The First Half Sees Steady Rise For Stocks Coupled With Low Volatility
The second quarter played out in a similar fashion to the first — new market highs with little volatility. In fact, the first half of the year experienced the second smallest drawdown (peak to trough decline) in history. During the first six months of 2017, the largest S&P 500 decline came in at down 2.8%. The only year with a smaller decline happened during 1995 when stocks pulled back 1.7%. What does this mean for the second half? Well, it may mean nothing, but we looked at the 5 years with the smallest drawdowns just to see if any patterns would emerge. There’s good news and bad. We’ll start with the bad news – in every instance the second half of the year saw larger drawdowns. The worst being an over 15% correction in 2015. Now for the good news — in each year the market built on first half gains and finished higher during the second half as well despite the corrections.
We’re always reticent to rely too much on one-off stats, but in this case, it fits our current view of the market. We believe investor complacency exists and expect it to manifest itself in the form of elevated volatility over the coming quarters. Despite this, we continue to have a favorable outlook for stocks based on improving corporate profits, solid relative valuations and the prospects for fiscal policy tailwinds.
A Similar Refrain: The US Economy Remains Resilient
At the risk of sounding like a broken record, we can find few cracks in the US economy despite being 96 months into the current expansion. The labor market is healthy with unemployment below 4.5%, jobless claims near all-time lows and 220,000 jobs added during June, a level above the post-crisis average. Wage growth is still hovering in the 2.5% range where consumers have more spending power and corporate profits can remain healthy. Confidence data taken from consumers, CEOs and small business owners all sit comfortably higher than a year ago, despite taking modest steps back from recent highs.
If we had to pick one area of clear slowing it would be auto sales. That said, the slowing in auto sales is not unexpected. The US has been running above its long-term average of 15.6 million cars sold annually since 2014 as customers re-entered the market following well below average purchases during and immediately after the recession. We expect the current rate of 16.6 million autos sold per year to decline further with an ultimate normalization around the long-term average. We don’t view this as a canary in the coal mine for the US economy. Rather, a natural progression coming on the heels of the worst financial crisis in roughly 100 years.
Second Half Likely To Experience A Bumpier Ride, But Outlook Positive
We’d be remiss if we didn’t touch on the Federal Reserve and its path to rate normalization as well as the gridlock in our nation’s capital. The Federal Reserve raised rates for the fourth time this cycle to a target range of 1.0%-1.25%. There is no way around the fact we’re currently investing in a tightening environment. But, let’s be clear, monetary policy can’t exactly be described as tight when real rates (adjusted for inflation) are still negative. The Fed is taking a very measured pace to this tightening cycle, which historically is a more favorable backdrop for stocks than fast tightening cycles.
Washington remains a mess. But this is nothing new. The Healthcare debate has led many investors to question whether the new administration will be successful in passage of its pro-growth policies. We don’t have a crystal ball on the legislation front. What we do know is legislation is always messy and there are things the President can do without Congress. Two immediate actions that have a high likelihood of success come to mind. One is less onerous financial regulations which could lead to faster EPS growth and higher levels of shareholder returns (dividends and share repurchases) for financial stocks. The second is more a lenient energy project approval process which could help MLPs grow assets at a faster clip. As far as legislation goes, we’d simply point out that it is always an arduous process and would not be too quick to dismiss the idea of tax reform occurring later in 2017 or early 2018. And if it does occur it would likely add more fuel to the fire driving corporate profit growth.
As we discussed, we expect a bumpier ride during the second half of the year for stocks after an extremely steady first half. The outlook, however, looks favorable to us. The economic backdrop is supportive and corporate profits have returned to growth mode following a “recession” during 2015 and early 2016. The biggest risk, in our view, for stocks are valuations which are on the high side of historical averages. The best cure for elevated valuations is old fashioned earnings growth, which we’ve started to witness. Additionally, when compared to the bond market which is being tested by less central bank accommodation around the world, stocks offer good value.
The Investment Committee
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