PERFORMANCE

The endless rally continued amidst a sea of calm, as US equities increased by 0.81%. It has now been 350 days since the last pullback of only 3%, the second longest streak on record.

The slowly climbing market represents a stark contrast to 30-years ago this past week when the 1987 market crashed. Fuel for the rally continues to be solid financial reports. So far, 70% of the companies that have reported earnings so far have topped estimates, and 72% and beaten on the top-line. The market was also helped when Senate Republicans agreed on a budget that would all tax cuts to pass with a majority of the votes, rather than 60.

International equities fell by 0.59%. Bonds dropped by 0.50% as interest rates increased. The spread between the 10 and 2-year narrowed by 3 basis points. The dollar was up 0.87% and crude rallied by 0.76%.

QUARTERLY WEBINAR

Our quarterly Review/Outlook Webinar was done on Saturday. You can find it at this link: https://www.youtube.com/watch?v=2d-pQLkfDVI.

EXPLODING US DEBT

Amidst all the talk about the tax cut plan, the resulting increase in the Federal deficit is for the most part being ignored. Proponents of the tax cut argue that increased growth will pay for the resulting deficits, but most economists do not buy that to the extent necessary to cover the lost revenue.

In this week’s Barron’s, Gene Epstein writes about the mushrooming debt and how it might lead to exploding inflation. In his 2007 memoir, Alan Greenspan predicts inflation will jump much higher around 2030, to around 4.5% or higher.

Greenspan’s predictions are in sync with the non-partisan Congressional Budget Office, that debt will soar due to exploding eldercare entitlements. In the face of out of control debt, the pressure would be immense for the Fed to print money and buy a portion of the federal debt. That would be liking pouring gasoline on a fire, causing inflation to burst higher.

When the Fed went to the printing presses over the last decade, inflation didn’t pop. But 2030 is likely to be a different era than what we just went through. The last few decades have been helped by the disinflationary impact of cheap labor around the world. But that will be played out by 2030. Plus, the amount of money needed to print will be far greater than what we just went through with no end in sight.

Higher inflation will depress the dollar, which will result in a sell-off of US bonds by foreigners, compounding all of the above problems.

All the more reason to seriously consider how the proposed tax cuts will impact the national debt long-term. What we really need is tax reform to promote an efficient economy, not pure tax cuts.

ECONOMY

Jobless claims hit a record low of 222,000. The job market continues to be the bright spot in this economic expansion.

SCOREBOARD

Robert Shiller writes about the impact of mass psychology on equity prices. Click to read.

HIGHLIGHTS

• International equities lead the way, up 1.89%, as global markets hit another high.
• VIX continues hovering at all-time lows.
• Trump close to nominating the next Fed Chair.
• Economic growth estimates improve.

PERFORMANCE

US equities improved slightly, up about 0.13%, while international equities advanced by 1.89% (see below). Bond rallied by 0.53% as interest rates fell and the curve got flatter. The dollar declined and crude jumped by 4.83%.

GLOBAL STOCKS HIT NEW HIGH

The MSCI World Index of large and midcap stocks from 23 countries hit another high on Friday. According to fund tracker EPFR Global, records amounts were invested in global stocks funds for the week ending October 11. Cheaper valuations and solid earnings are helping encourage investment overseas. The forward P/E in the US is about 18, up from 17 in January, while the P/E ratio on the STOXX Europe 600 is 15.2, up from 14.8. In Japan, the P/E on the Nikkei has fallen to 16.8 from 17.8 during that time. Overseas economies are also earlier in the economic cycle than the more mature US cycle.

VIX

Randall Forsyth writes about volatility in his Barron’s column this week. The volatility index continues to hover at close to all-time lows, closing Friday at 9.61. As shown in the chart below, the VIX has been hovering in the 10 area and below of late, much lower than historical norms, despite threats of war with North Korea, political instability in Washington, rising rates, and the soon to begin unwinding of the balance sheet. Traders have cashed in by shorting VIX futures or buying ETFs that profit from contango in the futures markets (when the near-term VIX contract is priced lower than a longer-term contract). If and when the market corrects, there could be huge short covering in the VIX, leading to unintended consequences, kind of like portfolio insurance in 1987, or mortgage-backed security fiasco of 2007.

FED CHAIR

Trump is close to naming his choice to lead the Federal Reserve. The choices appear to be current chair Janet Yellen, Stanford economist John Taylor, former Fed governor Kevin Warsh and current Fed governor Jerome Powell. Both Taylor and Warsh are considered more hawkish in terms of interest rates. While we do believe that Yellen was way to dovish in managing rates over the last few years, we are in agreement with her recent moves to slowing normalize rates and to gradually unwind the balance sheet.

