11 Sept 2017
Investors in the U.S. Market Should Stay Focused on the Longer-term
A couple of weeks ago we wrote in this space how the odds of a melt-up were increasing, as nothing seemed to dent the upward trend in stocks. What a difference a couple of weeks can make. The wall of worry that we were concerned was eroding has been at least partially built back up, and the uptrend took a hit. As a result sentiment conditions have corrected from overly optimistic levels based on most of the traditional metrics. In addition, the volatility index (VIX) spiked, rapidly pulled back, and spiked again—reminding investors that conditions can change quickly.
Volatility makes a comeback
The first brick in the rebuilt wall was an increase in the warnings of "bubbles" forming. From former Federal Reserve Chairman Greenspan telling CNBC that a bond bubble was brewing, to warnings from various other pundits that housing, tech stocks, and/or the overall stock market were in bubbles—the warnings increased over the past couple of weeks. Perhaps the warnings themselves helped alleviate overly-optimistic sentiment. We are again reminded of one of our favorite quotes from one of the titans of finance, Sir John Templeton, who opined, "Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria." We have argued for some time that this bull market has been one of the least respected in history, with skepticism remaining high among investors—helping the bull market to persist. But we are mindful of the growing risks and believe the market could struggle in the near-term. Even before the latest selloff, market breadth had been deteriorating and we are in the midst of a period of typical-seasonal weakness. For now though, we believe any corrective phase is in the context of an ongoing secular bull market. The first significant reversal occurred when rhetoric surrounding North Korea ramped up with nuclear threats from Kim Jong Un and President Trump's "fire and fury" volley back. As of now it looks like North Korea has backed down and investors have breathed a sigh of relief; but attention is now on the drama in the Trump administration and growing concerns about getting pro-growth policies passed, which has contributed to another sizable pullback in the market.
No bear in sight
Ultimately, we think traditional fundamentals will define market behavior. After a weak first quarter, U.S. economic growth has rebounded, with an improving employment picture, tightening labor market, rising median wage growth, and a relatively healthy consumer. Even though past performance is no indication of future results, a prolonged bear market has never occurred outside the context of a recessionary environment. Looking at the Index of Leading Economic Indicators (LEI) from the Conference Board, there are no signs of a coming recession.
Additionally, the U.S. economy is getting some support from the rest of the world—with the leading economic indicator for the Organization for Economic Cooperation and Development (OECD) having turned up from its 2016 low.
Global growth may finally be helping
Also, now that earnings reporting season is largely complete, the corporate picture also looks quite healthy. Although we've seen modest pullbacks in some corporate surveys such as the Institute for Supply Management (ISM) Manufacturing and Non-Manufacturing Indexes, the National Federation of Independent Business (NFIB) optimism index—which measure the sentiment of the important small business sector—actually rose in the most recent reading.
As mentioned, the labor market continues to improve and tighten, with the unemployment rate down to 4.3%, forward-looking jobless claims remaining near historic lows, and the Job Openings and Labor Turnover Survey (JOLTS) showing a record number (6.2 million) of job openings.
The healthy job market may finally be translating to increased spending as retail sales, according to the Census Bureau, rose a better-than-expected 0.6% in July, while June was revised higher.
Washington could throw a wrench in things
After a week of extraordinary tension and turmoil following the horrific events in Charlottesville, questions abound about the upcoming debt ceiling fight specifically; and the Trump administration's agenda specifically. Trump's business-oriented councils have disbanded, healthcare reform is already off the table for now and tax reform looks less likely until the debt ceiling is raised and a budget is agreed to. Markets have begun to take it on the chin as what were already likely to be contentious negotiations are likely to become even testier given the drama in DC.
On the QT
Separately, the Federal Reserve is likely to embark on its quantitative tightening (QT) plan, in order to slowly unwind its bloated balance sheet. We have confidence that the Fed has little desire to jolt the financial markets, but it and the market are in uncharted territory as unwinding a $4.5 trillion balance has never been done historically. We continue to believe this will be an additional volatility-driver.
The latest bout of volatility illustrates why investors should stay focused on the longer-term. Risks for a more substantial pullback in the near-term still exist, as valuations remain elevated; but we believe solid U.S. and global economic growth, strong earnings, low inflation and still-ample global liquidity should allow the bull market to continue.
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.