October 2017 Commentary
Global economic growth is on the rise which has led to an increase in the MSCI World Stock Market Index by 15% on a year-to-date basis. Global GDP growth is currently 3.2%, up from 2.5% last year. The U.S. stock markets are up 11-15%, depending upon the index. U.S. companies’ earnings should be up 10%+ in 2017 due to the rise in global economic activity, especially outside the U.S., and to the decline of the U.S. dollar. At the current time, US companies’ earnings are expected to rise 12% in 2018. For the most part, markets have not reacted to the political sparring in Washington D.C. and geo-political rhetoric between the U.S. and North Korea. The bull market appears intact for the time being.
Are we due for a stock market decline of 5-10% (1,100-2,200 Dow Jones Industrial Average points)? The U.S stock markets’ valuation, as measured by P/E (price divided by earnings), continues to be high at 17.7x earnings compared to the 15-16x historical average. This has been a continual theme for the past two years, while the market has climbed the proverbial “wall-of-worry”. The U.S. stock market periodically declines by 5-10% during most bull markets, but has not experienced a sharp decline since January 2016 when oil prices collapsed to $29 a barrel. I believe the stock market is setting itself up for a correction considering investor optimism, high valuations, and low interest rates. Typically, when a negative surprise occurs with this backdrop, a correction is likely.
Primary risks to our economy and stock markets: the reduction of the $4.5 trillion Federal Reserve balance sheet, and a tight labor market. The Federal Reserve (FED) built up a $4.5 trillion balance sheet of US Treasury and mortgage-backed securities as it was providing cash into the economy to stimulate growth. The FED is now planning to reduce the size of its portfolio to “normalize” its balance sheet. In doing so, if interest rates rise more than expected the stock market may decline in anticipation of economic growth being constrained.
I continue to advise clients to invest in the stock market for the long term, while having sufficient cash and bonds in one’s portfolio to ride through the next bear market. Although both optimism and complacency are in the air, we can expect to have a bear market and recession at some point in the future. During the past 18 months, LWM has been adding “long short” investments to most of our clients’ portfolios. These investments are designed to capture most of the market’s upside returns, while being exposed to only approximately half the risk of the market.
Rich Lawrence, CFA Managing Director