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U.S. equities continue on the path of least resistance: up

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October 13, 2017

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Quote of the week

“I plan to spend it as irrationally as possible.” – Behavioral finance pioneer Dr. Richard Thaler, on how he expects to spend his $1.1 million prize for winning the 2017 Nobel prize for economics.

The Lead Story: Looking back 10 years

On October 9, 2007, just before the financial crisis took hold, the S&P 500 Index closed at a then all-time best of 1,565. Investors cheered the possibility that the Federal Reserve would soon reduce interest rates after lowering them just weeks before, the first rate cut in four years. Over the next 17 months, though, the index plunged 57% before beginning what has become history’s second-longest and second-strongest bull market.

What have we learned about risk and volatility?

Brian Nick - 140px

Brian Nick, Chief Investment Strategist, TIAA Investments

Article Highlights

The stock market has been eerily calm recently. For the 12 months ended September 30, the S&P 500's standard deviation (a common measure of volatility) was 5.5%—well below its 10-year figure of 15.1% and not much higher than bonds’ 10-year level of 3.3%.It’s impossible to tell what might shake the market out of its slumber. As of late, stocks have powered through one record high after another despite geopolitical fears, hurricanes, terrorist attacks, Fed rate hikes, and gridlock in Washington. In our view, though, this is not the “new normal.” Volatility will eventually return.

Before it does, investors who haven’t been rebalancing their portfolio might benefit from doing so. Moderately aggressive investors who just five years ago selected an asset allocation of 60% stocks/40% bonds would today find their mix closer to 75%/25%, thanks to the S&P 500’s average annual return of 14.2% during that time versus just 2.1% for investment-grade bonds, as represented by the Bloomberg Barclays U.S. Aggregate Index.

Holding a higher percentage of equities means investors have dialed up risk, perhaps unintentionally. Bringing their allocation back in line requires selling stocks during a bull market to buy bonds, which may be both “painful” and counterintuitive. However, such a move could well pay off if and when stocks stumble.

Lastly, there’s the issue of earnings. Strong corporate earnings growth is necessary to support equity markets, especially when stocks have scaled fresh peaks, as they’ve been doing with regularity. But the quality of earnings is paramount. Ten years ago, investors believed all-time highs for the S&P 500 Index were reasonable because expectations for corporate profits were also at all-time highs. But as the financial crisis descended, many banks, insurers, mortgage companies, and the like were forced to write down asset values and with them, profits. Earnings, in many cases, vanished or turned into losses.

This time around, financial firms are still earning only 70% of their 2007 levels, reflecting tighter regulation and slower economic growth. While those profits should improve if the U.S. yield curve steepens or Congress passes a significant tax-reform package, the biggest risk to this equity rally is that stock prices have already “baked in” ongoing solid earnings growth. Disappointment on that front, in our view, could trigger a correction.

In other news: Global equities and U.S. Treasuries head higher

The S&P 500 continued to set record highs with incremental moves. Solid retail sales data helped the index rise 0.20% for the week, its fifth consecutive one-week advance. Europe’s broad STOXX 600 Index gained 0.50% in local currency terms, but a weakening U.S. dollar improved that return to a robust 1.48% when translated into dollar terms. The greenback fell steadily throughout the week, with a number of factors driving the drop. These include a conciliatory speech from the head of the Catalan independence movement in Spain, bullish Eurozone growth comments from the International Monetary Fund, and tepid U.S. inflation data.

In U.S. fixed-income markets, which were closed for Columbus Day on October 9, the yield on the bellwether 10-year Treasury note declined nine basis points (0.09%), ending the week at 2.28%. (Yield and price move in opposite directions.) Much of the descent came on the heels of soft U.S. inflation data. With yields falling, non-Treasury fixed-income sectors enjoyed positive returns for the week, led by investment-grade corporate bonds and commercial mortgage-backed securities.

Below the fold: A “Goldilocks” week of data for the U.S. economy

Markets applauded mild inflation and a rebound in retail sales. Among the week’s releases:

  • Higher prices at the pump, courtesy of the late-summer hurricanes, lifted the Consumer Price Index by 0.5% in September and 2.2% over the past 12 months. “Core” inflation, which excludes food and energy costs, rose a much smaller 0.1% last month and 1.7% year over year, a level that’s remained unchanged for five consecutive months.
  • In a bounce-back from August’s small slip, retail sales jumped by 1.6% in September, their biggest one-month increase in more than two years. Sales got a lift from higher receipts at building materials, auto, and auto-parts stores, as consumers replaced storm-damaged property and vehicles.
  • Bolstered by Americans’ bullish perceptions of the economy and their own finances, the University of Michigan Consumer Sentiment Index soared to a 13-year high in September.

The Back Page: Good news about U.S. household finances

According to the Fed, Americans’ net worth increased by $1.7 trillion in the second quarter amid rising real estate and stock prices. Home equity rose by 0.5%, to nearly $14 trillion, while shareholdings jumped by 4.6%, to almost $25 trillion.
 
At the same time, there’s little evidence that balance sheets are under threat from costlier liabilities. In fact, financial obligations (e.g., debt, auto, and housing-related payments) relative to income are close to 40-year lows. Moreover, the cost for households to service their debt—thanks mainly to lower interest rates—has plunged to its lowest point since the Fed began tracking the figure in 1980.

Amid this cheerful news, there’s one potential warning flag. In the past, rising balance sheets have liberated consumers to borrow more, spend more, and save less. Indeed, over the past two years, household savings rates have plummeted from 6.3% to just 3.6%, among the lowest level in a decade. This leaves people with a smaller safety net to withstand even a temporary spike in food or energy prices. Fortunately, we expect a strong economy and tight labor market to continue to support income growth, and by extension, wealth accumulation.

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