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2018 – MID-YEAR MARKET OUTLOOK

We hope everyone had a happy and safe Memorial weekend as we remember all the veterans who died protecting our beloved country. To all our clients, family and friends who were or are active members of the military, thank you for your service!

KEY TAKEAWAYS

The current corrective market environment is playing out to historical norms in average length, magnitude, and seasonal tendency. Thus far, our stance is that the 2018 correction is a constructive consolidation of the “Trump Rally” gains from 2017 and is not a pre-tense to a major bear market. Historically, mid-term election years like 2018 have seen choppy stock markets due to uncertainty around congressional changes and the political outlook. The chart below from Capital Group / American Funds, gives some insight on how “normal” the current market environment is versus history:

MARKET DOWNTURNS HAPPENED FREQUENTLY AND THEY DIDNT LAST FOREVER

Since our last market commentary in February 2018, several new potentially market damaging geo-political headlines have emerged. These included trade war talks, emerging market debt concerns, Euro worries, North Korea summits happening/not happening, key Trump administration departures and arrivals,…. And the list goes on. These “Wall of Worry” themes are continuous and can be contrarily viewed as bullish/positive as it keeps investor sentiment in check. From our view point, the reset of overly optimistic stock market and economic sentiment from late 2017 and January 2018 is a welcomed development.

We are purposely leaving out any political commentary or outlook as it is way too early to tell what may happen. Election season will soon kick into high gear and the expectation is for Republicans to lose seats and possibly even full control of congress. The subsequent market reaction to mid-terms, regardless of outcome, will be something we will watch and analyze closely for the remainder of 2018.

Last but MOST importantly, we continue to ask our clients to keep a long-term view of their investment portfolio and not be overly concerned with the news or the market movement of the day. Our preferred approach of combining your financial planning objectives with a disciplined investment process should help us persevere through this period of choppiness and future market cycles.

For more in-depth commentary and supporting data points, please continue reading.

TECHNICAL OUTLOOK

The technical (supply & demand) picture of the market, on balance, has ranged from neutral to positive in 2018. Most global stock markets continue to be in multi-month up-trends and our primary risk indicators have yet to break down en-masse during the current corrective environment.
Leadership remains in the more offensive parts of the market including Technology, Small and Mid-Caps, and Consumer Discretionary which we view as a positive. Weaker areas include defensive sectors such as Utilities, Consumer Staples and Bonds. At this time, our belief is that if equity markets were headed for a prolonged downturn we would see more of these defensive areas outperforming. We are watching weakness in emerging markets as potential waning of risk appetite are somewhat concerned around how much longer the momentum in technology stocks can continue leading the market.

TECHNICAL MARKET SCORE

Our Technical Market Score gauge (shown on right) continues to lean into the bullish/positive zone. Entering the year in the mid 80 range and getting into the low 60’s (neutral zone) at the lower points have been the corrective move this year. Our more tactical investment strategies will react more closely to this indicator while other less tactically sensitive strategies have remained more fully invested. From a risk/reward standpoint, and dependent on time horizon and strategy selection, our belief is that entry into the equity market is more favorable at this point than in late 2017 or early 2018.

 

 

S&P 500 CYCLE COMPOSITE FOR 2018

Next up is the S&P 500 Cycle Composite for 2018 (shown above and provided by Ned Davis Research). It shows the composite seasonal tendency for the S&P 500 market based on the 1-year seasonal cycle, 4-year presidential cycle and 10-year decennial cycle. By combining these average movements into a composite or analogue we gain a potential road map for how the market may move in the coming months. Focusing in on this historical seasonality study points to a potential rally into the summer months, followed by a sell off into the mid-term elections, and ending with the seasonally positive “Santa Claus Rally” for year end.
 

 

CURRENT CORRECTION

We also believe that taking a long-term view of the market’s movement can sometimes help keep proper perspective. Using the chart above of the S&P 500, from 1991 to present (27 years) can help us do just that. The current increase from 2013 to present, may be reminiscent of the 1990’s stock market, while the current correction almost looks like a “blip on the radar” when viewed in this context. This may argue for a continuation of the bull market and does not resemble the post-1999 – 2013 “Lost Decade” in US Stocks.

STOCK MARKET VALUATION:

 

Based on historical precedent, our US stock market valuation data points show that the market is currently slightly above “Fairly Valued”. Here we monitor a widely followed valuation stock market metric called the Price to Earnings ratio (or P/E for short) on a forward and trailing basis. In simpler terms, a lower number is viewed as “cheaper” while a higher number is considered more “expensive”. For context, the average trailing historical P/E is about 15, while the historical average forward P/E is about 17. We favor the forward -looking P/E =, due to the fact that our experience leads us to believe that the market tends to look to the future and what is coming vs. what has already happened.
Based on the P/E Ratios displayed in the table below, we see that valuation comes into a more normalized historical level compared to a few months ago. This is a positive in our view, as the market is now approximately 11% cheaper than it was at the start of the year, as we conclude using this metric:

  April 2018 January 2017
S&P 500 Forward P/E 16.6 18.7
S&P 500 Trailing P/E 20.6 23.3

 

 

Another one our preferred valuation metrics is “Price to Fair Value”, available to BluePrint Wealth Alliance as institutional clients of Morningstar. This frame work values stocks using a proprietary valuation model based on the characteristics of a specific stock and its respective sector/industry. As an example, fair value would equal “1.00” if a stock’s fair value target is $60 and it trades at $60. If the same stock traded at $54 it would be trading at .90 of fair value and if it traded at $66 it would be trading at 1.10 of fair value. Below is the Fair Value estimate of the average and median S&P 500 company. Again, this agrees with a fairly-valued but not “nose-bleed” expensive valuation for US stocks.

