Zeller Kern’s Investment Monitor

Surfing the Wave

August 1, 2017

By Steve Zeller

As we make our way through the 3rd quarter of 2017, the market has continued to climb upward. As of Friday’s market close, the Dow Jones Industrial Average was up 11.96% year-to date. Additionally, the S&P 500 Index posted a year-to-date return of 11.67%, the Russell 2000 index is up 6.07%, while the NASDAQ reaches a positive return for the year of 18.42% (source: Morningstar.com). This is great news for equity investors as this year has turned out to be better than last year, and certainly better than the prior two years of 2014 and 2015.

If you recall this time last year, the market environment was full of uncertainty as we were in full swing of a presidential election and it was next to impossible to get a grasp of any kind of direction. But this year has been one of more certainty and possibly a speculative frenzy that could just solidify a major market top in the future.

But for now, the market continues to achieve new highs as we’ve expected and volatility remains ridiculously low. In recent writings we have noted that we expected new highs to be realized and we still do. However, we wouldn’t be surprised if we get a significant correction that could rattle investors in the near future. Our guess is that even if a correction takes place, it shouldn’t be an end to this current bull market.

In our previous issues of the Investment Monitor, we have been pointing out to our readers that even though we remained positive towards the market, we also see the possibility of this market getting itself into significant trouble a few quarters down the road, and as early as the 1st or 2nd quarter of 2018.

Many of the things that you saw at the market top in 1999-2000 period are falling into place including unreasonably high equity valuations, investor optimism reaching historically high levels, margin debt near all-time highs, a near mania in speculative stock investing, a long cyclical bull market that is now 8.5 years in length, and market volatility that has reached record low levels.

Last week the market saw new highs rendered as well as the popular volatility Index, the VIX, hit an all-time low of 8.85. This low number, along with the other conditions we just mentioned, sets off all kinds of warning bells with us longer term. However, we are still convinced that we could still experience the market marching towards our long-term price target near the 2500 level to the low 2600 levels on the S&P 500, before a long-term top is complete. But given the previously mentioned market conditions, a short-term correction is certainly not off the table.

How this low volatility level can be interpreted is that investor complacency towards risk is abundant, even among investment advisors. After the advisory community and investors swung heavily towards managing risk, they have now flocked to the same old trap of passive asset allocation strategies, or a “just invest it and leave it” approach. The harsh reality of these market conditions is that, once a major high has been achieved, it is historically proven that this market high is usually a high that won’t be seen again for many years.

Granted, this current era is unprecedented, mainly due to Central Bank intervention and manipulation of the capital markets including equities, as central banks have been directly influencing the stock market indices with massive purchases. All of this taking place with record low interest rates, cheap money everywhere and debt climbing to unfathomable levels. Nevertheless, this has kicked the can down the road, much farther than we thought, and has enabled asset prices, including stocks, to reach record levels or form bubbles.

The past eight years of the Fed and other central banks engaging in quantitative easing and other schemes to pump up asset prices has produced investor sentiment that is largely without any sense of risk to owning stocks. Couple this phenomenon with record debt levels and you get a situation that is worrisome longer term.

In the meantime, the economy remains to be on the positive side, with the government reporting initial GDP growth for the second quarter at 2.6%. Though this is not a historically robust number, it is up from the revised first quarter number of 1.2%. Along with these positive numbers is a strong showing of corporate earnings. According to the Wall Street Journal, America’s largest companies are on pace to post two consecutive quarters of double digit growth, which is the first time since 2011. This is a result of several years of cost cutting and increases in efficiencies, a weaker dollar, and stronger consumer spending. According to the Journal, earnings of S&P 500 companies are expected to rise 11% in the second quarter, following a 15% increase in earnings in the first quarter. This is despite what appears to be a sidelining of any kind of corporate tax reform and increased government spending in infrastructure. On the other hand, if any of this were to come to fruition, it would be another positive break for earnings.

Currently, there appears to be an increasing challenge for any significant tax or health care reform to happen, as the Trump administration continues to be in a state of chaos and its political leverage waning. This is demonstrated by the recent and significant turnover in White house staff, the recent failure of a health care reform bill, and unproductive comments from the administration. If this were to continue, we can bet that it won’t be good in delivering any kind of meaningful reform, and the political uncertainty would continue.

