HIGHLIGHTS

• Markets roughly flat with the lowest one-week volatility since 1972.
• Fed to begin unwinding its balance sheet.
• War of words and name calling between Trump and Jung-un

PERFORMANCE

Not much happened in the market last week. US equities scratched out a 0.25% gain and international equities fell by 0.30%. The range on the S&P 500, from high to low, was only 0.49%, the lowest percentage since 1972. Kind of surprising given the threat of war (see below). Interest rates rose so bonds were down by 0.13%. The dollar was up by 0.54% and crude oil advanced by 1.54%.

FED TO BEGIN ASSET SALES

The long-awaited unwinding of the Federal Reserve’s balance sheet is finally about to begin. The Fed’s intent is to make the process as boring as possible so as not to upset the markets. Bonds will be allowed to mature and won’t be replaced. This will be the first time the Fed has attempted to engage in this process in such large amounts. While the market has so far ignored the announcement, only time will tell if the unwinding does not lead to market disruptions or impact the economy in a negative manner. For now, other central banks around the world, like the ECB, continue in quantitative easing mode, so that eases this transition. But at some point, they will reverse direction also.

TRUMP/NORTH KOREA/TWITTER

Trump said the US would destroy North Korea if they threatened the US or its allies and called the North Korean Leader Kim Jong-un a “little rocket man.” Jong-un, not to be outdone, called Trump a “frightened dog” and a “dotard.” And so the war of words has begun as if we are watching two out-of-control kindergarten children. It would be funny if it was not so serious. Both leaders need some basic lessons in common sense and civility.

Apparently, though, a crisis as severe as North Korea is not enough for our President to concentrate on. He thought it a good idea to start a spat with Seth Curry, and then followed it up by taking on the NFL. How is this guy President of the United States?

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PERFORMANCE

The S&P 500 hit a new all-time high and in the process took another step forward in a continuation of the stair-step pattern we wrote about last week. The index was up 1.09% while the overall US market increased by 1.67%. International equities rose by 0.94%. Bonds were down by 0.48% as interest rates were up by 10 to 12 basis points across the curve. The dollar advanced by 0.70% and oil had a big rally, +5.08 percent.

WHEN ACTUAL INFLATION DEVIATES FROM EXPECTED INFLATION

High valuations by some metrics in the equity markets have been justified by low-interest rates and low inflation. James Mackintosh writes in his Friday Wall Street Journal column that “what matters most to stock prices isn’t where inflation stands, but where it will stand in the future compared with what is currently priced in.” 1980 is an example, a period when inflation was ramping higher, before it was about to fall, as a good time to buy stocks.

Likewise, a bad time to invest in equities was when inflation is low and expectations for future inflation are also low, but then jumps higher. In the mid-60s, the economy was going on its seventh year of sub-2% inflation, at the same time, the Shiller P/E ratio was at its highest point since 1929. Once inflation broke above 2% at the beginning of 1966, the market fell by about 25%.

EQUITIES SPEND MOST OF THEIR TIME IN BULL MARKETS

There are lots of reasons why the market might go down, and we have outlined many of them at our webinars and in this column. But historically, staying in the market has always rewarded long-term investors. According to an analysis done by Bespoke, equities have spent about 88% of the time in a bull market since 1947.

ECONOMY

An early impact of hurricane Harvey was reflected in the August reading for US industrial production, it dropped by a seasonally adjusted 0.9%. That was the biggest fall since the 2007-2009 recession. The hurricane hurt oil drilling, petroleum refining, and other activity.

Initial jobless claims came in at 284,000 this week. That is down from 298,000 the prior week. But both of these numbers are big jumps from the 250,000 or so level that we had seen for many months. The increase is probably due to Hurricane Harvey. The impact of Irma will start being seen in the next few reports. The hurricanes will most likely hurt near-term economic performance before beginning to improve GDP in a few months as the recovery kicks in.

