November 2, 2017 – The most hated bull market in history found a new level of defiance over the last quarter, confounding even the most ardent believers in its ability to continue to rise. To paraphrase Mark Twain, rumors of its demise are greatly exaggerated. We saw good reasons for the continued rise earlier in the year. The tenor of the market admittedly shifted over the summer, but like a good prize fighter, it simply refuses to go down.
We’ve continued to preach patience and confidence. That’s not changing now. But even with this sustained uptick, it’s our job to study the risk and always be thinking about how this bull run ends. Throughout this historic bull market, we’ve identified three markers that could indicate its looming decline:
An inverted yield curve
Excessive risk taking from investors
A year ago, our attention was focused more on the yield curve than investor sentiment. For reasons we’ll outline in this letter, today we’re less worried about an oncoming recession and while valuations are high, earnings growth has kept them from what we feel is excessive. The bigger risk going into the fourth quarter is the fact that the market has simply not gone down for the last two-and-a-half months. We continually ask ourselves, what is the retail investor’s mindset in terms of risk?
Alan Greenspan recently said that typical bull markets see a period of investor euphoria before they end. That euphoria can last for a while, and he feels we’re just starting to see inklings of it now. We agree. In terms of the markers we’ve been watching, we don’t see any of those three boxes fully checked yet. As we speculated last quarter, this could indeed end up being the longest economic cycle without a recession in history.
We know markets can look like a staircase going up – and an elevator going down. As we move through the fourth quarter, we believe we’re still climbing and the market will continue to increase for some time, but we’re also increasingly looking to reduce risk through diversification and long-term strategy.
Global Goldilocks Conditions Continue
Strong performance across all asset classes remains driven by a Goldilocks global economy. In fact, global economic numbers show few signs of slowing. China followed up 6.9 percent GDP growth in Q2 with a 6.8 percent this quarter. Unemployment figures coming out of Brazil are better than expected. Purchasing Managers’ Index (PMI) figures in Brazil and around the globe are showing synchronized growth that has driven markets and economies worldwide. Of interest in the Global PMI chart (see Chart A) is that the aggregate reading of 53.2 (with 50.0 being the dividing line between expanding and contracting manufacturing bases) is as high as I remember ever seeing it, and every country on the list reports a reading above 50.0. The global synchronization of economic growth is a fundamental factor in this equity market rally.
With such strong global performance, we’re keeping an eye on risk that’s more political in nature. The elephant in the room, of course, is North Korea. A flare-up there could impact trade, particularly in Asia, though the market has remained relatively unfazed by the potential escalations on that front to date. Elsewhere, we’re watching the NAFTA negotiations closely. As the rest of Latin America improves, we’ve seen some weakening in Mexico’s capital markets and currency rates, suggesting some apprehension over those negotiations and their outcome. The recent election in Argentina was one potential flash point that seems to have diffused, though we’re still hearing populist whispers throughout Europe. Spain has made all the headlines in Europe with the crisis over the secession of Catalonia, but we’re also monitoring Italy, where a credit spread shift in the wrong direction could signal future instability.
While we’re vigilant to these risks, they continue to be speculative in nature. The global economy’s Goldilocks Moment continues, and that’s reflected in the equity markets.
US Economic Growth amidst Murmurs from the Fed
In the ninth year of expansion in the US economy, we’re actually seeing signs of acceleration. Despite two major hurricanes, which tend to stall growth in the short term and spur it long term, we continue to see strong GDP growth figures. Final readings report a 3.1 percent rise in the second quarter and estimates of 3 percent growth for the third quarter. Meanwhile, the Federal Reserve is the first of the global central banks to begin quantitative tightening. While quantitative easing serves as a fuel for the growth we’ve witnessed, we don’t expect this shift to have a drastic negative impact on the market. However, the circumstances are unique and we will monitor it closely. It is most likely to appear as stealth tightening of interest rates.
The Fed has continued to tighten the federal funds rate and will most likely do so again in December. At the same time, President Trump considered several candidates for the chairman role. While John Taylor, Gary Cohn, and Kevin Warsh were contenders, Fed governor Jerome Powell received the nod. A Powell nomination represents the most dovish choice, aside from re-nominating Yellen, and, therefore, is a more status-quo decision regarding Fed leadership.
The biggest risk we see in the US markets heading into the fourth quarter is whether or not real economic growth will be able to support the exact path toward normalization the Fed has laid out. Last week’s 3.0 GDP reading in spite of two hurricanes during the quarter shows that there is currently a good bit of economic momentum. However, there are a number of political markers looming. Chief among them is tax reform. That’s designed to spur growth. If it isn’t passed, or for some reason it doesn’t drive growth as intended, that is a negative sign.
All of these developments may indicate the US is turning a bit of a corner. We have a stronger economy with a relatively flat yield curve. Individual investors are beginning to be more willing to take on market risk. At this point, we think the market can support quantitative tightening and other Fed policy shifts, but we’re watching for inflection points indicating a change in that prediction. As we pass these milestones of typical bull market top behavior, it is important to remember how slowly this market cycle has evolved. We are seeing the start of a new phase which, while it definitely is a late-cycle phase of market development, may take months, or even years, to play out.
