Smoke on the Water

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by Timothy D. Carkin, CAIA, CMT
Senior Vice President

As the Western states struggle with wildfires and the Southeastern states get pounded by hurricanes, the stock market quietly made new highs. The S&P rallied this week 1.4 percent, closing in on the psychologically important 2,500. Conversely, bonds felt the swing into equities with rates on the 10-year U.S. Treasury rising 13 basis points to 2.20 percent. The pop in the markets occurred after Hurricane Irma’s wrath proved less damaging than was originally forecasted. The remainder of the week was far less eventful with traders turning to Chinese industrial production numbers coming in weaker than expected and the CPI increasing in August by 0.4 percent. The latter of these moves brought headline inflation closer to the Fed’s 2.0 percent target, bringing another rate hike this year back into consideration.

 Are We Due?

“Are we due for a correction in the stock market?” This question is asked every time the market rallies to a new high - and rightly so. Markets don’t go up in a straight line. Rather, they go up in a “saw tooth” pattern: rallying, then selling off, then rallying again. It’s healthy for the markets to retreat, which wipes out excessive exuberance and tests investors’ resolve in valuations. Since the S&P 500 broke out in November of last year it is up nearly 20 percent without a pullback greater than 3 percent. In fact, it’s been 20 months since the market has seen a 5 percent pullback. Generally, market pullbacks are led by or coincide with at least one of the following indicators: increased volatility, stretched valuations, a faltering economy and/or geopolitical strife.

Volatility in the S&P 500 as measured by the VIX index is close to all-time lows. The lack of volatility across asset classes may belie rising risk but evidence points to calm waters until the VIX rises. Along those lines, 103 stocks hit new 52-week highs in the S&P 500 this week. This is a good indicator of the breadth of a rally. Technically, there isn’t an imminent threat of a pullback.  

Equity valuations are currently extended with the S&P 500 trading at 17.5 times next year’s earnings. This is well over the 10-year average of 14.1 times earnings. It’s easy to think that with stretched valuations the market should revert to average levels but the price-to-earnings ratio hasn’t historically been a good predictor of market corrections. Many times, the earnings catch up with the advance in price, thus reducing the ratio while maintaining a higher-priced market. If earnings weaken, this could trigger the market to reevaluate its extended valuation and sell off.

The U.S. economy is threading the “goldilocks” needle. Employment, GDP growth and inflation are all indicating a healthy consumer environment that is “just right.” So far, the FOMC has been able to raise rates without any negative affects to the market. The strength of the economy is forefront in investors’ minds when justifying the growth implied in the markets at these levels. If any of these indicators wobbles, that could be an excuse for markets to sell off.

Lastly, there are the geopolitical wildcards. One can’t predict natural disasters, the actions of dictators and terrorists or the next scandal in Washington. Any one of these could roll the market over, but for the last few years they have all been greeted with a shrug and the fundamental strength of the market has held up.

Sir John Templeton once said, “Bull markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria.” The above data could imply that investors are somewhere between skeptical and optimistic.

Takeaways for the Week:

  • Markets are on solid footing, but not without risk
  • Markets aren’t yet euphoric