October 2017 Monthly Outlook

by on Nov 6, 2017 Categories: monthly outlook, u.s. stock market, u.s. economy

Economic numbers were mixed as a recovery in orders for durable goods, a nice comeback in retail sales, and a reassuring outlook from the Federal Reserve were offset by a drop in housing starts and mixed trends in home sales. During October, existing home resales were sluggish but demand for new dwellings was strong. Importantly, the weaknesses presented in the economic metrics seem to result from the devastation of recent hurricanes rather than a fundamental shift in direction.

The underlying trends point to future economic strength. While the latest housing trends are mostly uninspiring, building remains sufficiently strong enough to suggest that once the hurricane-induced softness passes, the uptrend will resume. In fact, the necessary rebuilding may give housing a boost later this year and in 2018. Elsewhere, results from the consumer and industrial areas are generally supportive, making it likely GDP growth will modestly surpass 3% in the quarter.

The Conference Board Leading Economic Index® (LEI) for the U.S. decreased 0.2% in September to 128.6.  “The US LEI declined slightly in September for the first time in the last twelve months, partly a result of the temporary impact of the recent hurricanes,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. “The source of weakness was concentrated in labor markets and residential construction, while the majority of the LEI components continued to contribute positively. Despite September’s decline, the trend in the U.S. LEI remains consistent with continuing solid growth in the U.S. economy for the second half of the year.”

Indicators point to the U.S. economy accelerating in the short term and in the long term continuing a slow but steady growth rate of ~2% annually. We remain in the late stages of a long business up-cycle without major excesses that brought down some prior economic upturns.

U.S. stocks continued their steady uptrend as the S&P index increased 2.36% in October. The October increase was driven by the technology sector's particularly large companies like Alphabet (Google), Apple and Facebook. These companies' stock appreciation has been driven by high earnings growth. We prefer to own companies such as these and shun companies whose earnings are hopes in the future like Tesla, Amazon and Netflix.

While there is no shortage of economic and political noise right now, we continue to monitor the yield curve as we believe this is the best predictor of future imminent economic recessions. Currently the yield curve (shown on the economic metrics by subtracting the 10 year rate by the 3 month rate) is not inverted, so we continue to tactically hold overweight allocations of stocks rather than bonds.

Though the yield curve is not currently inverted, there is a key reason we believe it is so critical to monitor. Since 1963, all 7 official U.S. recessions have been preceded by an inverted yield curve. Additionally 8 of 9 U.S. stock bear markets (drops of >20% from peak to trough) since 1963 have been associated with recessions and were preceded by an inverted yield curve. We will continue to closely monitor the yield curve, and when it becomes prudent, begin shifting portfolio allocations.

During a lengthy stock market rally, the possibility of a market correction begins to present itself. A U.S. stock market correction is defined as a drop in the S&P index greater than 10% but less than 20%. As shown in the table below, there have been 18 of these occurrences since 1963. These occurrences are significantly more frequent than recessions and shorter in duration. There are few, if any, warning signs of a correction, and attempts to avoid them are futile because they are a fundamental function of investing in stocks. Rather than change investment tactics in an attempt to avoid a correction, it is best to use these occurrences as opportunities to increase stock allocations. 

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