July 24, 2017 – DJIA = 21,580 – S&P 500 = 2,472 – Nasdaq = 6,387
SERENITY NOW!! (Insanity later)[i]
For something that comprises so much emotion, the stock market has amazingly ignored the passionate yet venomous division in the United States. In the midst of name calling, violence, protests, and a prevailing sense of hatred of those with opposing views, the stock market climbs higher. With the acrimony and polarity so elevated, why hasn’t this impacted the markets?
And not only have stock prices risen in the face of societal deterioration, they have done it in a remarkably smooth and steady manner. The S&P 500’s largest pullback this year is a hardly noticeable 2.8%. We all know that there have been times where the markets approach that level within a day! And not only is this incredible given the current landscape, it is historic. This is the smallest intra-year correction since 1995 and the second smallest dating back to the Great Depression.[ii]
This stock market serenity has gotten so widespread the U.S. seems to be exporting it as international stock markets are experiencing a similar tranquility. As measured by the MSCI EAFE (Europe/Asia/Far East), the MSCI EM (emerging markets), and the Nikkei 225 (Japan), global bourses are near record low levels of volatility. Traditionally, emerging markets are one of the riskiest assets classes with high levels of uncertainty. Yet so far in 2017, the MSCI EM has only undergone a mere 3% pullback. Contrast this to 1995’s 13% correction which was one of the least volatile years in history for emerging markets.[iii]
In 1995 the Nikkei 225 fell 26.4% from peak to trough. While this is not the lowest annual pull back for this index, it is among the smallest. Yet so far in 2017 the spread is a miniscule 6.5%.
Below is a graph showing variance for the S&P 500, the MSCI EAFE, the MSCI EM, and the Nikkei 225 since 1990. The red circle on the right is 2017. As measured by these four indexes, this is an astonishingly calm year within the backdrop of chaos.[iv]
There is no definitive reason for this quiet price action. Until recently, central banks were keeping short term rates low and this has likely contributed. Also, it is helpful that economies have been growing at a slow but steady pace. Indexing and passive investing has played a role as investors have been buying ETFs which index the market and its various sectors. These funds buy their underlying components as they receive inflows without concern for valuation or timing.
Whatever the cause, the stock market’s peaceful price action will end and volatility will return – someday. As shown in the graph, there is a cyclical component to this and there’s no reason to think things have been permanently altered. Whenever market volatility returns there will be much wailing and gnashing of teeth as investors will not be expecting it. In the meantime, the steady move higher continues and, as mentioned, the major indexes reached records last week. Here are the year-to-date returns as of the end of last week.
Dow Jones Industrial Average +9.2%
S&P 500 +10.4%
Nasdaq Composite +18.7%
Russell 2000 +5.8%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
Looking at the fixed income market, short term rates have move noticeably higher. First the 3-month Treasury bill’s yield closed 1.17% last week and this was actually higher than the longer dated 6-month T-bill which closed at 1.10%. Moving further out, the yield curve returns to its normal upward sloping direction with the 2-year Treasury note at 1.36%, the 10-year Treasury note at 2.24% and the 30-year Treasury bond at 2.81%. An interesting (and easy) place to park some short-term liquidity might be 6-month CD’s which were yielding 1.35% – 1.40% last week.
Foreign exchange is another market that is offering some unexpected developments. At the beginning of 2017, the common forecasts were for a stronger U.S. dollar based on the “Make America Great Again” theme. Increased domestic manufacturing, increased exports, and restrictions on imports were part of the landscape that would drive the dollar higher. Instead, as measured by the Wall Street Journal Dollar Index, the greenback has fallen 7.25% against a basket of currencies in 2017.
This translates into unexpected stock market leadership. Companies with high domestic revenues, which would typically benefit from a stronger U.S. dollar, were supposed to lead the markets. And companies with a more international customer base were supposed to be hurt. However, with the weaker dollar, technology (with big international sales) has benefited. Apple, for example, has approximately 60% of their revenues from foreign markets. Dow Chemical also has over 60% international revenues and the stock has done well.
Once again, this points out how the markets move against conventional wisdom. In the fixed income market, the yield curve has flattened rather than the predicted steepening. And again, the U.S. dollar has weakened instead of rallying which switched the stock market leaders.
Where can we currently look for similar predictions to be wrong? There appears to be two industries that are widely expected to have problems. One is retail. Everyone (including Amazon) expects Amazon to ultimately supply all of our purchases and that there won’t be a need for anyone else. To be sure, some retailers will continue to be challenged and some will fail. On the other hand, many will survive and trade at very cheap valuations.
Energy is another washed out sector. As the oil and natural gas markets seem to be well supplied, energy stocks have been laggards. The obvious problem is that the success of these businesses is largely a function of the commodity price. However, despite the growing popularity of electric cars and more renewable supplies, global hydrocarbons demand is predicted to grow. As with the retailing sector, there are some investment bargains in the energy stocks.
One of the biggest investment mysteries of 2017 is the markets’ disregard of the widespread social acrimony. Typically, such chaos and strife would be reason for at least caution, if not widespread selling. So far it has not happened. We don’t expect the division and polarity to subside anytime soon. This means that investors should keep watching how the markets react to new developments. If the indexes begin to lose momentum, it could be a sign that the serenity is switching to the insanity. In the meantime, deep breaths everyone.
[i] Seinfeld, October 9, 1997
[ii] LPLresearch.com, July 25, 2017
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13905