3rd Qtr Portfolio & Market Observations 2018

After 9 years of an upward market, with very few corrections along the way, the stock market seems to have hit a brick wall. Are we still in a bull market or has the longest bull market in history ended? The economy and stock market has been good to investors after two major declines caused by the dot-com debacle of 2000-2001 and the financial crisis of 2008. While many investors are fearful of another major market decline, they question if the recent market activity is the beginning of a major downturn or a correction in an ongoing bull market.

What is the difference between a correction and a major decline? Corrections occur along the way as the market is advancing. They occur when traders and speculators take short term profits because the market has gotten ahead of itself. While it is a fact that a major decline begins with multiple small declines the difference is in the magnitude. Corrections are considered to be negative moves of 5% to 15% while major declines can be anywhere from 30% to 50%. Corrections can occur anytime, for no particular reason, whereas major declines occur when investors perceive a slowing economy, reduced profits, and a recession. A correction of 5% to 15% is normal for the stock market and has occurred historically at least once or twice a year. Accepting this kind of volatility is the reason investors earn more in equities than in bonds and cash.

The third quarter proved to be very strong for domestic stocks. Favorable economic news and encouraging corporate earnings reports were enough to suppress investors’ concerns over the continuing tariffs saga between the United States and China. All the major benchmark indexes enjoyed robust gains, led by the large capitalization stocks of the Dow Industrials and the S&P 500 Indexes. The technology-heavy NASDAQ continued its strong showing while the small cap stocks of the Russell 2000 posted moderate quarterly gains. The last quarter marked more than nine and a half years, or 115 months of generally rising U.S. stock prices.

U.S. interest rates continued to slowly rise while remaining low by historical standards. Interest rates rose for short-term U.S. Treasury securities in the third quarter of 2018, in concert with the Fed’s interest rate hikes in June and September. The yield on the 10-year U.S. Treasury note also rose, but by a smaller amount than short-term yields, reinforcing the market’s concern over a flattening yield curve. For the quarter, the Bloomberg Barclays U.S. Aggregate Bond Index, representing investment grade U.S. bonds, was flat and remained slightly negative for the year.

The economic stars have aligned to create a macro environment not seen in generations. Small business optimism reached the highest level since the National Federation of Business began measuring it in the 1970s. Business owners with unfilled positions hit an all-time high, and a record of 25 percent of owners say finding qualified workers is their single most important business problem. Consumer confidence was at its highest level since September 2000.

The Federal Reserve raised short-term interest rates in late September – it was the third rate increase in 2018 and the eighth since the current tightening cycle began in late 2015. The Fed has said it will keep raising rates until it sees evidence that higher interest rates are hurting the U.S. economy. This is fairly standard thinking during tightening cycles and the Fed’s new leadership wants to establish its credibility with markets.

Worries about global trade relationships were steady headlines, but more than six months after President Trump first proposed tariffs on certain metals, the markets are still acting as though the current tensions – particularly between the White House and China – will not evolve into a full-blown trade war.

In our view, it is still unclear how much of the U.S. tariff action against Beijing is bare-knuckles negotiating aimed at creating more balanced trade between the countries and how much is a view in Washington that China’s trade tactics present a long-term threat to the U.S. economy. What is clear is that a number of companies with international supply chains don’t want to get caught off-guard, so, for now, they are holding off on capital investment decisions while waiting for more clarity. However, less capital spending could lead to less output and less hiring and thus affect growth.

The U.S. may appear to have an advantage in the dispute because it imports so much from (and exports so little to) China and therefore can impose more tariffs than they can. But China has options beyond tariffs, including currency devaluation or selling down their huge inventory of Treasuries. The longer the stalemate continues, the greater the risk that either side or both overplay their hand, and that markets and the global economy will have to deal with the unhappy consequences.

Ten years after the global financial crisis, the bull market continues with one constant being investors’ relentless desire to be ‘worried’ about something! For ten years the financial headlines have tended to be on the gloomy side with 2018 proving no exception, yet the market continues to climb despite some pull-backs in February and, most recently, in October. The bull market that started ten years ago is now one of the longest bull markets in history. Yet, it is important to remember that bull markets don’t die of old age, nor do they get critically wounded by geopolitical developments. Investment returns, in the long run, are driven by a set of fundamental variables: real risk-free interest rates, inflation expectations, the ability of businesses to pay for debt, make a profit and future earnings growth. The vast majority of geopolitical events do not significantly impact any of these variables. Instead, these events may lead to a change in investor sentiment and risk perception rather than an actual change in investment risk. As a result, most geopolitical events only lead to short-term corrections that can provide buying opportunities for investors with sufficient liquidity.

Dumont & Blake Investment Advisors, LLC
September 30, 2018

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