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U.S. Stocks Uptrend should Continue, but Risks have Risen

It’s easy to look at equity indexes in the United States hitting record highs and believe that all signs point to further bullish action. But below the surface there are some developments that we believe warrant a bit of caution. Investor sentiment is in the overly optimistic zone according to the Ned Davis Research Crowd Sentiment Poll, which can herald a near-term pullback. In contrast, investors’ actions don’t appear to match the sentiment, as money flows into equity mutual funds and exchange-traded funds (ETFs) remains negative according to Evercore ISI Research. Also, some of the former leading sectors, such as technology stocks—especially those in the social media space—have shown signs of weakness. This could represent a broadening of leadership, or a shift away from areas that are perceived as higher risk—or both. Meanwhile, the industrial sector has surged, perhaps bolstered by the recently weaker dollar, which has occurred despite 10-year Treasury yield again moving above 3%.

Rising bond yields, however, could pose a problem for stocks in the not too distant future should the trend continue. Higher yields have made the valuation picture more difficult to justify, while they also have the potential to make fixed income securities more attractive; which could move even more money flow from equities to fixed income. Finally, stocks largely shrugged off the announcement of additional tariffs between China and the United States—perhaps relieved that they weren’t as large as might have been expected. But the threat of further escalation remains very much in play.

U.S. economy looks strong, but are there cracks below the surface?

Trade disputes don’t seem to be having a significant impact on the U.S. economy as of yet, although the boost in tariffs on Chinese goods just occurred and aren’t yet reflected in the data. Business confidence remains elevated, with the National Federation of Independent Business (NFIB) Optimism Index recently hitting a record high; while capital expenditure plans remain elevated. But although both the manufacturing and services surveys done by the Institute of Supply Management (ISM) moved higher at the beginning of the month, almost half of respondents also noted they were concerned about trade. There is the risk that concern turns into action should trade disputes drag on or escalate even further. With the end of the third quarter closing in, investors will soon be able to hear the latest from management during reporting season, which we also believe is a risk to the continuing uptrend in stocks. With estimates for S&P 500 year-over-year earnings growth standing at about 21%, the bar is set quite high, and it could be difficult for the majority of companies to beat those elevated estimates. For now, earnings growth remains a support for stocks, and the healthy corporate picture is boosting the consumer via job growth and confidence. Initial jobless claims are at their lowest levels since the late-1960s and now “threatening” to move below the 200k mark, which is almost unheard of.

The strong labor market has boosted consumer confidence, which continues to hover near record highs. Which brings another cautionary note, we don’t know if this is the high for consumer confidence, but stocks have tended to struggle mightily following what in hindsight has been highs in consumer confidence.

But here too we have a bit of a mixed message. Confidence is high but auto and home sales have been weaker. We like to look at actions more than words and consumers’ actions appear to us to be still relatively cautious. Expectations for the holiday shopping season (yes, already thinking about that) are likely to be elevated given the strong economy, but if consumers remain cautious, there could be some disappointments in store.

Much like the stock market, we think the trend in the economy will continue higher and that a recession is not in the near-term cards; but upside surprises may be difficult to come by, potentially limiting potential market gains as we finish out the year.

Fed sending mixed messages as well?

The Federal Reserve again surprised no one by raising rates this week and did little to dissuade rising expectations of another hike in December. But while they are expressing little concern of overheating inflation and have shown no desire to crimp economic activity, the Federal Open Market Committee (FOMC) removed the reference to policy remaining “accommodative;” in keeping with the real (inflation-adjusted) federal funds rate now being in positive territory for the first time post-financial crisis. Coupled with the ongoing shrinkage of the Fed’s balance sheet, monetary policy has moved from loose to tighter (if not yet tight). We don’t believe the Fed has a desire to hurt stock prices, but the possibility of a monetary policy mistake adds to our belief that a neutral stance in U.S. stocks remains appropriate.

So what?

Recent records in the U.S. stock market do not, in our view, mean that investors should get more aggressive in their investment stance. High expectations, elevated investor sentiment, trade disputes, and the possibility of a monetary mistake lead us to take a more cautious stance. In the meantime, the bull market should continue, with a solid economic and earnings backdrop, but gains are likely to be more muted and bouts of volatility and corrective phases are more likely. Higher oil prices do have potential winners in the form of Canadian and emerging market stocks and have an impact on central bank actions, so we’ll be watching developments in the energy space closely.

 

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Institute for Supply Management Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation, by the Institute of Supply Management (ISM). The ISM Non-Manufacturing Index tracks economic data, like the ISM Non-Manufacturing Business Activity Index.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Content provided by Charles Schwab, Hong Kong
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