Quarterly Review October 2017

Markets Steam Ahead Despite Natural Disasters and Political Chaos

With apologies to the U.S. Postal Service, it seems that none of the hurricanes, fires, geopolitical nuclear threats, the hacking and release of critical personal information of probably everyone reading this, alleged Russian influence on the presidential election, or a restive domestic political circus could keep stocks from their appointed gains. While any of the above could have derailed the consistency of the advancing markets, ultimately none could thwart the upward march for long. With a tailwind made up of low inflation, modest but sustainable growth, and improved corporate profits, the economic climate was ideal for continued stock gains. These factors overshadowed the political chaos and natural disasters we have been experiencing.

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

​Index 3rd Quarter​ ​2017 Year to Date
​Dow Jones Industrial Average (the Dow)
​+ 4.9%
​+ 13.4%
​S&P 500 Stock Index (the S&P 500)
+ 4.0%
​+ 12.5%
​NASDAQ Composite
​+ 5.8%
​+ 20.7%
​Russell 2000 (small companies)
​+ 9.9%
​Dow Jones Global Stock Index (non-US)
+ 5.5%
​+ 18.7%
​10-Year Treasury Bonds
​+ 0.2%
​+ 2.7%
​Commodities Index (Reuter-Jeffries CRB)
+ 5.6%
​+ 3.3%
​U.S. Dollar Index (WSJ Index)
- 1.6%
​- 7.1%

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

All stock indices recorded healthy gains this past quarter, notching the ninth consecutive quarter of gains as measured by both the Dow and the broader S&P 500.With help from a declining dollar, foreign stocks also had an excellent quarter, trailing only the NASDAQ index for the year.The NASDAQ--dominated by large high-tech companies--was boosted by its mainstay members of Facebook, Amazon, Netflix, Google, Nvidia, and similar large tech companies whose stocks have been helping set the markets on fire.Small stocks didn't keep up with the other indices but it's hard to be disappointed in a 9-month gain of nearly 10.0%.Though not isolated in the indices provided above, banking, financials, health care, and emerging markets have done well.Bonds barely broke even this past quarter, falling far short of the attractive gains experienced by stocks.Other than the mentality of diverting investment money to stocks to participate in the party, another factor holding back bond returns is the expectation that continued economic growth and gains in employment will give the Federal Reserve ("the Fed") room to raise short-term interest rates one more time before year-end. As interest rates rise, the value of bonds declines--leading to limited total return. The commodities index had a robust gain this past quarter, led by a whopping 12.2% gain in the price of crude oil as measured by the value of West Texas Intermediate Crude.Oil prices have been supported by our country's record level of oil exports.The hurricanes forced the shutdown of U.S. refineries in the broad regions affected by the storms. This created excess supply of crude, lowering its price.Exports have reduced the stockpiles--resulting in the recovery of prices.However, end-of-quarter oil prices were still nearly 4% lower than where they started the year.

Where we are now

The rate of economic growth for the second quarter was recently revised upward to 3.1%.This robust rate of growth should further reduce unemployment and help corporations continue to improve their bottom line.If the growth rate were much higher it would normally result in an accelerated level of inflation. Usually an advancing economy increases demand--and therefore "cost"--of both raw materials and for labor.Our economy's growth without much inflation has been a puzzle to economists and to the Fed.The amount paid in wages has remained relatively and disappointingly flat--especially for lesser-skilled workers.A flat trend in wages paid restricts consumer spending--which accounts for 70% of our economy.If health insurance premium costs and reduced coverage return to their pre-ACA levels, this will likely let some air out of the consumer spending balloon.

The valuation (or "pricey-ness") of the markets remains high by historical standards.The logic of ongoing high valuation is that investors expect that good economic times will continue and future corporate earnings will justify current stock prices.The illogical argument is the fear of being out of the market and not participating in assumed future gains—i.e., being left at the dock only to watch the ship of positive returns sail.Market volatility has been remarkably low in the face of the chaotic factors that are part of life these days.Not to say volatility can't return overnight but at this point it has been extremely low.

Looking ahead

The good news is the current consensus opinion of economists is for this Goldilocks scenario--low inflation and sustainable growth with improving corporate profits--to continue.The iffy news can be described as mostly political risk.This is the risk that the chaos in Washington DC could increase as the President continues to confound and offend many members of both sides of the aisle.His ways are unorthodox and yet have some consistency that reflects his brash undiplomatic style:alienate and disappoint and threaten, then backtrack and open negotiations to complete a "rescue deal".In some areas the approach has served to get opposing interests to a bargaining table.Tax reform is in the current headlines.It will be interesting to see how the give-and-take may resolve sensitive features that affect so many.Preliminary indications of the proposals echo President Reagan's "trickle down" policy which unfortunately has been shown to have been unsuccessful for all but corporations and high-income households.Sometimes the net results of major reforms aren't known until much later.There are always positives and negatives but politics being what it is, the likely outcome is increased budget deficits and a higher debt limit as tax reduction is more palatable than reduced spending.Deficit spending equates to our government living beyond its means.More of the federal budget spent on interest expense (on debt) means less available for more constructive uses.Kicking the can of fiscal responsibility down the road will increase interest payments on that debt, especially as interest rates rise.The Fed has modestly increased interest rates this year and most observers expect another .25% increase in short-term rates in early December.

Now that our personal information has been hacked (the data breach at Equifax) and available to the highest black market bidder, the Social Security Administration has begun to study an alternative to our system of social security numbers.Soon SSNs will no longer be used by Medicare.In the near future Medicare recipients will be reissued a randomly-assigned ID number and new cards will be distributed.It's a good idea to monitor your credit these days.

Modest economic growth accompanied by solid corporate profits and low inflation are expected to remain favorable to the financial markets.Political risk remains the highest threat to the markets, which do not respond well to uncertainty.

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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