The Atlanta Fed’s GDPNow estimate for Q3 dropped by 0.8% to 2.20% on reports for retail sales, industrial production, and capacity utilization. The New York Fed’s Nowcast also fell by 0.80% to 1.3% The Q4 estimate is now at 1.80%.

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HIGHLIGHTS

• US equities down 0.61%, international stocks up 0.61%.
• Treasury rates continue to fall.
• US stocks still in a stair-step pattern.
• Debt ceiling and hurricane relief bill passes in bipartisan cooperation.
• Hurricane Irma hits Florida hard as we are writing this, Miami Financial District is under water.
• Hurricanes and low inflation might give the Fed pause on raising rates.
• Chinese yuan is on the rise.
• ECB might pullback on stimulus soon.

PERFORMANCE

US equities were down by 0.61%, but international stocks increased by the identical percentage, +0.61. Bonds were up 0.43% as interest rates generally fell by 8 to 10 basis points across the curve. The dollar fell by 1.53% and crude oil was up by 0.40%.

Not much can shake this market. The threat of nuclear war, hurricanes, mayhem in Washington, the market just hangs in there and ignores the news for the most part, continuing to focus on rising earnings and very low interest rates. But while US equities have not fallen, they haven’t risen much either lately. The S&P 500 is priced about the same as it was on July 20th. This is consistent with its pattern over the last year. Trading in a range and the breaking out to a new range in a stair-step fashion. Equities hit new highs, then consolidate and trade within a range, and then break out to another high, and higher-level range.

The market is way overdue for a correction or a pullback of some sort, but this is not news to investors. Maybe the fact that everyone is expecting the pullback is what has been keeping the stair-step pattern intact.

DEBT CEILING/HURRICANE RELIEF

Trump found some new friends in Democrat minority leaders Chuck Schumer in the Senate and Nancy Pelosi in the House, and in quick order, they put together a deal that provides hurricane relief and raises the debt limit through December. We would have preferred a longer-term deal, but are good with Trump making a bipartisan effort on legislation. Maybe that formula can work on other important initiatives down the line and lower the acrimony in Washington.

As we write this week’s column, Hurricane Irma is pounding Florida. While the storm’s center is aimed at the west coast of Florida, initial reports show that the east coast will not be spared. Miami’s financial district on Brickell was a few feet deep in water on Sunday afternoon, only midway through the storm.

Expect billions and billions in damages. The government must step in and help the communities devastated by the hurricanes. But from a bottom line perspective, this continues the pattern of more aid out of Washington, less fiscal discipline, more deficits and a larger intrusion by the government in the economy. With interest rates close to all-time lows, bigger deficits may not be a problem now, but will be at some point in the future when interest rates get to higher levels.

Near term impact of the hurricanes will be a slight increase in inflation (mainly due to higher gasoline prices), slower growth over the next few months (to be offset in the months following), lower employment and higher initial claims for unemployment. Total property losses from Harvey should be in the $70b to $100b range, which would be about 0.5% of GDP.  There are no estimates on the damage from Irma yet, but it will be immense.

HURRICANES/LOW INFLATION TO GIVE FED PAUSE

A combination of two monster hurricanes and an inflation rate that won’t budge higher are giving Fed officials pause as to whether to follow through on another interest rate increase this year. Inflation continues in the sub-2% range, short of the Fed’s 2% target. On top of the low inflation, hurricanes Harvey and Irma will likely have a negative impact on GDP growth in Q3 and Q4, although that will be offset later. Ironically, the dual hurricanes might increase inflation in the longer run as the shortage of construction workers becomes more severe, pushing wages higher as employers compete for workers.

YUAN ON THE RISE

In another example of the markets moving in the opposite of consensus, the Chinese yuan hit a 16-month high this week. It is now up 7% versus the dollar for 2017, and has made up all its 2016 decline. A combination of a weak dollar and currency controls by the Chinese central bank have given a lift to the yuan. Currency reserves are now up for the 7th straight month to $3.092 trillion. The higher yuan has dampened demand for Chinese products overseas. Year-over-year growth in sales to the US from China were down 8.5% in July.