MORNINGSTAR FAIR VALUE ESTIMATES AS OF 5/25/2018:
AVG. PRICE TO FAIR VALUE OF S&P 500: 1.03
MED. PRICE TO FAIR VALUE OF S&P 500: 1.00

 

 

EQUITY ET

The chart (left) analyzes global stock market valuations and where the US stands vs
other markets in P/E Ratio terms through May 2018. (Chart provided as institutional
research clients of Bespoke Investment Group www.bespokepremium.com).

Based on comparative analyses, our view remains that US Stocks are slightly above
fairly-valued.

Currently countries like Brazil, India, Mexico, and Switzerland have more expensive
stock markets than the US. The cheapest markets in the world are Russia, Singapore,
South Korea, UK, Italy and Spain.

Arguably, these less expensive markets may have their own set of challenges that
could warrant a cheaper valuation.

Recent economic strength in the US economy could be a factor for a premium
valuation vs. other global markets. In our opinion, valuation on its own is not a reason
to buy or stay away from a given stock or stock market. However, it does provide
another key data point in our decision-making process.

At this juncture we consider this data point to be a more neutral than negative data
point for US Stocks.
 

 

EARNINGS & ECONOMIC OUTLOOK:

 

Historically key drivers for stock price appreciation, earnings and revenue growth had stellar results in Q1 2018 according to data obtained from Fact Set Research on S&P 500 companies through 5/18/2018. This included a blended growth rate of earnings per share of 24.5%, (highest since Q3 2010) and revenue growth of 8.3% (highest since Q3 2011). Full year 2018 earnings and revenue growth are expected to be 19.4% and 7.3% respectively. For 2019, growth ratchets down quite a bit as earnings are expected to grow 9.9% and revenue is expected to grow 4.8%. The chart below shows historical S&P 500 actual earnings per share (EPS) from 2008-2016 vs estimates in 2017-2019. EPS is forecasted to accelerate in the coming years vs the flatline growth of 2014-2016.

EARNINGS INSIGHT

As stated previously, our belief is that the stock market is more forward looking than backward looking. We now have a better understanding of why 2017 was such a strong year for stocks, and how the in reported earnings and revenue in Q1 2018 played a role. In our view, one of the potential reasons why the market is now in a neutral trend could be attributed to the expected year over year deceleration in earnings. We can however, argue that growing revenue and earnings is not a bearish development, but caution that estimates for growth that estimates. These are subject to revision and discounting of new info, something we will continue to watch closely as a “re-rating” of lower future estimates could create additional near-term volatility.
Another key leading economic datapoint we follow are US initial jobless claims. According to research provided by Bespoke Investment Group, claims have come in under 300k for the 168th straight week and below 250k for the 33rd straight week, which is the longest streak of sub-250k readings since 1970 through May 24, 2018. Until this trend reverse, we believe that this is a strong positive for the US economy.

INITIAL JOBLESS CLAIMS

NDR – E0046C April 2018 January 2017
US Recession Probability Model 0.693 1.46
Copyright 2018 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

 

Although our US recession probability risk indicators currently display a low reading, global recession risk is on the rise and something we are watching closely. After a notable 2017, economic readings of global economic growth are coming in below expectations. The NDRG Global Recession Probability Model below is not decisively negative yet, but may be signaling the probability of weaker (but not negative) global stock market returns in coming months based on the current reading of 57.54.

NDRG GLOBAL RECESSION PROBABILITY

INFLATION & INTEREST RATES:

 
TREASURY BOND YIELD
 
After a decade of lower interest rates, US based inflation and interest rates are rising from historically low levels. We are also confident in saying that the days of accommodative US monetary policy are officially over, as the Federal Reserve has raised rates 6 times in the least 2 years while also ending other extraordinary programs aimed at keeping interest rates low. As shown at right, yields on shorter term treasury bond yields have risen briskly over the last year and have outpaced similar movements in longer dated bonds like 10yr and 30yr treasuries yields (not shown) over the same period.
On one hand, this may be welcomed news to conservative savers as they should be able to find investment opportunities offering competitive yields in shorter term assets like bank deposits, and short term high quality bonds. On the other hand, it now creates competition to perceived riskier assets (Stocks, Bonds, Real Estate, etc.) along with higher financing costs for consumers and businesses, which could potentially create more stock market volatility. Given this new paradigm, we believe that bond and yield focused investors should consider actively reviewing their portfolio holdings for undue risk in investment strategies that are perceived as conservative but could suffer more than expected in an extended rising rate environment.

We also believe the delicate balancing act of keeping rates low enough to continue supporting the economy with the competing objective of keeping inflation in check may be a continued narrative in the months and years to come. Central Bank Policy in Japan and Europe are still very accommodative, and for the first time in a while, we now are in a period of Global Central Bank “un-coordination” as US central policy pulls away from other developed nations in this regard.

We leave you with a longer-term view of inflation. While many of us rightfully note increases in the cost healthcare, education, housing, etc., the CPI index (Consumer Price Index) measures the change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Viewed more broadly, it is also trending higher in recent years but still has some way to go before becoming a bigger concern vs historical levels. In our view, the current year over year inflation rate (2.5%) is indicative of healthier economic conditions and normalized of the economy vs something more ominous  

CPI V CPI

The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness, or correctness of the information and opinions contained herein. The views and the other information provided are subject to change without notice. All commentary issued is without regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Company fundamentals and earnings may be mentioned occasionally, but should not be construed as a recommendation to buy, sell, or hold the company’s stock. Predictions, forecasts, and estimates for any and all markets should not be construed as recommendations to buy, sell, or hold any security–including mutual funds, futures contracts, and exchange traded funds, or any similar instruments. Please read all disclosures located by following the Disclosures link on the bottom of this page.