October 9, 2017

While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from John Lisle.

On Friday, the stock market took a very mild breather with the Dow Jones off by -1.7 after the monthly employment report was released in the morning. Non-farm payroll employment dropped by 33,000, but household employment rose by 906,000, the unemployment rate dropped to 4.2%, and Average Hourly Earnings increased 2.9% year over year. Hurricanes Irma and Harvey caused some temporary contortions in measuring the labor markets; these are apt to straighten out during the next few months. Millennials employment is growing at almost double the rate of the overall employment growth. This is clearly good news for the stock market and housing market especially with the US housing inventory at close to 60 year lows. Millennials are finally moving out and beginning to have those adorable money pits, children. The energy sector was off with worries that refineries in the Gulf of Mexico would need to close if tropical storm Nate developed into a hurricane; crude was off almost 2.8%.

Also, with average hourly earnings increasing, many investors are assuming that the Fed will raise short term rates in December. One assumption is if short term rates rise, the attractiveness of fixed income will increase causing investors to reduce their equity holdings in favor of interest bearing notes of one maturity or another. On the other hand, during Fed tightening over the past thirty years, the S&P 500 has risen significantly, a prime reason being that the Fed raises short term rates generally because the economy is growing at a faster than sustainable rate so corporate earnings have risen during these periods.

Why is the market continuing to plod ahead in the face of valuations well above average? There are several reasons. First, the market isn’t flagrantly overvalued at 19 times next year’s earnings estimates. Secondly, inflation and interest rates are historically low. Corporations are awash in cash, and the US financial sector is far more sound than it was 10 years ago. The four largest economies, China, the US, the Eurozone, and Japan are each growing simultaneously. The MSCI World Index is up 18 percent over the past 12 months. Wages are rising in the US and Europe. The US is deregulating to some extent, reducing those expenses for small and large businesses alike so profits are rising nicely. S&P earnings for the fourth quarter are estimated to rise by 12%. Lastly, there’s speculation that Congress may succeed in enacting meaningful tax reform. That would presumably include the ability for US corporations to repatriate some substantial portion of the $3 trillion they have parked overseas to avoid our world-high 35% corporate tax rate. This would be stimulative even if repatriation was partial.

The news obviously isn’t all good. We’ve got several geopolitical messes such as North Korea, the Middle East problems, Brexit, and China trying to take over an important part of the Pacific. The Fed appears set not only to gradually raise short term interest rates but is also planning to shrink its $4.3 trillion balance sheet for the first time ever. We have no example of how that will affect markets. Lastly, just about every kind of asset is overvalued based on historical measures.

How long will this almost daily good news last? The endless number of statistics being discussed in the financial press reminds me of reading baseball stats. For example on Friday, the Institute for Supply Management reported that US manufacturing activity made a 13-year high, and US service activity hit a 12-year high last week. These along with wage gains are clear signs of economic strength. The question then arises as to whether these measurements point to confirmation of a frothy market poised for a correction or even the end of the bull market. Manufacturing usually gets going toward the end of bull markets. Then, a few recent tech IPOs have surged, perhaps unreasonably; Roku is up 66% from its IPO two weeks ago, and Switch rose 23% last week. Who knows, but as Jim Meyer has pointed out several times, the excesses that usually accompany market tops haven’t arrived in force yet, just a few signs of possible overheating. In addition, investors continue to reduce equity exposure and increase bond exposure, hardly an indication of irrational exuberance.

At Tower Bridge, we regularly trim equity winners such as #McDonalds back to their suitable portfolio weights while adjusting overall asset allocation to meet clients’ investment objectives. These days, that typically means trimming equity portfolios and adding to bond portfolios in spite of the persistent low bond returns. The search for stocks with strong growth prospects and sound balance sheets at reasonable prices is a daily undertaking of our portfolio managers. Please let us know of any questions you may have; we’ll be glad to discuss your financial concerns.

Birthdays: John Lennon would have been 77.

John Lisle, Jr. 610-260-2221

Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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