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Second Quarter 2017 Update

July 24, 2017

The S&P 500 continued its upward trend in the second quarter, finishing the quarter up 2.57% (S&P 500 – Second Quarter 2017 Chart). Low volatility has been the theme of the quarter, with only one 1% down day (May 17th) and only one 1% up day (April 24th). The CBOE Market Volatility index finished at 11.18, nearly half of its historical average.

The second quarter’s increase brings the S&P 500’s price return up to 8.24% for the year (S&P 500 – YTD 2017 Chart). The majority of the performance in the S&P 500 was driven by growth oriented stocks, although that stalled in June. Historically, these types of trends, especially at the extremes we experienced, don’t continue.

Fed Raises Rates, Again

The Federal Reserve continued to fulfill its promise to normalize rates by raising rates by 25 basis points or .25% in June. Rates now sit in a range between 1% and 1.25%. As seen in the chart to the right, these rates are still at historically low levels.

U.S. Dollar drops

The euro extended its strength to the dollar throughout the quarter. The euro was at €1.04 to $1.00 in December, and is now trading at €1.15 to $1.00, as seen in the chart to the right. The dollar’s strength in days past was a headwind for corporate earnings, as U.S. products became more expensive for foreign consumers. Any continued weakness in the dollar may lower foreign investor’s appetite for U.S. Treasuries.

Bond Rates Still Dropped

Despite seeing an increase in fed fund rates and a weaker dollar, the 10-Year Treasury saw yields drop. Typically, yields would rise as the Federal Reserve increased rates, forcing bond values down. A weak dollar could also induce foreign selling, forcing prices down and consequently yields up. This has not happened thus far, as foreign investors continued to pour money into our higher yielding sovereign debt. Even as I write this report the 10-Year German Bund is yielding only 0.55% and the Japanese 10-Year Bond is yielding 0.08%. This is a great improvement over the negative yield from last year. Even the risky Italian 10-Year Bond is yielding 2.19%. The major question is how long will foreign investors stick with domestic bonds if they continue to lose value due to the drop in the dollar.

More Fed Action to Come

Fed futures indicate a 50/50 chance of one additional 25 basis point increase before the end of the year (Current Target Rate Probabilities for Dec. 13, 2017 Fed Meeting Chart), with only a 26.8% chance of the Fed leaving rates alone over the next 12 months (Current Target Rate Probabilities for Dec. 13, 2018 Fed Meeting Chart).

The U.S. Economy

Fed futures indicate a 50/50 chance of one additional 25 basis point increase before the end of the year (Current Target Rate Probabilities for Dec. 13, 2017 Fed Meeting Chart), with only a 26.8% chance of the Fed leaving rates alone over the next 12 months (Current Target Rate Probabilities for Dec. 13, 2018 Fed Meeting Chart).

Earnings Continue to Improve

Last quarter’s earnings, for S&P 500 companies, came in almost exactly where they were predicted. Future earnings expectations point toward record earnings, as we finally seem to be coming out of our earnings recession.

Valuations Improve Slightly

Valuations for the S&P 500 improved slightly as earnings growth outpaced market performance Some valuation measure show the S&P 500 as being slightly over valued, while other show it properly or even slightly undervalued.

Putting It All Together

Geopolitical issues have been plastered all over the media in recent months. As we have discussed many times in days past, most geopolitical storms have little or no long-term impacts on the markets. They typically create short-term sentiment shifts, causing emotional investors to flee the markets at exactly the wrong time. While we don’t summarily dismiss all geopolitical issues as being insignificant, we just want to reiterate that most are nothing more than headlines. We will continue to manage our portfolios in a clinical and disciplined manner, not reacting to the “noise” of the media but rather shifting our allocations using substantiated fundamental and technical research.

If the future earnings expectations are correct, which we have no reason to feel otherwise, we will see record earnings in the S&P 500 for several quarters to come. It appears that our six quarter earnings recession is over and we should see significant increases in earnings and, as such, upward momentum in the stock market. A weakening dollar, although double edged, should further help this cause. We are very bullish about the stock market and would use any pullback as a buying opportunity.

The global economy continues to improve and valuations abroad are cheaper than here at home. We continue to see opportunity in the international markets and will be continuing to invest more of our assets abroad.

Our biggest concern still remains with the long-term and intermediate-term fixed income market. The bond market has continued to elongate its game of musical chairs, defying typical price deterioration during a rising interest rate environment. At the end of 2013 the 10-Year Treasury was yielding a little over 3%. Since that time, the Federal Reserve has raised rates from 0% to 1%. Historically, a 1% increase in rates has caused an 8.6% loss for the 10-Year Treasury. Foreign demand for our sovereign debt has been the only thing that has propped up prices. This unusual demand has pushed prices up, and the yield for the 10-Year Treasury down to 2.27%. This is highly unusual.

Yields will begin going up, forcing prices down. It is not a question of if, but rather when. The Federal Reserve has already declared that they wish to have their target rate at 3.00% over the next few years. The 10-Year Treasury is only yielding 2.27%. Mathematically, this 3% increase in rates (from 0% to 3%) should cause a 25%+ loss in the 10-Year Treasury.

It is likely that sometime in the near future, as sovereign debt in major countries normalizes, foreign investors will lose their appetite for U.S. bonds. Fed moves and normalized foreign debt will cause the music to stop in our bond market game of musical chairs. Bond prices will tumble, causing significant loses in the “conservative” portion of an investor’s portfolio.

We encourage you to speak with your Polaris Greystone wealth advisor to have them reevaluate if you are properly positioned for our current market environment. We are happy to run (or rerun) your personalized financial plan and make sure that you are well positioned to accomplish your long-term financial goals. We look forward to hearing from you.

As always, I welcome your comments and questions.

 

 

 

  

 

   Sincerely,
   Jeffrey J. Powell
   Managing Partner

Categories: Polaris Greystone Financial Group, LLC.

Tags: Bond Risk, Bonds, Chicago Fed National Activity Index, Economic Data, Economic Indicators, Economy, Federal Reserve, GDP, Index, Interest Rates, Investing, Investments, Market, Market Outlook, market performance, Market Sentiment, Markets, S&P 500, Stock, successful investing, The Fed, 2017

 

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