The last full week of October was a box full of surprises.
First, U.S. economic growth exceeded expectations. The devastation wrought by Hurricanes Harvey, Irma, and Maria was widely expected to stifle U.S. quarterly growth, according to NPR. The Atlanta Federal Reserve predicted 2.5 percent gross domestic product (GDP)* growth for third quarter, down from 3.1 percent the previous quarter. Instead, U.S. GDP grew by 3.0 percent.
In fact, productivity has been flourishing around the globe. The Financial Times reported:
“…activity has again broken upwards in recent weeks, with growth in the advanced economies close to the highest rates seen since before the Great Financial Crash (GFC), apart from in the immediate recovery phase in 2010. Furthermore, world trade volume has now joined the recovery, and corporate expenditure on jobs and machinery is picking up. Overall, it seems that some of the symptoms of “secular stagnation” are beginning to fade…”
Tech companies were a sensation last week, too. Several of the biggest firms beat earnings estimates by wide margins, pushing share values higher, reported CNBC. Despite tech’s strong performance, the Standard & Poor’s 500 Index (S&P 500) has delivered third quarter earnings growth of 4.7 percent with more than half of companies reporting.
Earnings are lower than they would have been without the hurricanes, according to FactSet. With insurance industry earnings excluded, the S&P 500’s earnings growth pops from 4.7 percent to 7.4 percent.
The final surprise for the week was the doldrums. October is supposed to be the most volatile month of the year, according to Barron’s. Instead, we’ve experienced the calmest October since 1928.
The S&P 500 and the NASDAQ both finished last week at new all-time highs.
*GDP is the value of all goods and services produced in a region.
And the hits just keep on coming.
Last week was the anniversary of Black Monday. On October 19, 1987, the Dow Jones Industrial Average (Dow) lost 508 points, or more than 20 percent of its value, as it fell from the previous trading day’s closing value of 2,247 to 1,739. The culprits behind the historic drop are widely thought to be program trading, high valuations, and market psychology.
The anniversary didn’t put a hitch in the markets’ giddy up last week, though. The Dow closed above 23,000 for the first time ever on Wednesday. That’s the fourth thousand-point milestone the Dow has passed this year, according to Reuters.
The Standard & Poor’s 500 Index also finished the week at a new high. Strong earnings, along with optimism about fiscal and monetary policy, contributed to investors’ optimism. Financial Times wrote:
“U.S. stocks hit record highs yet again and the dollar touched its strongest level against the yen for more than three months as growth bulls applauded news that the Senate had adopted a fiscal 2018 budget resolution, opening the way for tax reform. U.S. Treasuries fell – most sharply at the longer end of the curve – as participants fretted about the prospect of increased federal borrowing and potentially higher inflation.”
It’s interesting to note, despite major U.S. stock markets hitting new highs, bullish sentiment has been below the historical average 36 times this year, including last week. The AAII Investor Sentiment Survey showed bullish sentiment down 1.8 percent, while bearish sentiment gained 1 percent and neutral sentiment was up 0.8 percent. Of course, some consider this survey to be a contrarian indicator.
There’s a new kid in town: narrative economics.
Last week, Richard Thaler was awarded the Nobel Prize in economics. His work in behavioral economics and finance recognizes not all economic and financial decisions are made after rational reflection. In Nudge, he wrote:
“The workings of the human brain are more than a bit befuddling. How can we be so ingenious at some tasks and so clueless at others?…Many psychologists and neuroscientists have been converging on a description of the brain’s functioning that helps us make sense of these seeming contradictions. The approach involves a distinction between two kinds of thinking, one that is intuitive and automatic, and another that is reflective and rational.”
Yale professor Robert Shiller, another Nobel laureate in economics, is exploring a field of study related to Thaler’s. It’s called narrative economics. Narratives are the stories we share with each other. They are fuel for conversation and popular narratives often become viral. During a presentation at the University of Chicago, Schiller explained narrative economics is “the study of the spread and dynamics of popular narratives, the stories, particularly those of human interest and emotion, and how these change through time, to understand economic fluctuations.”
Today, a popular narrative in financial circles focuses on Professor Shiller’s cyclically-adjusted price-earnings (CAPE) ratio, which suggests the market may be overvalued. Barron’s reported, “The CAPE, which is based on average inflation-adjusted earnings over the trailing 10 years, stands at 31, versus 32.5 in 1929 and 44 in late 1999.”