Global Stocks Continue to Lead
As we reported last quarter, global stock performance has been strong in 2017, and that trend has continued. Driven in large part by the strength of the dollar, emerging markets were up 7.9 percent. China and Brazil achieved particularly strong gains, up 24 percent and 23 percent, respectively. That puts Brazil at a 29 percent increase year to date. Core Europe remains strong as well, with France up 23 percent and Germany rising 27 percent. Although the dollar has started to weaken in recent months against a broad basket of currencies, it remains nearly 20 percent higher than its value three years ago. (See Chart B.) We see the dollar remaining firm in response to our Fed’s global leadership in quantitative tightening and raising the Fed funds rate.
US stocks have not been as strong as their global counterparts, but make no mistake, the US is enjoying a market an investment professional joining the business in 2000 wouldn’t even recognize. With the low trading volumes we usually see in August, market reactions can often be more extreme in late summer. Yet, despite headlines about hurricanes and North Korea, the market did not take a sharp downturn. Historically, minimal seasonal weakness like we experienced this quarter tends to make for a strong market entering the fourth quarter. But, we do expect emerging markets stocks to lead US stocks through the end of the year, driven largely by the robust growth environment of their economies and the relative cheapness in terms of valuation compared to US stocks and bonds.
US Equities: The Year of Large Growth
If the US markets in 2016 were defined by small value, 2017 is the year of large growth. Large cap growth in the Russell 1000 is at 20.7 percent for the year-to-date, and the S&P 500 is up 14.2 percent year to date – a very impressive number. Additionally, active managers are faring better this year. While last year passive, unmanaged accounts got a lot of attention, these returns are cyclical, and we’re seeing actively managed portfolios outperform passive non-managed approaches for the first time in a few years.
We are continuing to keep an eye on the kind of emotional investing that’s been on the rise in the last few quarters. Markets that refuse to go down, even in the face of bad news, combined with creeping valuations, introduce another element of risk into this market. An expensive, emotionally-driven market is traditionally more susceptible to short-term influences. So, developments like escalation against North Korea or a tax plan that doesn’t deliver are risks for a potential downdraft in the future. These types of shifts do not tend to be long-lasting, and a short downturn could relieve some pressure in a market that hasn’t gone down in months. Regardless, the rise of emotional investing is one area in which we’ve remained vigilant.
We’re also keeping an eye on valuations in regard to price-to-earnings ratios. As we wrote in the last commentary, this continued bull market has drawn comparisons to the tech bubble in 1999. But, we are in a much different environment today. Price-to-earnings ratios have increased, yet we have seen meaningful earnings growth – the denominator has kept the ratio in a reasonable range. However, that doesn’t mean capital markets aren’t still pricey as we enter the home stretch of 2017 – fixed income, US equities, and non-US equities are all slightly overvalued or expensive, depending on the measurement you use.
Fixed Income Remains Strong, if Overvalued
Despite their expense, demand for fixed income investing remained strong over the last quarter, with solid returns in Bloomberg Barclays US Aggregate Bond and mutual fund indices. Even in parts of credit markets with greater risk, the spreads remain narrow – a sign of a market that remains strong.
It’s hardly controversial to say that US fixed income is the most overvalued sector of capital markets today. Money continues to flow into the funds. (See Chart C.) Pitcairn’s diversified portfolio strategy offsets some of the risk that comes with this overvaluation. If this market does turn, a portfolio with lower-valued assets may go down on an absolute basis, but investors will be better protected on a relative basis. As we head into the fourth quarter of 2017, these efforts to mitigate risk are top of mind as we prepare for an eventual shift in the market – even if we believe it won’t happen in the near term.
Ongoing Confidence with a Focus on Risk
This year marks the 30th anniversary of Black Monday and the crash of markets around the world in 1987. If you were just to compare a stock chart from that year and today, they would appear to be quite similar. However, we see several factors that point to a stronger market today – lower risk appetite from investors and a healthier technical market chief among them.
But 1987 holds another lesson – one that is core to the Pitcairn strategy. An investor who purchased the S&P 500 on December 31, 1986 and sold it on Dec. 31, 1987 would have made money. While it would have been a small amount of money to be sure, 1987 was a positive performance year for the S&P. The investors that lost big in 1987 were the ones who were overly tactical, buying high and selling low in a highly emotional market environment. We see a similar outcome on a longer scale following the Great Recession. The market is up considerably since 2008. The last decade has given us the worst bear market in 80 years, followed by this incredible, unloved bull market. Those with a long-term plan that includes a diverse portfolio have found success. That’s the essence of Pitcairn’s approach.
We’re proud to say that someone who follows Pitcairn’s philosophy with a properly constructed portfolio has an extraordinarily high probability of reaching their goals over the next decade. We believed that to be true 10 years ago, we believe it today, and we’ll believe it 10 years from now.