August 7, 2017

While the Dow moved higher for the ninth straight session on Friday, both the S&P 500 and the NASDAQ 100 have traded in a sideways fashion over the same period. A handful of Dow components have accounted for all the gain. Most were in reaction to favorable earnings with Boeing being the standout performer. Friday’s strong employment report provided some lift, but the economic data last week was generally in line with expectations. Thus, individual stock performance related to Q2 earnings was more of a factor than macro tailwinds pushing the overall market in either direction.

One of the head-scratching dilemmas surrounding this 8-year bull market is the persistence of individuals moving money from stocks to bonds. But let me try to put that into context. Regularly you read in my notes the persistent plea to stay true to your asset allocation. If you accept that, and you accept the fact that during most of the bull market, stocks have outperformed other asset classes, particularly bonds of short-to-intermediate term duration, then the dilemma is solved. Investors aren’t being dumb or fearful; they are acting as they absolutely should by rebalancing, moving money from the fastest rising asset class, stocks, to other alternatives.

If you look at the data closely, you will also note that the money moving into bonds exceeds the money flowing out of stocks. What pulls that together in logical fashion is the fact that late in the bear market associated with the Great Recession, investors went to the bunkers, so to speak, and raised significant amounts of cash. The fear associated with the recession didn’t dissipate overnight. Thus, cash seeped into markets slowly but gradually. In addition, of course, we cannot forget that the Federal Reserve and other central banks around the world poured money into markets in an effort to lift growth and induce inflation. That effort, at best, has been only partly successful. While the impact on growth and inflation was modest at best, money not spent was invested in financial assets. That ultimately means all asset classes. That not only includes stocks but also real estate, art and gold. Only physical commodities, where supply overwhelmed demand, failed to experience a rise in price.

That explains the past but we are more interested in the future. What causes change going forward, if anything?

Indeed, there are changing dynamics. First, the Fed has stopped pouring money into the system and, in fact, is looking for a way to start exiting by gradually reducing the size of its balance sheet, perhaps as early as this fall. With so much excess cash still sloshing around (just look at bank balances still parked at the Federal Reserve window), a slow-paced reduction shouldn’t be disruptive. However, as central banks first slow and then stop pouring more money into a slowly growing economy, the excesses that have fed rising prices in financial markets will slow, suggesting the pace at which asset prices rise should slow accordingly.

While fund flows may slow, inducing a bit of a headwind, earnings growth has been accelerating and there is little reason to expect a repeat of the 2015-2016 earnings recession. Oil and other commodity prices are showing signs of stability at levels well above early 2016 lows. While it is difficult to project a return to price levels of several years ago when China and India were growing at extraordinary rates, there is little reason to expect future major contractions in capacity or capital spending. With that said, inflation is low and shows no sign of rising. Wage growth has been muted and, despite a falling unemployment rate, there are still few signs of a wage price spiral beginning. Actual physical capacity remains abundant for most industries. Moreover, despite efforts by President Trump to return jobs, especially manufacturing jobs, to the U.S., corporations are still quite able to move jobs to areas of low cost whether they be in the United States or outside the country.

The final lever, the value of the dollar, is probably the biggest unknown variable going forward. The dollar has been in steep decline since early in 2017. Its initial strength was linked to the notion that newly-elected President Trump would be able to quickly advance a stimulative pro-growth agenda. Obviously, that hasn’t happened so far. Instead, U.S. GDP growth in the first half of this year lagged behind expectations while growth in Europe, China and Japan exceeded expectations as overseas central banks continued to pour money into their respective economies. However, there are hints the tide may be turning. The weak dollar has given U.S. exporters a boost and, conversely, made products of key manufacturers like Germany more expensive. That is what floating currency values are meant to do. For now, U.S. multinationals should reap another quarter or two of benefit. Beyond that, however, the outlook is less clear.

This week will be a quiet week with just a few high-profile companies reporting earnings. Many of them will be in the retail sector, one that has been a serious economic weak spot this year. President Trump will be playing a lot of golf and Congress is now in recess. While staffers are working on tax reform legislation ideas, don’t expect much hard news through the end of August. The obvious caveat is that one never knows what Trump will tweet and the firestorm that could create at any time. With that red herring warning aside, markets will remain calm unless there is some unknown intervening event. By definition, unknown can’t be defined but, as I noted last week, given the news vacuum and vacation schedules of late August, any unknown has the potential of leading to an overreaction. Of course, it is just as likely that nothing untoward will happen and watching the markets for the next couple of weeks will be akin to watching paint dry.

Today Charlize Theron is 42.

James M. Meyer, CFA 610-260-2220

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