Schwab Market Perspective: Things are Looking Good … But are They Too Good?
- Earnings season has been solid and equity indexes continue to set record highs. The bull market should continue but the risk of a "melt-up" appears to be rising.
- The U.S. economy is growing modestly and the Federal Reserve is maintaining its slow pace of policy normalization—both supports for further equity market gains, but geopolitical risk remains elevated.
- While the weaker U.S. dollar is a benefit for U.S. companies, there is a downside internationally … but it may not be where you think.
What, me worry?
U.S. equity indexes continue to post record highs and the proverbial "wall of worry" appears to be losing bricks. The high expectations for earnings season have largely been bested, the U.S. economy continues to trend in a "Goldilocks" zone—not too hot, nor too cold—the Federal Reserve shows little interest in pricking any perceived asset bubbles; and despite political rancor, consumer and business confidence remains elevated—what could go wrong?
Source: FactSet, Chicago Board of Trade. As of July 31, 2017.
Of course there are always "black swan" events that could occur—one-off events that are unknowable and unpredictable—such as a natural disaster or sudden geopolitical crisis. We don't want to be the parents who stop the music and take away the punch bowl, but the risk of a melt-up appears to be growing and we believe a decent-sized pullback in the near future would help alleviate some of these pressures. Sentiment indexes such as the Ned Davis Research Crowd Sentiment Poll indicate investor optimism has gotten extended. In keeping with excess optimism, we're getting into rarified air in terms of the amount of time since the last 5% pullback. Only three time periods in history were longer than the current span over the past 50 years. Even the headlines coming out of Washington are having little impact on sentiment as stocks keep rising and investors and consumers remain confident.
Source: FactSet, Conference Board. As of July 31, 2017.
We still believe a near-term pullback is possible, but are becoming concerned about a possible melt-up, which typically ends with a commensurately harder fall. We continue to urge investors to maintain a diversified portfolio and rebalance as necessary around longer-term strategic targets. For those investors who follow our tactical recommendations, we are currently recommending a neutral (in line with strategic targets) stance for all three of the major equity asset classes—U.S., developed international and emerging markets. Within the U.S. equity market, we continue to suggest a bias toward large cap stocks over small caps cap.
Earnings looking good, while economy trudges along
Part of the reason for the tactical positioning we are recommending has been the drop in the U.S. dollar. A falling U.S. dollar can help those companies that have sales overseas and have likely helped to boost results for the larger-cap and more globally-oriented S&P 500 in this reporting period.
Source: FactSet, Intercontinental Exchange. As of July 31, 2017.
Second quarter earnings season started with high expectations and a relatively low preannouncement ratio of companies warning before the results were released. This has typically led to choppy market behavior, particularly if the expectations bar ends up being set too high. So far, the market has generally cheered earnings results—according to Thomson Reuters, through August 2, 72% of S&P 500 companies having reported have beaten earnings estimates, while 69% have beaten revenue estimates. The latter is encouraging as sales are much more difficult to manipulate.