Following a period of heightened volatility earlier in the year, the third quarter saw the market break out once again to the upside, with an impressive 7.7% return for U.S. stocks as measured by the S&P 500. This brings the year-to-date total return for the index to 10.6%. International stocks and U.S. bonds have not performed nearly as well, with the MSCI EAFE falling -1.4% this year and the Bloomberg Barclays Aggregate Bond Index declining –1.6%.
For U.S. stocks, the primary reason for the continued rally is strength in the U.S. economy and strong corporate profit growth. So far this year, corporate profits are on pace to grow by more than 25% versus the long-term average of about 7%. This has been largely attributable to strong economic growth, as GDP grew 4.2% in the second quarter. Profits have also been fueled by favorable tax legislation that was enacted at the end of last year. The surge in profits is expected to moderate somewhat next year, but growth should remain robust as the economy continues to expand.
The question we are hearing most often from our clients is whether or not there might be a significant market decline looming on the horizon. The primary cause for their concern has the been the long duration of the current bull market. Although there have been several bouts of volatility, and even significant declines from time-to-time, the current bull market has marched ahead, mostly uninterrupted, for the last nine and a half years. Our brief answer is that we are not overly concerned, at least not in the short-run.
Are we headed for a bear market?
According to JPMorgan, there are four primary risk factors that can lead to a bear market decline. They are: high stock valuations, economic recessions, commodity price spikes, and aggressive monetary policy tightening by the Federal Reserve. Despite a growing sense of anxiety among investors, there aren’t signs that any of these common causes for a bear market currently exist. We’ll address each of these risks below:
The long duration of the current bull market has led many to believe that the stock market is overvalued. This does not appear to be the case, as the price-to earnings (P/E) ratio on expected earnings for the S&P 500 is 16.8x versus the long-term average of 16.1x. Other classic measures of valuation such as price-to-book and price-to-cash flow are also reasonably close to long-term averages. So, generally speaking, the market may be priced a bit above fair value, but it is not significantly overvalued as many seem to fear.
As mentioned above, the U.S. economy remains on very strong footing. In addition to strong GDP growth, the most recent labor report announced that the unemployment rate has reached 3.7%, which is the lowest reading in almost 50 years. Many other measures, such as growth in retail sales and worker productivity also point to broad strength in the U.S. economy.
Although prices of some key commodities have been on the rise, there haven’t been any notable price “spikes.” Most commodities are currently priced at or below their average inflation-adjusted levels. Crude oil, which is of particular interest to many of our clients, has risen this year from $62 at the beginning of the year to $74, but remains well below the $100+ level last seen in 2014.
The Federal Reserve has been gradually raising their benchmark Fed Funds Rate for the last three years. At their latest meeting, they increased their rate to a target of 2.00% to 2.25%, marking the third increase this year. While short-term interest rates have risen, they remain well below long-term averages. It is also clear that the Fed is paying very close attention to the impact of their actions.
However, there is one measure we are watching carefully. As the Fed has increased their benchmark rate, short-term interest rates have increased significantly. This has caused the yield curve (or the difference between short-term and long-term interest rates) to flatten (or become smaller). If the yield curve were to invert (where short-term rates rise above long-term rates), it could be a cause for concern, as every time the yield curve has inverted, an economic recession has followed roughly 12-18 months later.
Given the long duration of the current bull market, investors have become increasingly anxious. While these concerns are worthy of our attention, we believe that the U.S. economy remains strong and can continue to grow for at least the next year or two. Under any conditions, it is important to remain well-diversified and remember that investing is a long-term proposition.
Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience. Lastly, don’t keep us a secret. If you know someone who would like help planning for their financial future, we will be pleased to speak with them to see if we can assist.
Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.