ECONOMY

Economic estimates for GDP growth picked up steam over the last week. The Atlanta Fed’s GDP model now has Q3 growth coming in at 2.70%, up by 0.20% from last week. And the NY Fed’s Nowcast raised their estimate to 1.70%, up by 0.17%. The Q4 estimate from the Nowcast was increased to 2.91%, up by 0.46% for the week.

New unemployment claims fell to 243,000. Since hitting a peak of 298,000 after Hurricane Harvey, new claims have been consistently falling and are now back in the pre-hurricane range. A historically low number.

SCOREBOARD

HIGHLIGHTS

• US equities up by 1.29%, fourth straight week of gains.
• The market is closing in on the all-time record without a 5% correction.
• The US and the global economy is strong.

PERFORMANCE

US equities advanced for the fourth week in a row, up 1.29% and continued their recent outperformance over international equities, which advanced by 0.40% for the week. Bonds fell slightly, down 0.08%, as interest rates were up about 5% across the curve.

The general consensus over the last few weeks has shifted. In August, the mood was that we would have some kind of pullback, but now, the “experts” seem to think it is smooth sailing ahead, at least for the near-term. That in itself may be some kind of warning.

This Monday will mark 333 business days without a 5% pullback. The last time that happened was the period beginning on November 23, 1994. Assuming nothing crazy happens on Monday or Tuesday, this will be the longest such period ever.

ECONOMY

The Global Purchasing Managers Index (PMI) came in a 53.2 in September, its highest level since May of 2011, indicating continued worldwide growth. The international economy is now back to pre-crisis growth levels. Almost every country is now in growth mode. Developed markets showed a slight edge over emerging markets, and Europe was the strongest region.

Here in the United States, the Institute for Supply Management’s (ISM) September Manufacturing Report came in at a very strong 60.8. That is up from 58.8 in August and it is the highest reading since May of 2004. It was the 13th consecutive month of growth in manufacturing.

Initial claims for unemployment fell by 12,000 to 260,000. Claims are still being negatively impacted by the hurricanes but are at levels that are considered historically low indicating a continued tight job market.

The Atlanta Fed’s GDPNow shows Q3 growth at 2.50% and the NY Fed’s Nowcast has growth at 1.53%. The Nowcast, which also is currently forecasting Q4, has growth improving to 2.45%.

SCOREBOARD

HIGHLIGHTS

• US equities improve by 0.90% led by small caps.
• A strong September.
• Proposed tax reform helps move markets higher.
• Yellen comments on interest rates.

PERFORMANCE

US equities improved by 0.90%, helped by a surge in small-caps, +2.7% on the week. International equities fell by 0.20%. Bonds fell another 0.16% on slightly higher interest rates, the dollar was up by 0.90% and crude was up 1.99%.

September turned out to be a strong month. The Dow was up 2.08% while the average for September has been a 1.09% loss, according to the Bespoke Investment Group. But small-caps were the story in September, the Russell 2000 was up 6.09%, helped by a stronger dollar and the possibility of tax reform (see below). Financials also were strong, the KBE was up 9.08% and energy advanced by 8.75% (XLF). In fact, September looked a lot like the post-election rally.

For the first 9 months of the year, US equities are up about 14%, international equities by 21% and bonds by 3%.

TAX REFORM

Markets advanced on excitement over tax reform, whether the proposal ever makes it into law is another matter.

On the individual side, there would now be three brackets instead of seven, the highest rate would fall from 39.6% to 35%, business income would “pass through” at a 25% rate, the estate tax would be eliminated, and the deduction for state and local taxes would be taken away.

An obvious problem is that everyone will now try to move individual income to “pass-through” entities (LLCs and Sub-S corporations) in order to take advantage of the lower 25% rate for high-income earners.  If the idea is to simplify the tax code, this provision does the opposite.

And taking away the deduction for state and local taxes would likely doom this tax bill, in its current form, from ever being passed. There would be too much opposition to that, even though it makes sense from a simplification standpoint.

For corporations, the maximum tax rate would fall to 20% from 35%. But companies would now be taxed on international profits. Overall, it is estimated that this would add about $10 to S&P 500 earnings. It would also help small companies, even more, thus the big rally in small-caps.

The third tier to the tax plan would be the repatriation of US profits currently being held overseas at a reduced rate.

YELLEN ON RATES

Federal Reserve Chairwoman Janet Yellen said if the Fed determines that there are long-term changes in the trajectory of inflation that it could slow down the pace of interest rate increases. Inflation has been coming in lower than the Fed’s 2% target this year, leading some economists to want to keep interest rates lower for longer,  but that also could lead to financial bubbles that would present bigger problems later.

Under the current scenario, the Fed will probably continue on the path of gradual rate hikes. The market is now expecting a December rate hike.

SCOREBOARD

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?

SCOREBOARD

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%.

SCOREBOARD

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.

SCOREBOARD

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.

SCOREBOARD

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.