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We’ve been overweight stocks relative to bonds in our overall asset allocation for balanced accounts from a strategic perspective for most of this period of economic recovery, but this quarter led us to a decision to neutralize our stock and bond allocation. There are several factors leading us to be more cautious and to believe that the possibility of a market correction or recession has increased, although maybe still not an imminent threat.  We do not want to overlook this possibility, despite the outlook of many economists that the chances of recession are low (economists do not always do well with predictions, including mostly missing the Great Recession of 2008). Corrections and recessions are a natural part of the market cycle, and investors have been riding the bull market wave for over eight years now. Therefore, we felt it prudent to begin to reduce the stock allocation.  We are balancing our caution and alert with the underlying strength of our economy and the positive data that we’re seeing.  Below, we will discuss the various dynamics at play. 


A Mixed Bag
Depending on what measures you look at or who you ask (i.e., the Fed, as we’ll talk about later), there are differing messages about the health of the economy. However, there does seem to be agreement for the most part that growth, if at all, will be modest this year. So far, we’ve had approximately 2% growth in GDP for the first half of the year. Generally speaking, the economy has continued to improve, but there is clearly a limit to the amount of growth possible this year and in the years that immediately follow. Some measures would indicate less growth, such as commodity prices. Oil comes to most people’s minds first, but it isn’t just oil where prices are unimpressive. Other commodities such as copper and natural gas aren’t signaling any sort of high demand that would indicate a spur in economic growth. Auto sales have been declining for most of the last six months, and there have been three months of declines in new home construction, both of which could weigh on growth. These are examples of things that tend to happen at the end of a market cycle. However, consumer confidence is up in June after a downtick earlier in the year, job growth has been steady, and companies are making money. Earnings have been better than expected for many companies, and estimates for future earnings and profits are optimistic, as well. 

The market’s rallying performance in 2017 (the S&P 500 Index finished the second quarter up over 9% year to date) may feel a little inflated given the slow and steady backdrop. That seems to be the concern of many investors, and it is certainly our concern, as well, because there seems to be a growing disconnect between the stock market and the profits of those companies making up the market. While stock prices have continued to rise, there has to be the same magnitude of positive corporate earnings data to back it up for it to be sustainable. The forward PE multiple is around 18x, which is well above the long-term norms. To further convolute things, monetary easing by the Fed for the past eight years has acted as a significant buoy for the stock market. Stock market performance, then, is becoming increasingly dependent on corporate earnings, which are increasingly more reliant on increased revenues due to shrinking margins. Corporate earnings reports going forward are increasingly more important for investors to learn if the growth in prices is in fact justified and sustainable. We’d also be remiss to not mention President Trump’s corporate tax cut plans and the uncertainty surrounding their viability. There is no doubt that his plan for reducing marginal tax rates at both the individual and corporate levels is economically stimulating, but there is doubt about whether we will see such plans come to fruition. 

Fed Action


We know that the Federal Reserve Bank raised rates for the fourth time in mid-June, again by 25 basis points. The FOMC members anticipate, on average, one more action this year (probably in September). The Fed is mostly confident in the growth we’ll have this year, and it paints a pretty healthy picture from an employment, consumer spending, and GDP growth perspective, thus its plan to stay on course. However, it did hint at closely monitoring the Consumer Price Index (CPI). That’s because CPI, which the Fed likes to see above the 2% average inflation goal, has moved lower since the beginning of the year.  The Fed also gave itself some wiggle room in terms of drawing down its balance sheet of assets. That, too, could start to happen this year, but it’s been made clear that it will depend on the economy growing as the members predict it will. It seems, then, that even the optimistic Fed is giving itself an out if need be, which aligns with other economists who say the data is softer than the Fed is presenting it. 

It is interesting to look at historic stock market performance in relation to Fed activity. Generally, what we’ve seen is that when the Fed begins tightening, stock prices don’t typically go down right away. It isn’t until the Fed has tightened significantly that the stock market then finally anticipates a real slowdown, and we see a bear market in stocks. For the past nine years, the bull market has been “climbing a wall of worry” with periodic corrections along the way. History is certainly not a guarantee of future events, but the end of the cycle or another correction may be approaching if Fed action is an indicator.


Conclusion

As we talked about in the last newsletter, we understand our clients’ concerns about the market, for reasons ranging from all-time highs for the S&P 500 and Dow Jones Industrial Average, uncertainty surrounding Trump’s presidency, and the perception of high stock market valuations. These concerns are very legitimate, especially given that high stock market valuations typically make the market more susceptible and vulnerable to negative surprises. We, too, are aware and cautious of this fact, but we do not believe that this is a time to sell out of the market. However, we do believe it is prudent at this time to reduce our exposure to the stock market. Timing this sort of thing has proven to not only be incredibly unreliable, but staying in the market across swings is a better choice for most investors from a long-term perspective, especially when Howe & Rusling is actively managing against this risk for you with our asset allocation and bottom-up tactics. There are still companies, geographic regions, and sectors we feel optimistic about and confident in, and it is in those spaces that we will continue to focus, while always looking for other opportunities, as well.
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