All major categories of financial investments produced positive returns in the third quarter.  Domestic large-company stock benchmarks gained around 4%; smaller-company stocks provided somewhat higher returns, on average.  Non-U.S. stocks outperformed for a third consecutive quarter, albeit by a slim margin.  Real-estate returns were modest, though timber-related issues posted solid gains.  Industrial commodities rebounded smartly from early-year weakness (oil gained more than 12%); gold was up 3%.  After drifting lower through early September, bond yields rebounded sharply to finish the period marginally higher (the 10-year Treasury began the period at 2.30% and ended at 2.33%), resulting in modestly positive fixed-income returns.

Among large-cap U.S. stocks, stronger groups included Basic Materials, Communication Services, Consumer Cyclicals and Financial Services; Capital Goods, Consumer Staples and Transport names lagged.  ‘Growth’ and ‘value’ stocks posted roughly similar results, on average.

Benchmark Performance – Equities

  Third Quarter 2017 Last Twelve Months
     S&P 500 Index +4.5% +18.6%
     Large-Cap. Core Mutual Fund Avg. (Morningstar) +4.2% +17.6%
     Small-Cap Stocks (Russell 2000) +5.7% +20.7%
     Non-U.S. Stocks (Developed – MSCI EAFE) +5.5% +19.7%
     Non-U.S. Stocks (Emerging – MSCI EM) +8.0% +22.9%

Benchmark Performance – Fixed Income

Third Quarter 2017 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +0.5% +0.1%
    Intermediate Municipal Mutual Fund Avg. (Morningstar) +1.0% +0.5%

Review

A conducive investment environment persisted during the July-September period: a supportive global-growth backdrop, robust profit gains, low inflation and central banks in no hurry to raise interest rates combined to propel most investments higher.

The U.S. economy was in fine fettle.  Second-quarter GDP growth accelerated to an above-average gain of +3.1% after an early-year dip below 2%.  More timely data also indicated broad-based strength: the index of leading economic indicators, consumer-confidence and purchasing-managers surveys, building permits/housing starts, as well as jobless claims and job-creation were all firm.  The residential real-estate market cooled slightly, but still notched price gains of more than 5% over last year.  Retail sales were again somewhat disappointing, perhaps reflecting a stubbornly slow pace of wage gains.

Overseas economic developments were, if anything, even more upbeat.  The Eurozone, Japanese and Chinese economies all accelerated to above-trend growth in the second quarter.  Brazil, Russia and South Africa, too, recorded relatively solid gains from depressed bases.  India was an exception, with growth falling below its recent torrid pace under the weight of major monetary and tax reforms.  Notable current-period data included European business confidence re-attaining its pre-financial-crisis peak, while various reports suggested Japan was on pace to record its best multi-quarter growth streak since 2000.  Although China’s economy appeared to cool slightly (retail sales, industrial production and fixed-asset investment all came in below expectation), growth remained comfortably above the sluggish readings that gave rise to ‘hard landing’ fears in early 2016.

Signs of an impending surge in inflation remained scarce: ‘core’ measures that strip out more volatile components hovered below 2% across all major developed economies.  The U.S. Federal Reserve declined to raise short-term interest rates following three hikes between late 2016 and June.  Following their most recent policy-setting meeting, however, U.S. central bankers for the first time explicitly laid out plans for reducing the Fed’s vast holdings of Treasury and mortgage-related bonds, purchased during nearly a decade of ‘quantitative easing’ (QE).  Post-meeting communications were also less dovish with respect to the likely pace of future interest-rate hikes, emphasizing ‘transitory’ (rather than structural) factors keeping inflation below target.  The Japanese and European central banks remained reluctant to follow the Fed down the path toward more normal (less aggressively accommodative) monetary policies.  At recent meetings, the BOJ pushed back to 2020 the date by which it expects (hopes?) to achieve its 2% inflation objective, while the ECB was content to announce plans to begin discussions regarding reducing the scope of (i.e., ‘tapering’) its QE program.

