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The U.S. Bull Market will Continue, and Investors should Remain at Their Target Allocations

The ongoing uptrend in the U.S. stocks has only recently seemed to capture the hearts and minds of investors. The recent lack of volatility and “Teflon” nature of the stock market has boosted investor optimism; but may have also bred complacency about ongoing risks. We expect more upticks in volatility.

As noted, most measures of investor sentiment have moved firmly into optimistic territory; with the Investors Intelligence survey showing a high in newsletter writer optimism not seen since 1987. But behavioral measures of sentiment don’t yet match that optimism:  flows into U.S. equity mutual funds and exchange-traded funds (ETFs) continue to be flat-to-negative on a cumulative basis. As we’ve been highlighting, it’s easy to argue that we are in the latter innings of the market cycle; even though past performance does not indicate future results that phase often ushers in strong performance.  

Gains typically accelerate in the final innings of a bull market as investors become more confident and push more money into the equity pot. As John Templeton’s famous quote says, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”  This bull market has fed off skepticism for much of its duration—only recently displaying optimism, but not yet euphoria. We believe the current bull market will ultimately be followed by a traditional bear market—at a point of either excess tightening by the Federal Reserve and/or the anticipation of an economic recession. Neither is in our sights; although there are enough risks that a pullback could occur with even a minor catalyst.

Who’s afraid of the big bad wolf?

Although there will always be worries that an economic “wolf” is waiting around the corner, dressed up as grandma, waiting to devour unsuspecting bulls—the current economic expansion looks to be more a case of Goldilocks than Red Riding Hood to us. Inflation has picked up modestly, with the Consumer Price Index (CPI) posting a still-benign 1.7% gain year-over-year in the most recent reading. But a new broader measure of inflation put out by the NY Fed—called the Underlying Inflation Gauge (UIG)—shows a loftier 2.7% year-over-year increase. Last month, retail sales posted a robust 1.6% gain month-over-month, although some of that was likely hurricane related; while both the Empire Manufacturing Index and the Philly Fed Index helped confirm the boom-level Institute of Supply Management (ISM) readings. Additionally, we are in the midst of a period of synchronized global growth; with all 45 OECD (Organization for Economic Cooperation and Development) countries in expansion mode; and with confirmations from indicators such as copper, lumber, and the Baltic Dry Index (measuring shipping rates).

Is it haunted?

Although some scary things can come out of Washington at times, we don’t think some of the investor fear is justified. Partisan conflict is high—both among and within parties—but it’s not something we fret to a significant degree. In fact, the Philadelphia Fed keeps a “Partisan Conflict Index,” and historically stocks tend to perform well when conflict is in its highest zone. We have been inundated lately by questions about the prospects for tax reform and the implications for stocks.  Treasury Secretary Mnuchin recently told Fox News that the stock market would “see a reversal of a significant amount” if the tax deal the administration is pushing doesn’t get passed. While the lack of a deal would likely be disappointing, we don’t believe economists or analysts have yet built the expectation for tax reform into forward-looking estimates; so the effect is likely to be more psychological than numerical.

So what?

Global and U.S. economic growth, along with a solid earnings picture and a potential tax reform tailwind, suggest investors should remain at their target equity allocations.  Pullbacks are possible but a recession doesn’t appear to be in the cards in the near term, which historically has meant the risk of a pullback turning into a bear market is low.

Important Disclosure
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.

Content provided by Charles Schwab, Hong Kong
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