Since bottoming in March 2009, the S&P 500 Index has put in a remarkable 8 years: 262% performance with only a few significant pull backs along the way. During that time, the market has often traded at notably stretched valuations. A combination of earnings growth and higher multiples (investors paying more for a dollar’s worth of earnings) propelled the market ever higher.
Today the market trades at its loftiest valuation since the tech bubble, and while we are wary of high priced markets, we continue to be constructive on global stocks. We remain so even in the face of recent downbeat economic and market developments. Specifically, those developments are 1) persistently low long-term interest rates in the face of a Federal Reserve determined to lift short term rates and 2) the whiff of deflation implied by recently soft commodity prices.
When short term rates rise and long-term rates fall we say the interest rate curve is “flattening”. A flattening yield curve is a reliable indicator of approaching economic weakness. Currently (as of July 3) the spread between 2 year treasury bonds and 10 year bonds is only .93%, down from 1.27% in November of 2016. This significant “flattening” is notable but we believe long term rates will rise as labor rates increase and inflation expectations rise.
There have been early indications of deflation as the U.S. Consumer Price Index has unexpectedly dropped. Deflation heralds lower profits and a potential lowering of economic growth estimates. We believe much of the recent softness in the CPI is attributable to the lowering price of oil and natural gas which we think will rebound in the second half of the year.
There are two other positive factors which also contribute to our relatively sunny near-term outlook: earnings growth and an accelerating global economy. We believe the current earnings season could provide double digit year-over-year profit growth, providing support for stocks at elevated levels. Economies in the U.S., Europe, Japan and China are growing. U.S. growth is projected to accelerate in the last half of the year. Just this week, the Atlanta Fed increased its forecast for U.S growth from 2.7% to 3%. This provides another level of support for equity markets.
Certainly, there are risks to this sanguine view and several factors which could temper our outlook. The chance of a policy mistake is high as central banks negotiate the pace of interest rate “normalization,” triggering our next inevitable recession perhaps in 2018 or 2019.
However, rebounding earnings have placed the market in what we believe is a “sweet spot” which will remain until a combination of inflation and interest rate increases begin to bite. This view is also the reason we counsel that bond portfolios remain shorter in duration as we believe interest rates will rise along the curve as the fear of deflation recedes.
As always, we welcome your questions and concerns. We thank you for your continued confidence in Altavista and wish everyone a safe and relaxing summer.
The Altavista Investment Team – Summer 2017