The ongoing U.S. stock market advance continued to distinguish itself.  According to data compiled by Bespoke Investment Group, the post-financial-crisis Bull Market that began in March 2009 has become both the second longest (in duration) and second largest (in percentage gain) in history, trailing only the 1987-2000 advance.  The current advance has also featured unusually low volatility: by the end of September, the S&P 500 Index had gone nearly 600 days without a 10% correction; more than 450 without a 5% decline; and more than 325 without even a 3% dip; respectively, the eleventh, sixth and second longest such streaks on record.  Quantifying the same phenomenon, the Leuthold Group reported the volatility of 2017’s daily returns has been lower than in all but two years in the S&P’s 90-plus-year history (1964 and 1965), while the largest year-to-date draw-down (-2.8%) was the smallest of any year except 1995.

This year’s market advance is also noteworthy for having persisted and even gained momentum even as investors have become increasingly skeptical about the political climate.  An analysis published by the Bank Credit Analyst showed the relative performance of stocks likely to be major beneficiaries of corporate tax reform and/or increased infrastructure spending (two signature Trump campaign promises) peaked soon after last year’s election and receded steadily through August before recovering slightly in recent weeks.  This pattern underscores our assessment that the 2017 rally should be ascribed to factors beyond (and independent of) the advent of the Trump administration and GOP-controlled Congress.

Earnings reported by S&P 500 constituent companies during the quarter (mostly covering the April-June period) showed solid gains, nearly 19% above the year-earlier figure.  The improvement was unusually broad-based, with profits expanding in all eleven S&P industry sectors.  Wall Street analysts expect third-quarter earnings growth to decelerate slightly to around +15%, though the full-year projection remains pegged at almost +20%.

What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

                 * based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +4.5% S&P 500 total return?

Third Quarter (July – September) 2017
Dividend Income +0.5% +4.5%
+ Change in Earnings +2.9%
+ Change in Valuation +1.1%
= Total Return +4.5%

Our read:  Once again, price gains outpaced the improvement in forward earnings, leading to rising (deteriorating) valuation.  At the risk of sounding like a broken record: heightened valuation is unlikely to be the catalyst for a market downturn, but will constrain prospective (i.e., future) returns at some point.

 Outlook

As we look ahead, many of the fundamentals underpinning the financial markets seem entrenched in Goldilocks territory.  The synchronized global economic expansion dating from mid-2016 looks set to persist, likely extending the run of heady earnings growth.  And with inflation at bay and memories of the global financial crisis still fresh, central banks seem unlikely to err on the side of too-tight monetary policy, helping keep a lid on bond yields and supporting stock-market valuation. ‘As good as it gets,’ opined a recent client note from bond-fund titan PIMCO.

The economic backdrop looks particularly benign.  There are scant signs of an impending slowdown in the U.S., whose post-crisis expansion is most advanced and is therefore a good candidate to be first to end.  Leading indicators are firmly in growth territory, and the recent rise in bond yields and steepening of the yield curve suggest an improving outlook (you may recall our July letter flagged a flattening yield curve as a cause for concern).  Even if the American consumer shows signs of flagging (vis: disappointing wage gains, sluggish retail sales), any weakness is likely to be at least partially offset by a firm corporate sector boosted by currency weakness (the dollar has declined 8% on a trade-weighted basis from its post-election peak), healthy and broad-based overseas demand, and the possibility of business-friendly tax reform.  Clean-up and rebuilding from recent natural disasters will provide a further near-term prop to demand.

Meanwhile, the European and Japanese economies appear to be gathering momentum and retain substantial room to ‘catch up’ to their North American counterpart (though euro strength could become a headwind on the Continent).  Likewise, key emerging-market economies are either enjoying sustained robust growth (India) or are in the early stages of recovery following recent, deep recessions (Brazil, Russia).

The outlook for the Chinese economy is clouded by the looming five-yearly Communist Party Congress, slated to open October 18th.  As we noted in July, authorities in Beijing were loath to allow any nasty surprises in the run-up to the Congress; the path forward will be much less circumscribed.  While most observers expect President Xi to emerge from the Congress considerably strengthened, two schools of thought vie to explain how this will play out in policy terms: via a relatively conservative acceleration of previously announced reforms of the financial and state-owned-enterprise sectors, or as a radical change of direction involving entirely new initiatives.  While investors seem to be expecting the former, the latter could entail substantial short-term dislocations, with impacts rippling across much of the global economy.

