Summer Brings New Highs and Lower Volatility: What, Me Worry?
The U.S. economy continues to deliver benefits on the job front as evidenced by last week’s employment report which indicated 151,000 new jobs in the month of August. While this figure marks a decline from the prior three month’s average of 180,000 additions, it reinforces the resilience of the U.S. recovery. The drop off from the earlier pace of gains, however, may give a toehold to those at the Fed arguing that rates should remain lower for a bit longer. The unemployment rate remained at 4.9% despite those new additions, as more people returned to the workforce, and core PCE inflation—the metric watched by the policymakers—remains below the Fed’s 2% target. As the market awaits clarity on Fed policy, some investors are expressing increasing concerns that the continuing accommodation in monetary policy is allowing stock prices to move to unsustainably high levels amidst unusually little volatility.
The S&P 500 reached new highs in August, and after finishing last week just shy of 2,180 its 12-month forward multiple to S&P component company earnings stands at 16.9, slightly above its 25-year average. Yet when we look around the globe, we see many reasons—beyond accommodative Fed policy—to justify current multiples.
First, the recent data reaffirms the U.S. as one of the strongest economies in the world. While Brexit has not triggered near-term catastrophe as some had feared, many investors in Europe are taking a harder look at risks to growth prospects on the European continent as well as longer term in the United Kingdom. These concerns are likely to pull more investing activity toward the U.S. Following a decline in 2015 in foreign net purchases of U.S. securities, we are seeing the trend reverse this year and the strongest increase has come from Europeans.
Second, negative interest rates abroad are propelling a search for yield that has drawn funds into the U.S. which not only has helped keep U.S. interest rate expectations low—as we have written before—but also provides support for the prices of solid dividend-bearing stocks in the U.S.
Third, we are starting to see renewed spending activity after a weak first half, when many firms delayed spending amidst greater economic uncertainty. Computer and Electronics were up 3.7% year over year in July and orders for Computers and Related Products were up 10.3% month over month. And Intel, a bellwether for broader IT spending trends, reported an uptick in shipments of high-powered chips for servers—and servers are the engines for larger, faster data centers, for the world’s communications backbone, and for cloud computing. A main driver of economy-wide productivity lies in information technology infrastructure and if spending continues to track favorably we could see the benefits spread beyond the suppliers to firms making such upgrades.
Fourth, the housing and energy markets in the U.S. continue to recover and this is not only likely to propel earnings higher in these two sectors, but also to generate a further expansion in U.S. employment and so continue to support broader economic recovery. We also believe that the housing market remains only in the middle innings of its recovery and energy is also likely to have bottomed.
Despite these reasons to remain cautiously optimistic regarding the market’s resilience, we should be wary of the seeming calm that’s settled over the S&P 500 in the final weeks of summer. Since spiking over 25 in late June, the S&P 500 Volatility Index (VIX) dropped considerably in the following weeks and settled just below 12 on Friday. Fed rate increases, the upcoming presidential election, the slowdown in China, threats to global trade arrangements, and uncertainty in progressing through Brexit may very well lead to renewed market turmoil. In this environment, perhaps, we should worry, but not overly since the U.S. recovery appears robust. Moreover, we are continuing to bring into all our equity portfolios stocks available at value multiples—we view this as increasingly essential for long-term investing as we head into the fall.
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