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If you prefer a PDF version of this report, please click here to get the 2017 – Q4 Tempo Report.

Last Quarter / Year Review:   12-months in a row of positive US market gains; the first time in history. According to Charles Schwab, the consistent gains of 2017 were supported by an equally consistent monthly rise in both actual and estimated earnings for companies in the MSCI All Country World Index. In 2018, global stocks may again be driven primarily by earnings growth fueled by back-to-back years of growth in all of the world’s 45 largest economies tracked by the Organization for Economic Cooperation and Development OECD—making up more than 90% of global gross domestic product (GDP)—for the first time in a decade.

Bob Doll, chief investment strategist of Nuveen, stated Dec. 29, “From an investment perspective, 2017 may have been the first “perfect” year ever. The U.S. economy continued to slowly improve, with unemployment dropping to nearly a 20-year low. Global growth expanded and became more synchronous, with Europe in particular showing strength. And while growth improved, inflation remained tame. This allowed global central banks to keep monetary policy accommodative, even as the Federal Reserve and other policymakers were slowly tightening.” Now we must look forward and we do that below.

Investment & Economic Summary (source – Moody’s Analytics): Economic data, in general, remains positive with some back and forth results. The latest Economic details are:

  • The Conference Board’s leading economic index rose 0.4% in October, in line with consensus expectations. This is a modestly smaller increase than the average gain in the past six months.
  • The Chicago Fed National Activity Index three-month moving average is a more reliable indicator of economic strength. At 0.41, the moving average remains healthy.
  • Consumer confidence fell 6.5 points to 122.1 in December. This was the largest monthly decline since 2015, but there is no cause for concern. Though the decline reverses a good portion of the gain over the prior two months, the index remains up more than 8 points on a year-ago basis and remains among its highest points since the early 2000s.
  • Though the ISM manufacturing index came in weaker than we expected, our confidence that manufacturing will perform well this quarter and early next hasn’t changed. The U.S. and global economy are doing well and past depreciation in the U.S. dollar should support exports and manufacturing production. The nonmanufacturing segment of the economy is doing well, but growth narrowed in November. This segment of the economy accounts for 88% of nominal GDP. The nonmanufacturing survey doesn’t raise a red flag.
  • Productivity is not only volatile from quarter to quarter but also from year to year. Therefore, the longer-term trend is important and it remains poor. Over the past five years, productivity growth has averaged 0.8%, which is one reason why nominal wage growth remains mediocre. Generally Capital Spending increases Productivity.       The new tax reform has 100% write off of capital spending for 5 years. It is designed to help both productivity and wages.
  • Retail sales comfortably exceeded expectations in November, growing 0.8%. On a year ago basis, sales are up 5.8% and are among the strongest in five years.
  • The probability that the U.S. will be in recession in six months fell from 5% to 2%. There is no immediate threat of a recession; we normally adopt a recession as our baseline when the probability of recession hits 60%.

Expectations – next quarter:   Markets and earnings continued to power forward. Year over Year earnings are the headline analysts pay attention to (9.17%) but the Quarter over Quarter earnings change of +2.65% was good as well. Earnings have historically led to market appreciation. Perhaps more to come, yet we expect volatility in the market as earnings are announced and rancor continues in Washington.

Corporate earnings reports power the stock market as we have seen these past 18 months. Perhaps 2018 will be no different because there have been some mighty changes that have been positive for earnings growth. Fiscal policy finally has become the engine of growth. The recent Tax Reform Act that reduced corporate tax rates from 35% to 21% and reduction of personal tax rates gets the headlines. While this is no small accomplishment and likely to increase earnings, other under-the-radar earnings optimizers have been 22 eliminated regulations for each 1 new regulation out of Washington. Regulation is a hidden tax, so another tax cut of sorts. Additionally the US has lower domestic energy costs than most all of our trading partners. An example is the difference in the West Texas Crude price in the US v. Brent Crude price outside of the US. The US typically has a 7-10% lower cost. Since the US now is an oil exporter (because of fracking) rather than a dominent importer, this is a critical benefit for companies. And to add to that good news, there are more oil/gas pipelines and approval for more drilling on Federal Lands such as the Alaska North Slope. This all should keep oil prices lower than the competition. Finally, with all of this good news, the US is very attractive to new and old businesses relocating to our shores. Total costs of business are now lower, we have a large economy attractive to business, and a general work ethic that is strong. This all points to better earnings which power the stock market. If the above expectations are realized, then the market is expected to continue to rise.

From Schwab Center for Financial Research…expectations for 2018

  • Economic growth likely will lift earnings, benefiting stocks. With a tight labor market, wage growth may accelerate, along with inflation.
  • Broad global growth and falling correlations across stock markets bolster the case for global diversification.
  • The Federal Reserve is poised to raise rates at least two or three times in 2018.
  • During 2018, the yield on 10-year Treasury bonds may exceed 2.6%.

There is some concern that the US market is over-priced. According to the Schwab Center for Financial Research, the U.S. tends to behave like the global tech sector, as you can see in the chart. So it isn’t surprising that the MSCI USA Index is valued like the MSCI World Information Technology Index, with a similar PE of 25. Strictly speaking, the U.S. stock market is composed of only about 20% tech stocks. So, in theory, the incredibly tight correlation of 0.99 between those two blue lines shouldn’t exist. But, in reality, it does. A bottom up weighting of the PEs of the stocks that make up the U.S. index misses the point of how the U.S. stock market actually behaves, and therefore, is valued. Major stock markets are valued in relation to the sectors that drive their performance.


Indexes measure cumulative total return in U.S. dollars since start of 2006.
Source: Charles Schwab, MSCI data as of 10/31/2017.

All this suggests that relative valuations do not currently favor one country or region’s stock market over another when seeking excess returns. We favor global asset allocations rather than US only and have made those allocation changes during 2017.

Bob Doll, Nuveen Chief Strategist, 12/11/17 “Will the potential upside in stocks outweigh the downside risks? In general, equity bear markets are usually associated with recessions. And since we don’t expect a recession before 2019 or 2020, we think equities still have room for gains. The conditions that have promoted equity prices remain in place (reasonable economic growth, strong corporate earnings, low inflation and accommodative monetary policy), so we think it makes sense to continue overweighting stocks, at least for now.”

With all the records in the stock market, are we in a bubble leading to a recession or are there fundamental data supporting the appreciation? In the graphic, you can see the impact of previous recessions and key economic fundamental data. Note the key. During recessions, most if not all of the data points are negative. At this time in our business cycle, NONE of the data point towards a recession. Note for July-81, all indicators need not be negative to have a recession. And for Dec-07, all indicators suggested problems and in 2008, the market was down more than 40%. So it is important to pay attention… and we will.

2018 looks like a good year for investing in the stock market but not so good for the Bond Market. Will the Bond Market be a bear market? Perhaps not but it is likely that relative performance between the Bond and Stock Market will be widely different as it was in 2017. The Aggregate Bond Index, AGG, gained 1.18% with the S&P 500 gaining 19.42%. We don’t expect a repeat in 2018 but stocks are likely to outperform bonds.

Keep in mind that the stock market has not had a correction greater than 5% since August 2015. It is likely that in 2018 we will have such a correction. However, given the above graphic, it is unlikely to be the beginning of a bear market.

We hope you have a wonderful start to 2018!

Brent and Dave Romenesko

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