Healthy global demand is only one factor likely to drive continued strong profit growth.  In addition, U.S. export-oriented industries will benefit from the dollar’s 2017 slide, while stable-to-higher energy and commodity prices will boost the energy and materials sectors.  Abroad, Eurozone earnings will depend greatly on whether currency strength is sustained or continues to reverse in light of a marginally more hawkish Fed (the common currency has slipped nearly 3% versus the dollar since the early-September nadir in bond yields).  In Japan, improving corporate governance (a key component of ‘Abenomics’ reforms), combined with a substantial currency tailwind (the Yen has fallen 10% and 16% versus the dollar and the euro, respectively, over the past twelve months), could drive year-over-year profit gains of more than 20% in coming quarters.

Despite the largely benign back-drop, we remain mindful of several potential risks.  Though investors seem remarkably unperturbed, the flare-up of tensions between the U.S. and North Korea is worrisome.  We are encouraged that alarming rhetoric has not so far been matched by concrete indications that either side is preparing for what would surely be a disastrous military confrontation; we continue to monitor this situation closely.  Proliferating trade disputes and rising protectionism are another concern.  President Trump and his advisors have embraced the politically expedient but economically illiterate notion that the U.S. ‘loses’ from unbalanced trade.  Aggressive tactics in trade-related dealings with China, the renegotiation of NAFTA and the recent commercial-aircraft dispute involving Canada and the U.K. risk braking an important engine of global growth.  Finally, given the legislative track record to date, we would not be shocked to see recently proposed tax reforms meet a similar fate – likely resulting in a reversal of the latest market gains.

Undoubtedly the biggest threat facing financial markets is the potential for an abrupt rise in global bond yields resulting from a change in investor sentiment toward evolving monetary policies.  The Treasury yield curve indicates investors expect a meaningfully slower rate of policy normalization than the Fed itself has indicated.  And although the recent back-up has marginally reduced the magnitude of risk, yields remain exceptionally low; an unexpected rise in inflation and/or unforeseen consequences attending the reversal of QE could be problematic.  As we try to assess the probable impact of central banks stepping away from nearly a decade of aggressively accommodative policies, we are not comforted by the fact that no one knows exactly how or why QE worked (economists have proposed various theories; consensus is elusive).  We are encouraged that central bankers seem acutely aware of these risks and are doing everything in their power to avoid surprising the markets.  Nevertheless, we are entering uncharted waters.

On a salutary note, we were pleased by a distinct improvement in stock-market breadth and leadership in recent weeks.  We noted in July that some commentators were concerned by indications of a classic late-Bull-Market ‘narrowing’ of participation, characterized by massive outperformance earlier in the year by the so-called FANG stocks (Facebook, Apple/Amazon, Netflix, Alphabet/nee Google), which seemed to echo the late-1990s dot-com bubble.  While the comparison was always a stretch, recent developments should put such anxieties to rest: small-company stocks, as well as the Dow Jones Industrials, Transports and Financials all reached new highs as the quarter came to a close; mega-cap technology companies were relative laggards and shares of Kohl’s handily outperformed those of Amazon!

Strong underlying fundamentals and improving market ‘internals’ suggest the path of least resistance could lead stocks higher in coming weeks.  However, even robust earnings growth will barely match recent price gains: valuation persistently above long-term averages seemingly ‘prices in’ a lot of good news.  History strongly suggests that either a sudden correction (a draw-down greater than 10%), or a longer period of disappointing returns, lurks somewhere in the future to restore value to a more sustainable level.  Accordingly, we believe it remains prudent to emphasize below-market valuation among individual holdings, to maintain exposure to lower-valued non-U.S. equities, and to adhere to asset-allocation discipline by trimming some of the year’s biggest gainers.

We welcome your questions, comments and suggestions regarding our management of your investments.