ECB

The European Central Bank indicated it is getting closer to putting the brakes on its expansive monetary policy, but will wait a little longer before taking action. President Mario Draghi said he will probably announce at its October meeting some details of changes it plans to implement.

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HIGHLIGHTS

• Market rallies, 4-points off all-time high.
• How this bull market might end.
• Q2 GDP revised up to 3.0%.
• Nonfarm payrolls increase by 150,000, below consensus estimates.
• North Korea sets off a hydrogen bomb.
• Hurricane Harvey lowers the chance of a government shutdown.

PERFORMANCE

The S&P 500 rallied last week and is now 4.36 points away from its all-time high of 2780.91, set on August 7, 2017. Overall, US equities were up 1.5%, international equities +0.52%, bonds were flat, the dollar was up slightly, +0.19% and crude oil declined by 1.21%.

“HOW THIS BULL MARKET WILL END”

That was the cover story in this week’s Barron’s. Barron’s does not think the end of the bull run is imminent. Most bull markets end due to recession, and there is not appear to be one around the corner.

According to Barron’s, there are two conditions that currently exist that increases the odds of a selloff. One is valuation. The forward p/e on the S&P 500 is 17.7, close to the highest since the dot-com era.  High valuations have minimal short-term forecasting value, but when bear markets begin, it is usually when the market is in a high valuation zone.

The second condition is rising interest rates. The main risk is if the Fed moves too fast.

Mix in a recession with the above two conditions and then you have the makings of a bear market. Recessions led to the bear markets of 1973-1974, the tech bust and the Great Recession.

An economy that revs up would be another possible threat. This is what happened before the crash in 1987. The economy began to accelerate, inflation rates and interest rates began to rise. But back then, interest rates on long term treasuries touched 10%, we are nowhere near that now. But if economic growth were to accelerate, given the tight labor market, inflation could suddenly pick up, forcing the Fed to move faster than anticipated, which would increase the chance of error eventually leading to recession.

Other potential threats include a hard landing in China, antitrust actions against the FANG stocks, and the shrinking of the Fed’s balance sheet. The shrinking of the balance sheet has never been done to this extent before and it remains to be seen how the markets will react.

Some warning signs could include widening credit spreads, an inverted yield curve, the closing of the spread between the earnings yield and the 10-year treasury, making bonds more attractive versus stocks, a rise in the unemployment rate and an increase in jobless claims.

Changes in the structure of the market sometimes accelerate a market selloff. In the Panic of 1907, trust companies were new. They weren’t required to hold any cash reserves like banks. Over time, they increased their risky investments and when the economy turned to the downside, it led to a run on the market until JP Morgan led a group of banks to step in and save the day. In the crash of 1987 it was portfolio insurance. Today, more than $2.4 trillion are invested in exchange traded funds. Up from more than $534 billion in 2007. Some argue such a concentration in these passive type funds would accelerate the next downturn as everyone ends up selling the same stocks. Also, today, you have an acceleration in the dominance of algorithms. What happens if the market begins to sell off and all the algorithms begin sending sell signals at the same time?

GDP REVISED UP

GDP growth in Q2 was revised to 3%, up from 2.60%. That was the best second quarter in two years. It remains to be seen whether the economy can sustain that pace. Right now, Q3 growth is estimated at 3.2% by the Atlanta Fed’s GDPNow model. Some factors supporting improved growth include strong economies around the world, a tight labor market and good corporate profits.

The ISM Manufacturing Index increased 2.5 points in August to 58.8. It was the second biggest gain since June of 2013 and the highest level since April of 2011. This would suggest that GDP should be strong (by recent standards) this quarter.

PAYROLL REPORT

The payroll report came in slightly below consensus. Nonfarm payrolls were up by 156,000, falling short of the consensus estimate of 180,000, and the prior two months were revised lower by 41,000. The increase continues the longest streak ever of increasing payrolls, almost seven years at this point. Normally, August payrolls numbers are revised higher in subsequent months, that has happened in seven of the past eight years.

