Zeller Kern’s Investment Monitor

Is the Expected Correction Underway?

August 23, 2017

By Steve Zeller

So far, the market performance of 2017 has been pretty favorable. At the market close of the last Friday at the end of July, The Dow Jones Industrial Average was up 11.96% for the year, and the S&P 500 was up 11.67%. The Russell 2000 was up 6.07%, and the NASDAQ was up 18.42% (Referencing our last issue of the Monitor). Since then, a little more volatility and uncertainty has come into the picture. As a result, the market has pulled back, leaving the major indices weaker from where they were earlier. As of the market close on Friday, the S&P 500 had pulled back to being up 9.76%, the NASDAQ is up 15.48%, the Russell 2000 has erased almost all of its gains for the year, being up just .85%. The Dow Jones Industrial Average still remains close to where it was at the end of last month, up 11.43% year-to-date (source: Morningstar.com).

These are still favorable numbers, except for the small company index the Russell 2000 which is barely above water for the year.  The high for the S&P 500 this year was around the 2480 level, which was achieved during the first week of August. Currently, this index is hovering around the 2,450 level, which is down approximately 1.2% from the highs.

A lot has happened since July. With turmoil in the Trump Administration, tax and other expected reforms are at risk. Investors have been optimistic that a significant tax reform and budget reform would actually happen. But now, the current administration appears to be weakening, politically, putting the possibility of all of the positive reforms in jeopardy, including a significant reduction in tax rates across the board, a reduction in corporate tax rates, the repatriation of off-shore assets, infrastructure rebuilding, and other reforms that are key to further economic growth.

Some good news reported last week includes positive retail sales data, which last week’s retail sales report posted a 0.6% gain in sales versus the expected 0.3 % growth. The interpretation of this is that if this continues, it would add to the argument of a favorable GDP growth number for the third quarter.

According to the August 11th report put out by Factset.com, 73% of S&P 500 companies have reported positive earnings per share (EPS) surprises, and 69% have reported positive revenue surprises. That is great to see, especially the top line growth. Earnings growth for the S&P 500, for the 2nd quarter, is up 10.2%. All 10 sectors have reported growth with the energy sector leading the way. However, 59 S&P 500 companies have issued negative EPS guidance and 35 S&P 500 companies have issued positive guidance. 

Thompson Reuters S&P 500 2017 Q2 Earnings Dashboard

Furthermore, a major ingredient for the market rising for the past 8 years has been due to “share buy backs.” According to a recent article in the New York Post, U.S. companies have dumped nearly $4 trillion of cash into buying back their stock since 2008, which is in record territory. Also keep in mind that we are at current levels by riding a wave of unprecedented Central Bank intervention and manipulation and historically low costs of borrowing money.

The forward 12-month P/E ratio for the S&P 500 is at 17.4. This P/E ratio is above the 5 year average of 15.4, and is above the 10-year average of 14. But, the Shiller P/E ratio, which is arguably a more relevant ratio, is near historical highs.

The Trump administration appears to be in a growingly weak position, politically, which means that all kinds of uncertainty is now back on the table. Should we really be surprised? After all, it was only a matter of time that President Trumps “loose cannon behavior” would compromise his political leverage. Along with that, the endless attacks from the media, Democrats, Republicans, and globalists, have begun to stack the deck against him, though it seems. The current administration also seems to have a revolving door with its staff, with the latest departure being Steve Bannon on Friday.

Outside of the much needed budget, tax and healthcare reforms, some of the efforts of the Trump Administration is concerning, particularly, launching a trade war with China. Protectionist policies usually don’t work, because the other side usually retaliates, and the war escalates and hurts both sides. Granted, some of the efforts, so far this year, have been positive, such as the pull back of many regulations, but moving forward and looking at what lies ahead is where the concern lies.

Other challenges are ahead as well, including the raising of the debt ceiling, North Korea and other geopolitical risks.  Any of these could add to the uncertainty and ignite a negative trend within the equity markets.

Corporate earnings and revenue growth, along with general growth in the economy has been positive up to this point. The GDPNow model from the Atlanta Federal Reserve has third quarter GDP at 3.8% growth. That would be a very good thing if that were to happen. But investors look beyond the current quarter, and they are becoming increasingly concerned. That brings us to the question, “Is this current market behavior the beginning of a significant correction or bear market?”  We do not know the answer, but we have been expecting a substantive correction, even if we hit further new highs before this bull market cycle is over. We are, however, concerned about the market realizing a grand top somewhere in the first half of 2018.

Many indicators for gauging whether or not we are nearing a final high had been suggesting we were indeed nearing a high. As we have discussed in recent issues of the Investment Monitor, many of the contrarian indicators, such as investor sentiment, margin debt, market valuations, ultra-low employment, and various asset bubble behavior patterns, are or were suggesting that we are nearing a top. Will this just be an interim correction before a final top is achieved, or, has the final top already been realized?

We’ll just have to see where we wind up for the rest of the year and whether or not the market and the economy will find itself in trouble in the fourth quarter of this year or in 2018.

Looking back on last week

Last week was another disappointing week. It was the second loss in a row as markets continue to decline from the all-time highs. The S&P finished down 0.8%, the NASDAQ down 0.7%, and the Russell 2000 underperformed down 1.2%, dropping to a flat line for the year.

On Monday, the S&P 500 gained 1% as investors breathed a sigh of relief after a quiet weekend in regards to the North Korean situation.

Tuesday was a very flat session as the North Koreans said they had decided against executing last week’s threat to launch missiles at Guam. A positive note was the release of the July retail sales that came in hotter than expected up 0.6% versus an expectation of +0.3%

Wednesday was somewhat chaotic from a political standpoint as president Trump ended his Manufacturing council following the departure of several globalist CEOs. Also, the release of the Fed’s minutes showed that they were concerned about softer than expected inflation readings. This helped to head off any concerns about further rate increases for the time being.

Thursday was the big day as there were rumors that director Gary Cohen planned to resign but the White House said these rumors were false. Also, a terrorist attack in Spain killed 14 a left more than 100 injured. This triggered the S&P to decline 1.5%, NASDAQ down 1.9% and the Dow Jones down 1.2%.

Concerns eased a bit on Friday after president Trump fired White House chief strategist Steve Bannon. It was a decision that was well received by the markets. Following the week’s events, the Fed Funds market now points to a March 2018 rise in interest rates with an implied probability of 51.5%. Market participants are now expecting rate increases to be rolled out into Q2 and Q3 of 2018.

*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee