What Did We See?

• Markets around the world continued to diverge in the 3rd quarter of 2018.
• The US rallied to record highs while Emerging Markets and Asia (Ex-Japan) stumbled.
• Federal Reserve tightening and an impending yield curve inversion have a good chance of spooking investors.
• Europe continues to see some weakness while the UK lost ground.

Where do we stand?

• The resetting of expectations we had talked about for some time came in Q1.
• Q2 brought us a consolidation phase that is not too uncommon after a correction.
• Q3 is now on record as a very strong rally that typically follows these “reset” and “consolidation” periods.
• All eyes turn to the Federal Reserve as higher rates could potentially drive irrational exuberance out of the markets.
• We continue to rebalance your accounts accordingly.

Waiting for Guffman…

As the equity bull market moves through it’s mature phase, investors around the globe have all been asking the same question. That is, when is the next correction/recession/downturn going to come? Much like the eponymous character in the cult favorite film, Waiting for Guffman, the expected turn of events did not come to fruition again this past quarter. Instead, the exact opposite occurred as the US equity market rallied to all time highs.

While some have been reluctant to stay fully invested, those that have remained fully invested have been rewarded nicely. In fact, while the political and geopolitical rhetoric have continued to heat up (sure to scare off even the most astute long term investor) US Large cap stocks have continued to turn a blind eye to the risk. Thus far in 2018, the S&P 500 has returned more than 10% with more than 7% of that return coming in the third quarter. Was this a “blow off” top or was it further validation that the US economy is strong enough to weather any storm?

When we get to potential inflection points in the economy or markets like we are at today, we like to explore the drivers of said economies and markets for clues to their strength. The things we have learned over twenty years of investing that tend to matter are the following:

As it relates to the Economy – Growth (GDP), jobs including wages and wealth, inflation or buying power, The Federal Reserve and interest rates, momentum as measured by PMI.

As it relates to Markets – Earnings (or profits), valuation, investor sentiment.

For this quarter we will briefly explore each one to help us determine the right course of action.

Economy

Growth (GDP) – The US economy has been booming as of late. GDP growth accelerated from 2.2% in the first quarter to 4.2% in the second quarter. Third quarter estimates are for slightly higher than 3% growth. It is a strong economy.

Jobs – The US is now experiencing one of its best job markets in centuries. However, wage growth has not kept pace.  Wealth has grown steadily but mostly at the high end (likely driven by very strong market gains).

Inflation – In check and low, for now.

The Federal Reserve – Here’s where things get interesting. The Federal Reserve has been actively raising interest rates recently in a bid to return short term rates to a more normal level for this phase of the economic cycle. Since the 2008 collapse, the Fed has kept rates artificially low in an effort to stabilize the US economy. It has remained so low for so long because job growth was stubbornly low and inflation was non-existent. Over the past few quarters, job growth has returned to very robust levels and unemployment is now at a 50 year low. Hence, raise rates they will. However, a very interesting thing is happening as they do. The yield curve (simply put the difference in yield between the 10 year Treasury and the 2 Year Treasury Bonds) is coming very close to inverting. This will occur when 2 Year rates are higher than 10 Year rates and has historically been a very good predictor of recessions. However, keep in mind, the yield curve was also similarly almost inverted in 1995, a full 5 years before the dot-com market crash. If you got scared out of the market in 1995 you would have missed outsize returns for 5 years.

Momentum – The Purchasing managers Index has historically been a good predictor of economic activity 6 – 12 months out. Readings above 50 indicate growth, below 50 indicate contraction. Today the PMI sits at 59.8, down from a recent 61.3. This is likely due to the effect of tariffs and is something to watch.

Markets

Earnings – Very strong but driven mostly by the one time tax cuts. The effect here will dissipate as it should. However, our economy is growing and companies are healthy.

Valuation – High but not in dangerous territory yet. At about 17 times forward earnings the market is slightly expensive.

Sentiment – Bullish sentiment remains above its historical range while Bearish sentiment remains below its historical range.

Where do we stand at Shorepine Wealth Management?

Taken holistically, the above exercise leads us to believe that it is ok to remain optimistic on the health of the global economy and markets overall. However, the threat of risk has certainly risen in recent months. The gains we have experienced in the markets have been impressive over the past three years and since 2009. The looming mid-term elections will bring volatility but we do not expect them to crash the markets. In fact, political changes rarely do change markets in the long run. The Federal Reserve is more likely to effect our bull market than an election.

Hence, we take a cautious view on the markets but do not want to subject our clients to missed opportunities. Thus, we continue to rebalance your accounts opportunistically and keep you invested according to your risk profile and unique circumstances. As always, we wish you well for the coming quarter and look forward to talking about your investments soon.

If you have any questions or have experienced any changes in your financial situation please do not hesitate to contact me.We appreciate your being a part of the Shorepine Wealth Management family and wish you all the best!

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