures are building and risk is rising. Nevertheless, this is a time to fully understand the risks of the market. During these times, it's important to focus on your long-term plan and objectives. Investors need to stick true to rebalancing asset classes back to desired targets and place heightened importance on asset class diversification and downside protection. ----- Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680. Published: Mon, Sep 03, 2018