The unemployment rate increased from 4.3% to 4.4%. Average hourly earnings rose by only 0.1% and the average workweek declined to 34.4 hours from 34.5 hours.

NORTH KOREA

North Korea set off a hydrogen bomb on Sunday, continuing their provocative actions. For the most part, the market has ignored all of this, but this is a geopolitical threat with potentially grave consequences.

ODDS OF GOVERNMENT SHUTDOWN NOW LOWERED

Hurricane Harvey lowers the chances of a government shutdown. Given the situation in Texas, no one wants to be blamed for sidetracking the government when they need to concentrate on relief efforts. Most likely, relief funding will be coupled with legislation to increase the debt limit.

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MARKET PERFORMANCE

The market rallied on Tuesday on renewed optimism that tax reform would pass, but stalled later in the week as Trump threatened to shut down the government (see below). The S&P was up 0.72% for the week. International equities were up 1.43% and bonds increased by 0.15%. While treasury yields are generally down about 7 to 14 basis points this month, the yield on CCC bonds (high yield) are up by 52 basis points month to date, a possible warning sign.

Traders are worried about technical signals indicating a weakening market. The S&P 500 remains below its 50-day moving average. Only 45% of S&P 500 stocks are now trading above their 50-day moving average, a decline of 30 points from one month ago, according to Bespoke Investment Group. The number of stocks making new 52-week lows is on the rise. And the beginning of a trend of lower highs and lower lows continues.

HURRICANE HARVEY

A major hurricane hit Texas over the weekend. It is too early to know the economic impact but it will be significant, at least on a regional level. There will also be an impact on energy prices. The WSJ reports that about 12% of fuel making capacity is currently out of commission. Exxon’s Baytown refinery (560,000 barrels per days) and Royal Dutch Shell’s Deer Park refinery (325,000 barrels per day) are both shut down. In total, about 2,000,000 barrels a day are off-line. Flood claims from the storm will push the $24.6 billion that the National Flood Insurance Program owes the US Treasury much deeper into the red, possibly putting even more pressure on Congress to reform the program. That eventually could later impact real estate prices in coastal properties around the country.

DEBT CEILING

Trump threatened a government shutdown unless Congress funds a wall on the Mexican border. As is often the case, Trump has his priorities backwards. His main emphasis should be on first getting legislation passed to increase the debt ceiling, from there, he should try to work with Congress on legislation that might actually have a chance of being passed. Trump also needs to know that running the USA is different than running his real estate operation. It never bothered him when he didn’t pay his creditors in his past life, but now he represents the full faith and credit of the United States, a higher standard.

BUYBACKS

A report by Societe General on corporate buybacks shows that buybacks declined by $100 billion in the past 12 months versus the prior year. Hopefully, less buybacks and more capital expenditures would enhance long-term growth. Besides, it probably would not make sense for corporations to be buying back their stocks at elevated valuations.

ECONOMY

Home sales were down by 1.3% in July probably due to a lack of inventory.  The smaller inventory has a secondary effect of pushing up home prices. Total housing inventory was down 9% from one year ago. The median home price is up 6.2% year over year. The housing data depressed Q3 growth forecasts, the Atlanta Fed’s GDPNow model fell by 0.4% to 3.4% and the NY Fed’s Nowcast has Q3 growth at 1.93%, down by 0.16%.

Jobless claims came in at 234,000. A historically low number.

Larry Swedroe writes about why the market may not be overvalued, and why investing now versus waiting for a pullback might be the right decision.

Click here for the article.

HIGHLIGHTS

• Market falls on mayhem in Washington.
• Debt ceiling needs to be increased by October 1.
• Poor market reaction to positive earnings reports.
• Growth around the world is solid.
• North Korea backs down.

