Quarterly Review April 2017

Stocks Surge Again: Is There Steam Left?

The optimism of the previous (fourth) quarter carried over into the new year, with stock indices posting all-time highs. The gains notched in the first quarter would, in many years, be considered normal for an entire year. Most of the gains took place in the first two months of the quarter as a continuation of what has been called the "Trump Bump".Stocks had been riding the coattails of continued modest but sustainable economic growth.Anticipation for federal spending and regulatory changes has continued that momentum. Enthusiasm waned in March as the expectations for change collided head on with a divided Republican party and the inability to pass new health care legislation. The upcoming proposed tax law changes and the conflict between promised infrastructure spending and deficit spending and the debt limit could create a headwind for the new administration. Even though the Republican party controls the While House, the House, and even the Senate, political fractures have limited legislative results. President Trump has made liberal use of Executive Orders to accomplish a laundry list of actions he promised, but that has its limits. The President will increasingly confront the hard issue of what can and cannot be done based solely on his will.He will need the support of Congress for more sweeping changes. This is not to say the party is definitely over. The potential for economic stimulation is still out there, if a way can be found without creating massive deficits.

Let's take a look at how various indices fared for the past quarter.

​Index 1st Quarter​
​Dow Jones Industrial Average (the Dow)
​+ 4.6%
​S&P 500 Stock Index (the S&P 500)
+ 5.5%
​NASDAQ Composite
​+ 9.8%
​Russell 2000 (small companies)
​+ 2.1%
​Dow Jones Global Stock Index (non-US)
+ 7.4%
​10-Year Treasury Bonds
​+ 0.9%
​Commodities Index (Reuter-Jeffries CRB)
- 0.3%
​U.S. Dollar Index (WSJ Index)
- 2.8%

All index values come from the Wall Street Journal. Stock indices do not include dividend return..

Both the Dow and the S&P 500 had solid gains, and the NASDAQ index (dominated by large technology companies) knocked it out of the park.A recent article in the Wall Street Journal (WSJ) pointed out that multinational companies did better than domestic-market companies. The Russell 2000 index didn't fare so well, perhaps because it was consolidating last year's gain of nearly 20%.Foreign stocks did very well this past quarter, helping to offset their poor performance last year. With economic reports painting a low inflation/low unemployment "Goldilocks" scenario, the Federal Reserve Bank ("the Fed") increased short term interest rates by ¼ of a percent in March and vowed more increases during the year.It was surprising that intermediate term bonds—reflected by the 10-year bond index above—had a positive quarter. Bonds usually suffer a setback with interest rate increases, but the Fed's adjustment to short term rates did not influence intermediate term bonds this time. This struck a cautionary note in the markets, reflecting skepticism about future economic growth. Overall commodity prices declined slightly. Oil led the way down with a nearly 6% drop in price. The U.S. dollar eased by nearly 3% in the first quarter, making imported goods more costly and exported goods cheaper.

Where We Are Now

At this time, earnings reports for the first quarter are being released.Expectations for the earnings of S&P 500 companies are very positive compared to the previous year. Economists are expecting an increase of 10% compared to the previous year. However, the first quarter of 2016 was not a particularly good quarter for earnings so an earnings comparison to that quarter is diluted in its meaning.In terms of an overall valuation yardstick—the Price-To-Earnings (P/E) ratio—the market continues to appear fully priced, factoring in the expectation for continued growth. The ratio is quite high compared to historical averages, reflecting a healthy degree of optimism. On the other hand, the current valuation by this measure is nearly identical to that of a year ago which preceded a positive market year.Is the current valuation warranted? Time will tell.In the 4th quarter of 2016 the economy grew at a rate of 2.1%. Over the past few months, a collection of economists polled by the WSJ have lowered their estimates for the most recent quarter's growth rate from 2.3% to 1.9% and then to 1.4%. Not a good trend. Retail sales have declined although consumer confidence is up. Consumers apparently aren't "putting their money where their mouth is". This helps explain why only short-term rates have increased.Inflation (+1.9%) and unemployment (4.5%) are in the sweet spot that the Fed has targeted. President Trump recently voiced confidence in Fed Chairman Yellen and this was met with some relief.

Looking Ahead

When the Fed increased rates by .25% in December as expected, they stated that they expect to increase rates three times in 2017. Of course, this is the same Fed that predicted four rates hikes in 2016 instead of just one. The Fed's action during the year will depend on our growth rate, employment gains, and inflation. Right now, it There is always room for surprises, and we have more room than usual for surprises right now. As if it weren't enough to consider the unknowns related to the success (or failure) of the administration to proceed with domestic policies like tax reform, infrastructure spending, and another run at health care, geopolitical risk is elevated to a degree we haven't seen in a while. This risk includes the rising tensions within and between countries. This could translate to trade restrictions and reduced global government and consumer trade resulting from conflict.

With expectations for near-term growth waning a bit, the Fed may hold off on interest rate increases for the time being to figure out whether any action taken on their part would be positive or negative. If inflation maintains its course and employment holds firm, we could expect rates to increase modestly. On the other hand, if our economy sputters the Fed would likely leave rates where they are for a while.

As mentioned, much of the risk currently perceived is political—both within our country and abroad. The expansive spending programs proposed by President Trump are unlikely to be accepted without being dampened by the need to restrict deficit spending. This is especially true if the changes to the tax law—whenever these come out—reduce revenue to the government. Reduced revenue and increased spending equals increased deficits. An increase to the debt limit must take place very soon to avoid a government shutdown. With this fresh in the minds of members of Congress, it's hard to imagine a consensus to increase the deficit by embarking on an extensive spending program.

In the near term it would not be a surprise to see stocks decline a bit. At this (near-record) level of the stock market, it will take positive developments to preserve the economy's growth rate and support a market advance. It could happen, and it will be interesting to see the outcomes of current events in Washington. The struggles experienced with health care legislation do not portend an easy path.Geopolitical tensions could be a major factor in both the U.S. and global markets.

As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP

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