The Bottom Line

The rally in stocks continued during the 3rd quarter, as the market tacked on another 4.5%, bringing the gain in the S&P 500 to 14.2% so far this year. While generally favorable economic fundamentals have been the engine behind these returns, there have been many issues that would be logical candidates for investors to be concerned about: a potential North Korean conflict, uncertainty in regard to expected tax reform, continued Federal Reserve tightening and last but certainly not least; potentially richly valued markets.

Yet the market ignored all of these concerns and continues to move higher with barely a pullback. This is what we refer to as the market climbing a wall of worry, a hallmark of bull markets. Make no mistake, the challenges outlined above are important issues the market must contend with and we are concerned about them as well. In the near term, the market is quite overbought so a small pullback over the next few months would not be a surprise. However, the most important issues – the economy and earnings – aren’t flashing the warning signs that signal a significant secular decline is in the cards. Our expectation is that it’s likely that extended valuation measures are warning us that future long term returns (4-7 years) have a good chance of being less than historical averages.

Putting it all together, the market has been quiet with a slow grind higher, but we expect more cross currents over the next few years. We see bullish and bearish factors competing for the market’s attention. Future volatility (both to the upside and downside), is quite likely in the next few years, in our estimation.

The Economy, Earnings, and Monetary Policy

The current U.S. economic expansion is 96 months old and appears to be on good footing. The latest readings on the economy appear to show that the economy has strengthened in the most recent quarter.  This probably sounds like a broken record, but the economy continues to be good enough. Moreover, it is appearing more and more likely that some positive fiscal policy is coming from the Trump administration. To be sure, if they don’t deliver, it will be disappointing, but progress behind the scenes appears to be occurring. Hopefully, this continues.

Earnings season is upon us, so it’s too early to tell how companies in aggregate are doing, but last quarter was a good one for companies as a whole. Moreover, our earnings model is not showing signs of disappointment either. Like economic measures, earnings since a brief scare in 2015 are looking fine.

The Fed, on the other hand, may not be the friend for the market that it has been since 2009. The Fed has raised interest rates twice this year, and the outlook is for more hikes in the future. Just as importantly, they are now attempting to reduce the size of their balance sheet. The Fed has been on a buying spree over the last 8 years, purchasing bonds to keep rates low under QE1, QE2, and QE3. They have said that they will reduce the size of their balance sheet gradually, in a manner that won’t affect rates too much. We’ll see! Hopefully that is the case, but we now have to say that the Fed is not going to be helping the economy as they have in the past. That makes following the fundamentals even more important than ever.


By many measures, valuations appear to be extended, some of which we covered in last quarter’s outlook. One mitigating factor, however, is interest rates. The forward P/E ratio on the market is 17.7, a fair amount over the average P/E – 15.2 (since 2000). So on the surface; it’s certainly plausible to be concerned that the market is somewhat overvalued. But instead of looking at P/E, let’s look at the earnings yield – E/P. This is just another way to think about valuation. The earnings yield is 5.4%, which is fairly low; historically it’s averaged 6.3% since 2000. But compared to interest rates – the 10 Year Treasury note is yielding 2.4% – it’s still very attractive.

So while we are still in the camp that says the market is somewhat overvalued, it’s certainly mitigated by the fact that rates are very low. This is another example of why we believe that of all the things we look at, valuation is the least important. There are many ways to measure valuation, and they often reach very different conclusions. Moreover, if the economy falls into a recession, it doesn’t matter if the market is cheap or expensive, the market will suffer! This is exactly what happened in 2008. The market was not overvalued then at all, but the economy got hit hard and good valuations didn’t matter then either.

Sentiment and Technicals

In the very near term, the market has become quite overbought and it has been nearly 20 months since we have seen a 5% pullback. Volatility is also at all time lows. Last week the Volatility Index, otherwise known as the VIX, closed at an all-time low of 9.19. By many measures it would seem the market is susceptible to a pullback, but the 4th quarter is typically a good quarter for the market so it would not be surprising that weakness doesn’t surface until next year.

Longer term, we continue to see few signs of excess enthusiasm that are associated with secular peaks. Flows into equities compared to bonds are not excessive. Most articles we read are about bubbles and concern. That’s not typically how markets top. They usually top when investors throw caution to the wind. To be sure, we are seeing more signs of that now than we did a few years ago. The enthusiasm over Bitcoin and Semiconductor stocks are two examples.

Equity and Fixed Income Strategy

Our individual stocks continue their strong performance again this year.  In our ETF strategy, we are starting to see better relative strength in Small/Mid Cap and the International areas. This is a change over the last few years as these areas have been a drag. This could be signaling an important change and we have started to allocate a higher allocation in these areas. While our Long/Short process continues to outperform similar alternative managers, it needs a pullback to take advantage of, and as we discussed, it’s been almost two years since we’ve had one of those!

Our outlook for an improved economy and higher rates is unchanged. Our bond strategy is fairly conservative and will stay so until signs of economic weakness show themselves.