January 5, 2018

Stocks set new all-time highs yesterday for the third day in a row.  This was the first time since 1964 that stock markets began a year setting new record highs in each of its first three trading sessions.  Despite the rise in stock prices, long term bond yields remained in a tight range.  At the same time, short-to-intermediate term rates have been rising reflecting expectations that central banks, and the Federal Reserve in particular, are going to have to maintain or even possibly accelerate their pace of interest rate increases over the next year or two.

There are some who fear that the pace of rising short term rates will eventually lead to an inverted yield curve.  That is always a possibility.  While central banks have a lot of influence over short term rates, they don’t have much when it comes to longer term rates.  Those mostly reflect inflation expectations.  If markets continue to exhibit low inflation expectations, one would expect that central banks will read that message and slow the pace of rate increases.  What makes that conclusion a bit opaque is that the Fed now has new leadership and soon will have many new members.  While incoming Chair Powell professes to follow a very similar cautious line to Janet Yellen, only time will tell how he opts to implement policy.  But whatever he chooses to do, the likelihood of an inverted yield curve this year still appears relatively remote.

Market strength reflects a variety of factors:

  1. Most important, earnings growth is accelerating, a combination of strong worldwide economies and the new lower U.S. corporate tax rate. It doesn’t get any better than it is right now.  For the next four quarters, earnings growth should be in double digit range.  Stocks typically look 6-9 months ahead.  For the moment, that outlook is pretty rosy.
  2. While everyone is looking for inflation, long term bond yields don’t reflect any angst. Yields remain just about where they were a year ago.  That could change with data showing higher wages or persistently higher prices but so far, despite fears that a tight economy will give inflation a lift, the data hasn’t shown much change.
  3. The dollar remains weak. It is now down close to 10% against a trade-weighted basket of currencies on a year-over-year basis.
  4. Oil prices are rising as are prices for other base metals giving a lift to important parts of the economy that have been slumping for more than a year.
  5. Rising consumer confidence has helped lift Christmas sales to multi-year highs.
  6. Investors, whose distrust of the market and the political upheaval in Washington, are capitulating and coming back in.
  7. Hedge funds, whose performance clock starts on January 1 every year, are rushing in. They don’t want to start the year falling behind.

Futures point to another gain this morning after the key employment report.  The numbers this morning were a bit off consensus, mostly on the top line.  The number of jobs added in December was 148,000, about 40,000 below consensus.  The wage inflation number, up 0.3% month-over-month and up 2.5% year-over-year, continues to show negligible change in inflationary pressure.  What is hard to determine is the impact of the trio of major hurricanes which appeared to bump up employment numbers in September and October as rebuilding activity increased.  Most sectors showed solid gains with the notable exception of retail where 20,000 jobs were lost in December and 67,000 year-over-year.  Note that Amazon warehouse worker increases don’t show up in the retail sector.  Thus, the decline in retail jobs reflects the closing of stores (Sears and Macy’s both announced more closings yesterday) but not a slowdown in consumer spending.  The trends toward online shopping are going to continue for several more years and that will force even more store closings as the traditional retail marketplace continues to right-size itself for a world where a rising percentage of sales shifts to online.

The unemployment rate remained at 4.1%, and the labor participation rate was also unchanged.  Demographic changes (i.e. more baby boomers retiring) puts downward pressure on the labor participation rate.  No change, therefore, should be read positively.

In summary, today’s employment report reads positive despite the fewer net new jobs number.  The numbers are supportive of 3%+ overall economic growth with little added inflationary pressure.  That is the message an equity market wants to hear.

Chasing momentum isn’t usually a good investment strategy.  As I always do, I will say that every investor’s number one task is to keep true to your own asset allocation model.   One doesn’t have to rebalance after three strong sessions and there is nothing wrong about letting stocks run for a few days, weeks or months.  But your asset allocation model is built to fit your needs.  If you are young, have a good job, and are building a retirement nest egg then you should stay with stocks and add on dips.  If you are about to retire, you need to focus on your spending rate and how that will be funded.  If your retirement nest egg is sufficiently large to fund all your retirement needs and then some at a spend rate of 4% or lower, than capital preservation should be the dominant influence of your asset allocation.  For most of us, we lie somewhere in between.  We still want or need to grow our capital base but don’t want to be too exposed to risky assets when the next major correction comes.  Yes, it will come.

But, at least for now, it doesn’t seem that there are sufficient storm clouds present to set off a major enduring correction or bear market any time soon.  Bull markets never die of old age; they die for a specific reason.  They can either die because of economic imbalances or excess speculation.  While some fear we might be approaching the moment of excess speculation, I think that isn’t so.  Thanks to the sharp drop in corporate taxes in the U.S., stocks today trade at about 17.4 times estimated 2018 earnings.  That is about 10-15% above average.  Obviously on the high side, but 10-15% isn’t anywhere near bubble territory.  Moreover, the alternatives, i.e. long term bonds, offer much worse than average returns.  One can easily argue that the benefits of lower taxes impact stock valuations positively and bonds negatively (if they help to accelerate inflation).  While logic suggests a good part of that adjustment process happened in the latter months of 2017, obviously the adjustment hasn’t been completed yet.

Over the next four weeks, most companies will report 2017 year end results and offer at least preliminary guidance for 2018.  Deciphering the tax law changes company-to-company isn’t a simple exercise.  Investors know what happens to the top rate for U.S. earnings, but the geographic mix, as well as new or eliminated deductions, have differing impacts on individual companies.  Over the next few weeks companies will add some clarity.  For the most part, I expect expectations to be strong and that might sustain the rally a bit longer.

Today, Bradley Cooper is 43.  Diane Keaton turns 72.  Robert Duvall is 87.

James M. Meyer, CFA 610-260-2220

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