Another observation on earnings worth noting, is that even though earnings are positive, especially for the corporate giants, the retail sector is taking a battering from the “Amazon effect.” The credit rating agency, Fitch, recently reported another spike in loan defaults by retailers in July. According to the report, the trailing 12-month high yield default rate among U.S. retailers rose to 2.9% in July, up from 1.8% at the end of June. Many investors are bracing for an even worse report in the near future, as it is expected that Claire’s, Sears, and Nine West to default by the end of the year. As the Amazon concept takes hold with consumers, it remains to be seen how it will ultimately impact the retail sector. But there is little doubt that the application of technology is taking a toll on the traditional retail model.

Another concern for the economy is job growth, not in the sense that there is a lack of it, but rather, there aren’t enough laborers to fill open positions. The labor supply for the trades has dried up and is reaching a crisis level in many parts of the country. This is a problem that may be due partly to the rising drug problem, if you can believe that. According to a recent article in Zero Hedge, the Boston Federal Reserve commented that the qualified labor shortage has gotten so bad that the success rate for hiring after a simple math test and drug test, has now fallen below 50%, which is a first. If you are young, drug free, ambitious, and are skilled or educated, you will be in the “cat bird seat.” That being said, the current opioid and heroin epidemic is widespread and very concerning for not only the labor pool, but for the American fabric of our society.

Employment data will be released on Friday. There is a continued expectation for 180,000 new jobs and the employment rate to drop to 4.3%. This is likely to be enough to keep the market sentiment in a positive trend. Monday was the release of the Chicago PMI, Dallas Fed Manufacturing, and Pending Home Sales. Tuesday, PMI Manufacturing, ISM Manufacturing and Construction Spending. On Wednesday, ADP Employment Report with expectations of 175,000 new jobs and on Thursday, Jobless Claims, PMI Services Index, Factory Orders, and ISM Nonmanufacturing Index will be reported. This will be capped off with the Employment Situation to be released prior to the open on Friday. Hundreds of earnings reports will be released throughout this week which is also likely to drive market sentiment. If the trend continues, there is an average beat of around 23%. We’ll see if this keeps the market in a positive uptrend.

Looking back on last week
With the massive amount of earnings released last week, the results were generally positive but equities sold off as many companies rallied for several weeks in front of these reports. While the S&P 500 managed to close flat for the week, the NASDAQ declined 0.2% and the Dow Jones outperformed and climbed 1.2%.

While the market was quiet last week, we did see a new high rendered on Thursday. But prior to that, the markets were very choppy in a range bound affair.

While Alphabet reported better-than-expected earnings and revenues, it declined 2.9% on Tuesday but had little effect on the overall market as companies like Caterpillar, McDonald’s, DuPont, United Technologies all beat their earnings estimates. Those positive results pushed the S&P 500 higher and the NASDAQ to a new record high.

The Dow Jones joined the record high club mid-week as it outpaced its peers with Boeing leading the way as it surged 9.9% followed by AT&T who also moved sharply higher, adding 5% to its price.

Market participants took a break on Wednesday afternoon after the Fed released its latest policy directive which, as expected, had no effect to the markets’ directional movement. The Fed is getting creative with their words using things like “relatively” and “neutral” throughout their directive which is code words for “we’re doing nothing.”

Earnings came back into focus on Thursday with Facebook headlining the lineup. The social media giant jumped to a new high after reporting better than expected revenues but most of the gains were surrendered as the NASDAQ composite reversed sharply lower, dropping over 100 points from its highs.

This would set the tone coming into Friday as markets went back into a complacent mode finishing slightly lower on the session and basically flat across the board for the week.

While last week’s action overall finished flat, Thursday is the day that needs to be focused on as we saw a sharp reversal after making all-time new highs basis the NASDAQ composite. This reversal was quite dramatic and did pull the S&P and the Dow Jones down with it. This will be the next new mark that needs to be overcome before the markets can resume any type of trend movement.

*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee