The market appears to be building a nice base of broad reasonable valuations.
We did not experience the feared, panic fire in the markets this week. Thank goodness; then what did we see?
Year-To-Date stock market performance numbers continued to move lower for the year. The downward move was actually rationale, which is hard to acknowledge given the magnitude of the recent drop. The size of both upward and downward moves is getting larger as the market base gets larger and this takes some getting used to going forward.
Other than the size of the moves, last week, we experienced two major changes that impacted investors’ expectations. Elevated trade restriction threats and the end to monetary easing from the U.S. Fed came into play.
We started the month with markets above fair value by a moderately high, but reasonable level. MidCap and SmallCap were slightly elevated in the teens, but they were not unreasonable. With investor expectations on the positive side, above 100.0% Fv, major events such as a change in central bank policy and the thought of a global trade slowdown pushed markets lower. The direction was unwanted, but rational.
However, even with fears on trade and Fed policy becoming more restrictive, overall expectations remain positive. Economic factors are still pointing to a growth economy globally, and consumers still have a positive outlook with higher employment and higher earnings in place.
I believe the current adjustment is a “less than 1-year event”. The drop in market values has already marched through 3 months and valuations are much closer to 100% Fv than at any time in the past 12 months. It is unlikely the end of the year will be able to post a long-term average gain, but we still believe it will be positive, and maybe even come close to the long-term average.
The total market is now down a little over 3% for the year with value stocks taking the brunt of the drop. Value has moved down over twice as much as the overall market. Interestingly, SmallCap, the unwanted stock class for much of 2017, is now the best performing area for the year and last 12-months.
U.S. LargeCap relative valuation moved up to 112.2% Fv, a 2.3 point gain while MidCap and SmallCap stayed relatively close to previous levels. These are much better levels than the beginning of the year when MidCap was overvalued, SmallCap was in cautionary territory and LargeCap was on the edge of moving into cautionary territory. Current, valuation levels may provide a good based for longer-term growth.
Three LargeCap sectors are now below 100% Fv, Consumer Staples, Materials and Telecomm. Seven sectors are within 10 percentage points of 100% Fv. Only one sector is considered overvalued, Consumer Discretionary at 133.6% Fv. At this point in time, the sector is responsible for elevating overall market valuations. It is also the best performing sector even at an anemic 1.51% gain for the year. The only other positive sector is Technology. The remaining sectors are all negative for the year with Consumer Staples having the most difficult time with a loss of 10.6% and just barely holding on to a positive value for the past 12 months. Telecom is also struggling with a loss of 9.1% continuing the disappointing news for the sector from last year.
MidCap has the largest loss for the year so far at -4.1% but remains positive for the past 12 months. Five of the sectors are within 10 percentage points of 100% Fv. There is a slightly wider dispersion between individual sectors than what is seen in LargeCap. Just as in LargeCap, Consumer Discretionary is overvalued at about the same level at 131.5% Fv. Health Care is in cautionary territory at 125.6% Fv. Industrials and Technology are both in the upper ranges of the teens in fair value. There is a higher expectation level overall in MidCap than LargeCap at the moment. Telecom advanced the most in relative terms moving from a previous 90.0% Fv to 102.8% Fv.
Almost 2/3rds of the industry groups are within 10 percentage points of 100% Fv with two groups overvalued.
SmallCap has a much different composition than either of the other two market capitalization classifications. Health Care is the most overvalued sector at 136.1% Fv relative value placing it well into overvaluation. Information Technology is in cautionary range at 124.3% Fv. Just as in MidCap, Telecom advanced, moving from 91.1% Fv to 101.5% Fv. Only four sectors are within 10 percentage points of 100% Fv and only one is below this level.
Almost 2/3rds of the industry groups are within 10 percentage points of 100% Fv with two groups overvalued. Both, Consumer Durables & Apparel and Retailing are overvalued at 134.9% Fv and 137.8% Fv, respectively. Health Care & Equipment is in cautionary range at 121.6% Fv. The overall balance amongst the groups has become more centered toward fair value since the last report.
Negative performance this year is not limited to domestic stocks. The bond market is showing its fair share of reductions. Investment grade corporates are taking the largest hit at a loss of 4.8%. All categories are now negative for the previous 12 months. As central bankers begin to unwind previous quantitative easing policy and practices, the bond market will certainly be a delicate place to reside. Never before has the world ever experienced extremely low interest rates for such a long period of time. History will be written for future generations. Fortunately, global economics appear to be in position to support the gradual reorganizing of the debt markets.
There is uneasiness surrounding the amount of debt held by some localities and states. The environment may get more difficult for these entities as interest rates rise and debt service costs escalate. Debt service does little to promote economic growth. And, now with state and local income taxes no longer deductible for individuals, tax rates may have longer term influence on a single states ability to attract new enterprises.
International stock markets are also seeing red, except for Mexico. The market that was supposed to be crushed by a renegotiation of NAFTA is the one positive market in 2018 with a slight 1.3% gain. Unfortunately, all of the other markets are struggling, even China which has just slipped over to the negative side of the balance.
The year is showing signs of an adjustment year. Adjustment to new practices in global relations, adjustments to an end of global quantitative easing, and adjustments to favorable global economic strength. In other words, just another normal year for the markets, lots of adjustments.