MARKET PERFORMANCE

The market could no longer ignore the avalanche of bad political news. After falling 1.4% last week, all seemed like it was back to normal on Monday, Tuesday, and Wednesday as the S&P 500 advanced 1.1%. But the combination of Trump’s Charlottesville’s comments, the possibility of the departure of National Economic Council director Gary Cohn and the general mayhem in the White House led to a sell off on Thursday and Friday. Trump’s business advisory councils disbanded after his ambiguous comments regarding the neo-Nazi’s, the KKK and the white supremacists at Charlottesville. And a viscous terrorist attack in Barcelona did nothing to help.

For the week, the S&P 500 was down 0.65%. US equities have now put in a lower high and lower low. So, we have the makings of what might become a pullback. For now, though, the damage on the large cap indexes has been limited, the S&P is only down 2.23% from its high on August 7 of 2480.91.

DEBT CEILING

Forget healthcare reform, forget tax reform, Congress has a deadline to raise the debt ceiling by October 1 or the country will likely default on its debt sometime in October.

EARNINGS

S&P 500 companies that have beaten analysts’ earnings estimates have declined by 0.3% during the period that started two days before and ended two days after the earnings announcement, per FactSet. That compares to a 1.4% average increase over the prior five years. This probably indicates that investors are more weary of high equity valuations. Although during late July of 2006, the market had a somewhat similar reaction to earnings and then managed to put in another big rally.

GLOBAL/US GROWTH

The global growth story continues, real GDP was up at an annualized pace of 4% in Japan, 2.2% in the euro zone and 4.3% in eastern Europe. In the US, positive economic news increased Q3 GDP growth estimates to 3.80 from 3.50% from the Atlanta Fed’s GDPNow model and the NY Fed’s Nowcast increased to 2.09% from 1.96%.

NORTH KOREA

On Monday, North Korean leader Kim Jong-un said he would watch what “the foolish Yankees” do before taking any action. This is Jong-un’s way of lowering the stand-off. At the same time, South Korean President Moon Jae-in urged the US not to launch an attack without its consent. The defense agreement between the US and South Korea required that they must “consult together” if either country is threatened. Both moves should help alleviate the tension.

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HIGHLIGHTS

• Equities fall around the world.
• Consensus shifting to the view that a pullback is on the way.
• Market falls by more than 1% for the first time in 58 sessions.
• Coming into a rough time of the year.
• Madman theory.
• Lots of positives still in place.

MARKET RECAP – UP OR DOWN?

The long overdue pullback/correction may be on the way. It has now been 410 days since the market fell by at least 5%, the longest such streak since at least 1995. And it seems like the market consensus is shifting to the view that now might be the time for this long overdue pullback. Or then again, maybe it is not.

The S&P 500 slipped 1.4% on the week, which was better than international equities, which dropped 2.1%. The S&P is down only 1.6% from its recent high, but underneath the surface the damage has been greater. On Thursday, the market fell by more than 1% for the first time in 58 sessions. The Russell 2000 which tracks small-cap stocks is down 5.2%. The declining dollar is also a problem. While it bumps up US earnings and that helps the market. An offset is the huge amount of investments held in the US by foreign governments and institutions. A declining dollar, coupled with a possible market pullback, could lead to a lower allocation to US assets which would drop equity prices further.

Another issue is the calendar, August, September and October have sometimes been rough months for the market.  But it is not only the “months” that might give one worry, the Leuthold Group has pointed out that years that end in the number “7”, dating back to 1887, have produced a drop during this time of year. We had the market crash, down 22%, in October of 1987. In 1997, we had the Asian currency crisis and hints of the forthcoming financial crisis started to appear around this time in 2007. Each of the above was set off by a financial or monetary event. Although the Fed is in tightening mode, their extra cautious pace would not indicate a crisis in the near term. However, the Fed does plan to begin unwinding their balance sheet sometime soon, a process that really has never happened before, at least to this extent.  The process will be gradual but it remains to be seen how the market will react when it starts. But maybe the biggest threat to this market might be a geopolitical event like North Korea.

