Slowly and Steadily Winning the Race

3Q 2017

Day after day, the stock market continues to march higher, and this has some people confused. Many pundits have been looking for a correction (a drop of 10% or more) or at least a pullback (a drop of 5% or more) of some sort for quite a while. And it has been quite a while!

The last correction we experienced was at the very beginning of 2016, when oil had fallen to $26 a barrel and the US dollar was hitting a new 13-year high. The market seemed like it was in free fall for the first six weeks of the year as investors struggled to assess:

  1. How significant the oil impact would be to energy sector earnings (and whether that could trigger a broader US recession).
  2. How the dollar’s 26.6% rise over the prior 18 months would negatively impact US exports (because when the dollar rises 26.6%, foreigners experience a 26.6% increase in the price of goods and services they purchase from US companies).

But the market fully recovered over the next six weeks. Things got choppy again with a 5% pullback just three months later (Brexit), and then another 5% pullback four months after that (right before the election). A strong post-election rally propelled the market to new highs by the end of 2016 which led many pundits, having just witnessed a year with a decent amount of high-profile volatile events, to predict continued volatility into 2017. So far, they’ve been wrong.

The market has been remarkably “unvolatile” this year. As measured by the “VIX” (the S&P 500 Volatility Index), excluding the two small pullbacks of last year, we are a little more than 18 months into a period of sustained low-volatility. And while we would never predict a period without volatility (because statistically-speaking, 5% pullbacks occur almost every year, and 10% corrections occur in more than one of every two years), it is important to note that low-volatility cycles can occur for long stretches of time (for example: 1991-1996, 2003-2007, 2012-2014). These periods of slowly grinding higher can have a significant compounding effect on a portfolio. Since the Feb 2016 correction, the S&P 500 is up a whopping 37.7%!

This impressive run-up has some commentators suggesting that stock market valuations are too high. And while we would agree that they are higher than their long-term average in the US, we would make two important disclosures:

  1. Similar to periods of volatility, valuations can stay “above average” for sustained periods.
  2. Economic growth (which produces earnings growth) can provide a natural soft landing to “high” valuations, without the need for a correction.

On that second point, we would note that S&P 500 earnings are about 18.4% higher over the last year, which is the highest growth rate since 2011.

Looking beyond our borders, it is becoming increasingly evident that the global economy is in a period of synchronized economic growth. Recent elections in foreign developed market countries have generally resulted in victories for pro-market candidates. Manufacturing numbers, as represented by the Markit PMI data, show that for the first time in years nearly all countries’ manufacturing sectors are in expansion. Inflation data in emerging markets seems to be largely under control, with the BRICs (Brazil, Russia, India and China) experiencing much lower inflation levels than they did a year ago, which affords considerable flexibility to their respective central banks to conduct monetary policy and help keep their economic growth on track.

Remaining mentally-prepared for a correction/pullback is appropriate, but beyond a systematic rebalancing trade, positioning for one is not. As we said in a recent post, pullbacks happen when they happen – never before. Sooner or later, it will happen. But they are usually caused by unforeseen circumstances. What we can see is that central banks around the world remain extremely accommodating. Even the Fed (which raised rates once in 2015, once in 2016, twice in 2017, and is in the process of shrinking its balance sheet) is still very “loose” when it comes to monetary policy. If it continues to “tighten” monetary policy at this rate, this recovery (which is six months away from being the second-longest-ever) may end up being the longest one ever.