“Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses.”– Seth Klarman
The stock market continued to reward investors with positive returns in the third quarter of 2017. The Standard & Poor’s 500 index has now risen for six consecutive months. The Dow Jones Industrial Average and the S&P 500 have each posted their eighth straight quarter of positive returns. Additionally, the NASDAQ Composite rose for a fifth quarter in a row.
Solid corporate earnings and economic data helped support the major stock indexes over the past three months. Volatility remained muted despite the massive damage from hurricanes and an escalation in rhetoric with an increasingly belligerent North Korea.
The healthy stock gains during the first nine months of the year have been fueled by the best quarterly earnings gains among S&P 500 companies in almost six years. The full year 2017 earnings growth projected for the S&P 500 is now 10.6%, while earnings are projected to increase 10.4% in 2018, according to Standard & Poor’s.
Technology stocks in the U.S. have continued to be the best performing sector this year and were the top gaining sector in the third quarter. The Energy sector, still down overall for 2017, was the next biggest gainer in the stock market, as U.S. crude oil prices rose 12% in the past quarter. The recent oil price increase was due to unexpectedly strong demand just as oil producers were slowing production slightly. Ten of the eleven S&P 500 sectors posted a gain during the third quarter, with only the Consumer Staples sector failing to join the party.
Financial stocks rebounded strongly in September as interest rates moved higher. As the expectation of tax reform has increased recently, so have interest rates. Rates on the 10-year Treasury bond have increased from 2.04% in July to 2.33% by the end of September. Whether the rate increase is due to a higher expected growth rate (from tax cuts) or higher inflation (from deficit spending), it’s a positive for the earnings of financial stocks.
The Federal Reserve Bank Board of Governors held the overnight lending rate at 1.00% to 1.25% at their recent meeting in September. The Federal Reserve signaled the likelihood of raising the overnight lending rate one more time in December despite relatively low inflation. Inflation, excluding volatile food and energy, was 1.4% in July, which is down from 1.9% in January and below the Fed’s 2% target. The Fed continues to forecast three rate increases in 2018, two in 2019 and one in 2020. Investors are forecasting a 78% chance of one more rate hike in December according to the federal-funds futures tracked by CME Group Inc. The CME Group reading is up from about 50% before the September Fed meeting.
The U.S. Economy continues to steadily improve. The economy is at or very close to full employment with many employers looking for qualified help. Interest rates are low while inflation remains modest at around 2%. Corporate revenue is increasing, which leads to solid corporate earnings. A continuation of these conditions should be a positive force for equities and the stock market going forward.
Currently, the stock market trades at approximately 18.4 times projected earnings over the next 12 months. This is a 13% premium to the 16.3 times average since 2000. This is a somewhat higher than normal historical market valuation, but with interest rates so low, it is not unreasonable. Corporate earnings growth should remain the key driver of stock prices this year. Analysts are now projecting double-digit profit growth for 2017 and 2018. Given the earnings projections, in our view, any recession risk appears more likely a result of geopolitical, rather than economic, risks.
Marietta Wealth Management, LLC