President Trump could not hold back from the continuous prodding by North Korean leader Kim Joung-un and said clearly several times that North Korea better watch its step. The words he used to kick off the verbal storm were that the North Koreans would be “met with fire and fury like the world has never seen.” He told the Koreans to back down on their threats and actions, which of course, they refused to do and responded in like kind. Given that North Korea has threatened the use of nuclear weapons at various points, “fire and fury” might not be the best choice of language. But that seems to be what Trump intended.

Trump might be using a form of what was called in the 1970s the Madman Theory. Basically, the idea is that Trump wants North Korea to think he is crazy enough to engage in an all-out war or even a nuclear war. Of course, the worry for many is that no one really needs any convincing, Trump’s previous actions have already convinced many that he is somewhat unstable. On the assumption that the North Korean leader were to be convinced that indeed Trump is crazy enough to engage in a war, Joung-un would back down. Which North Korea hasn’t done. The Madman Theory only works when you have two rational actors, not two irrational ones.

A complicating factor is China. China holds the most leverage over North Korea, and is the one country that can influence North Korean policy. Now, while at the same time asking for Chinese help, Trump is about to begin investigating China for trade violations. Specifically, intellectual property violations.

There is also the threat of a government shutdown in late September or early October as Congress needs to reauthorize the debt ceiling. Getting Congress to agree on anything has been close to impossible.

Those are all the reasons why the market might fall. On the positive side, the market still has solid momentum, corporate earnings have been strong and the falling dollar adds to that. About 90% of companies have now reported Q2 earnings and earnings are up more than 10% over last year, according to FactSet. There is a chance for corporate tax reform which would give another boost to earnings. Economies around the world are in expansion mode and the US economy continues in its slow and steady growth mode, around 2%. The job market is very strong.  And interest rates are so low they provide an economic justification for higher equity valuations.

Warren Buffet on the problems with inflation, written in 1977. Click here.

HIGHLIGHTS

• The Dow Jones Industrial Average sets another record, breaking 22,000.
• Broader indexes are flat, transports are down.
• Solid payroll report
• Late credit card payments increase

PERFORMANCE

The Dow broke through another milestone, cracking the 22,000 barrier and ending the week at 22,092.81, plus 1.20% for the week. However, the broader indexes were closer to flat. The SP500 was up 0.19% and the Nasdaq Composite fell 0.36%. International equities rose by 0.82%.

After peaking on July 14, transport stocks have been down. The IShares Dow Jones Transportation Average Index Fund (IYT) has fallen by 4.78% while the Dow (DIA) has increased by about 1.99% during that time. A divergence between the two signifies a market warning based on the 117-year-old Dow Theory. The Dow Theory states that a rally in an index like the Dow should be confirmed by a rally in the transports (the Rails back in 1900). Times have changed since then and there have been several times in this market rally over the last few years where we did not get this confirmation, but it is worth a mention.

Bonds were up by 0.19% as the treasury yield curve going out from five years fell a few basis points.

ECONOMY

The first look at Q3 growth from the Atlanta Fed’s GDPNow model came in at a strong 4.0%. However, by week end it had dropped to 3.70%. The New York Fed’s Nowcast has Q3 growth at a much milder 1.98%.

SOLID PAYROLL REPORT

Non-farm payrolls increased by 209,000 in July, higher than the consensus estimate of 180,000. It was the 82nd straight month of job creation, the longest such streak ever. As shown in the chart below, this expansion has been noteworthy for a slow but very steady and long pace.

The May and June non-farm payroll numbers were also revised higher. The unemployment rate fell to 4.3% from 4.4%, the lowest number in 16 years. The labor force increased to 62.9%, up 0.1%. Average hourly earnings were up 2.5% year over year. Almost half of the gains were in bars and restaurants, and healthcare.

LATE CREDIT CARD PAYMENTS

Credit-card issuers are starting to have collection problems. The average net-charge off for large US card issuers increased to 3.29%, the highest level in four years. Losses are still low based on historical levels. Around 2014 banks started relaxing underwriting standards, which led to a big increase in credit-card spending. That might have led to the higher charge-offs now.

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