If stocks are overvalued, why do investors keep buying shares? It’s a question narrative economics hopes to help answer in the future
Slow and steady...
It has been 332 days since the Standard & Poor’s 500 (S&P 500) Index experienced a 5 percent drop, reported Barron’s. If there isn’t a selloff on Monday or Tuesday, this will become the longest rally without such a drop.
During this period, the Index has gained 33 percent. Think about that for a moment: 33 percent over 332 days. By Barron’s calculations, the market has gained less than 0.1 percent per day. That’s a very slow rate of increase, relatively speaking. The longest-ever rally without a 5 percent drop, which began in November 1994, was accompanied by a gain of 56 percent or 0.17 percent per day.
The most recent issue of The Economist pondered the phenomenon of the slow-as-molasses bull market that has pushed asset prices higher:
“No one would mistake the bloodless run-up in global stock markets, credit, and property over the past eight years for a reprise of the ‘roaring 20s,’ or even an echo of the dotcom mania of the late 1990s. Yet only at the peak of those two bubbles has America’s S&P 500 been higher as a multiple of earnings measured over a ten-year cycle. Rarely have creditors demanded so little insurance against default, even on the riskiest ‘junk’ bonds. And rarely have property prices around the world towered so high…the world is in the throes of a bull market in everything.”
It would be a mistake to assume asset prices will continue to move higher indefinitely. One characteristic that may signal the onset of a bear market is investor euphoria, and we haven’t seen that. The most recent American Association of Individual Investors’ Sentiment Survey showed 2.3 percent more investors were bullish last week, pushing the total to 35.6 percent. That’s still well below the historic average of 38.5 percent.
Last week was punctuated by a senseless shooting. Our hearts and prayers are with the people of Las Vegas.
Weekly Focus – Think About It
“What is now proved was once only imagined.”
--William Blake, British Poet
A lot happened during the third quarter of 2017, but not much changed.
The bull market in U.S. stocks continued to charge ahead. Traditional measures of valuation continued to suggest the market is overvalued, but some analysts argued it’s different this time. The Economist explained:
“The current [cyclically-adjusted price-to-earnings] ratio of 31 suggests that stocks are about 50% over-valued – a figure that has only been exceeded in the past 60 years during the dot-com bubble. Bulls argue that the S&P 500’s constituents can justify this heady valuation. Big American companies are wielding increased market power, enabling them to earn outsized profits at the expense of America’s customers.”
The bull market in U.S. bonds continued. Interest rates on 10-year Treasury bonds were lower at the end of September than they were at the start of the year, despite the Federal Reserve increasing rates in March and June. The Fed also has indicated it will soon begin to unwind its balance sheet, which includes about $4.5 trillion in Treasury bonds, mortgage-backed securities, and government agency debt.
Geopolitical tensions remained high, but investors were impervious to the potential effect of various conflicts on stock and bond markets. In August, Barron’s wrote:
“The biggest surprise of 2017 remains that geopolitical risk continues to not matter. Until Monday, North Korea’s nuclear missile program had again faded into the background as just another high impact/low probability risk with no discernible effect on market sentiment. Brexit, the changes in leadership roles in China after the 19th National People’s Congress, the possibility of a United States-China trade war, and the unpredictable nature of the Trump presidency are not weighing on stocks.”
The CBOE Volatility Index (VIX) keeps plumbing historic lows. The VIX reflects investors’ expectations for market volatility in coming months. The lower the Index reading, the lower volatility expectations are. The historic average for the VIX is about 19.
During 2017, the number of days on which the VIX finished below 10 – suggesting investors are exceptionally calm – increased significantly. In early June, the VIX had closed below 10 just 14 times since 1990. Six of those closes had occurred in 2017. By the end of September, the VIX had closed below 10 on 32 days since 1990 and 24 times in 2017.
We’re still waiting for inflation to move higher. At the end of the quarter, inflation appeared to be heading the wrong way. The core Personal Consumption Expenditures (PCE) index, which is the Federal Reserve’s favorite measure of inflation, came in at 1.3 percent, year-over-year. That’s its lowest level since October 2015, reported Barron’s. The Fed’s goal is to have inflation at 2 percent. It has raised rates during 2017 in anticipation of higher inflation rates, but those higher rates have yet to materialize.