“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.” – Sir John Templeton
Review
The stock market had a very solid first quarter of 2017 as witnessed by the Dow Jones Industrial Average crossing the 20,000-point milestone and setting new all-time highs. The bull market in stocks has continued to roll onward and upward. A bull market is commonly defined as a sustained period of rising stock prices of at least 20%. Conversely, a decline of stock prices by more than 20% would be considered a bear market. The current bull market started eight years ago, and has not endured a 20% decline since it began in 2009. Furthermore, during the last eight years, we have only had four market corrections, defined as stock market declines of more than 10%. The occurrence of these corrections is well below the historical average of one correction per year. The most recent of the 10% corrections occurred in the first quarter of 2016.
Despite the length of the current bull market, it is well understood on Wall Street that bull markets do not die of old age. They also do not die on euphoria alone despite our often-referenced clever quote noted above by Sir John Templeton. Instead, they die when the prospect of an economic recession becomes significant. At this point in time, there does not appear to be a likely recession in the foreseeable future. Although, current geopolitical events could pose a risk to the economy. If we had to prognosticate on where we are in the timeline of Sir John Templeton’s quote, we are likely transitioning from the skepticism to optimism phase.
Broad economic measures, such as housing and employment, ticked up in the first quarter and served to bolster investor sentiment as the post-election “Trump trade” began to fade. Beyond economic data, key drivers of the stock market have become consumer confidence and business optimism. Notably, the University of Michigan consumer survey in March reached its highest level of economic confidence in 17 years. Similarly, the National Federation of Independent Business reported in February that its index of small-business optimism was at its highest level in 12 years, up dramatically from its October 2016 reading.
In March, the Federal Reserve showed improved confidence in the US economy by increasing short term interest rates by 0.25% to mitigate the potential of future price inflation. The Federal Reserve set the new range for the overnight lending rate at 0.75% to 1.00%. Based on the commentary of the Federal Reserve, they are going to “go slow” in raising interest rates for the rest of 2017. Economists now project the Federal Reserve will likely raise interest rates at least two more times this year assuming there is continued strength in the US economy.
Outlook
We agree with the general view of economists that the Federal Reserve will raise interest rates at least two more times in 2017. As the economy likely enters a stronger growth phase over the next year, the Federal Reserve will feel continued pressure to increase interest rates to minimize the inflation threat. Therefore, we are maintaining our cautious approach towards fixed income investments by shortening the duration to reduce interest rate risk.
Corporate earnings are forecasted to continue to strengthen during the remainder of this year. On the global front, positive world-wide economic trends are expected to accelerate global growth. Domestically, it is anticipated that Congress will deliver a new infrastructure spending bill along with individual and corporate income tax rate relief legislation in 2017, both of which should serve to support the current stock market valuations.
Some of the potential risks to the stock market include:
(1) US Politics: Investors are still optimistic about deals being done on infrastructure and tax reform even after the abandoned US House of Representatives vote on an overhaul of health care. However, if the political process stalls again, the market could react negatively in the short-term.
(2) European Politics: The continued rise of nationalistic candidates may pose a risk to economic growth and equity markets. The implementation of protectionist policies could reduce demand for export oriented US companies.
(3) Corporate Earnings: The forecasted increase in earnings this year may be too high. Analysts see earnings for S&P 500 companies growing over 9% in the first quarter of 2017 versus the prior year period. Stock prices may have already moved up in anticipation of these higher earnings projections.
(4) Geopolitical Risks: The ultimate fear is that North Korea is an irrational player intent on challenging anyone and everyone with its nuclear ambitions. The economy and stock market would both be negatively affected if the current missile tests and provocations escalate to a military conflict.
While recognizing the risks laid out above, we believe infrastructure spending and tax reform will be well received throughout both houses of Congress. We also believe that the impact of European protectionist policies, if implemented, will be slow to take effect. And lastly, we are confident that corporate earnings will not disappoint investors. Therefore, we maintain a positive outlook for equities in 2017.
Sincerely,
Marietta Wealth Management, LLC