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Market Perspective for November 15th, 2017

The global stock markets seem “tired” right now.  It has been a very good year, with the S&P 500 up around 17% with dividends included and EAFE up just under 21%.  Yet EAFE is almost 2% off its October highs and the S&P 500, while less than 1% below all-time highs, also seems to be laboring.  The small cap Russell 2000 is close to 3% below its October high.<1>  See Chart 1.  That said, every index is well above its 50 and 200 day moving average, so the benefit of the doubt remains with the bulls.  The reason I felt compelled to write about the markets today is that the biggest impetus behind the strong stock advance in 2017 has been central global bank purchases of debt and in more and more cases, stocks themselves – and that impetus may be waning. Chart 1

We all have been told that rising profits are behind the strength in stocks this year, and to some extent that is correct.  It is important to remember, however, that stocks rose from 2014 through 2016 on next to no net profit advance, so corporate profits and stock prices are not that highly coordinated in the short run.  Tax reform could help stock prices, but it is increasingly less likely that we will get reform and more like we will see tax cuts, which generally means that the same size pie will be sliced differently.  If, for instance, the tax burden is shifted more towards individuals and less toward corporations, then individuals will have less after-tax income to spend and therefore consumer-oriented businesses will suffer relative to those that sell to other businesses.  No, the thing that has moved stock prices for the last several years is central bank activity.  Buying debt to lower interest rates brings down borrowing costs, making everything from buying back shares to issuing new debt cheaper.  The fact that the stock market boom has been largely debt-fueled doesn’t make it wrong, but it does suggest there is a limit at some point.  Global central banks are at least talking about beginning to rein in excess credit.  The Fed is starting to do that here, and the European Central Bank has indicated that they will do the same in 2018.  The Bank of Japan has been extremely active in buying both its bonds and Japanese stocks this year.  The Japanese Government Pension Investment Fund hit its target weighting of 25% in Japanese stocks and is now “selling into strength and buying into weakness”.<2>  China stimulated their economy leading up to the recent Communist Party National Congress, but they are deleveraging now and at the same time interest rates there have recently surged to above 4%.  That is not a recipe for higher stock prices. Bottom line:  The best is behind us.  Further gains are possible but the central bank tailwinds are all but gone and valuations are high.  Proceed with caution. Reasons for concern:

  1. This week’s IPO calendar lists 13 initial public offerings this week, the highest in a very long time. This doesn’t happen near market lows.

  2. High yield debt has sold off modestly over the past two weeks. Stocks do not tend to rally for long when high yield bond spreads widen, for they are both sensitive to liquidity and economic health.

  3. Emerging market debt has also had a rough couple of weeks. Rising interest rates due to strengthening economies eventually affects emerging market stock prices as well.

  4. Low volatility is the best performing factor in November<3>. Utilities are the best performing industry group.  Both are up.  This suggests a bull market taking a breather.  If they were the best performing factors/industries and both were declining, I’d be a lot more worried. Other observations:

  5. Latin American stocks have been selling off all quarter. They may actually be oversold right now, as the correction has taken them right back to the longer term uptrend line.

  6. After rising for much of October and November, the Japanese stock market has now declined four days in a row.<4> Momentum can be fickle.

  7. If you are looking at alternatives, merger arbitrage is a low risk, low return option which is more palatable in a low return environment. Of the choices available, the IQ Merger Arbitrage ETF (MNA) has done quite a bit better than MERFX or ARBFX over the last one, three and five years albeit with a little more volatility.<5>

  8. Closed-end fund discounts had been in an 18 month period of narrowing, eventually rising to less than 6%.<6> This was great for closed-end investors, especially for those that owned leveraged bond funds.  Unfortunately, the trend appears to have topped out in October.  Closed-end funds are not having a very good November.

  9. Internationally, growth has crushed value as a strategy in 2017.<7> You were either in the fast growing Chinese internet stocks (Alibaba, Tencent, and Asian technology giants (Samsung and Taiwan Semiconductor) or you weren’t.  It’s nearly that simple.

  10. Sometimes your benchmark is everything. Parnassus Endeavor (PARWX) is a large cap fund with an ESG mandate and a very good long-term track record.  It has generally been considered a large cap growth fund by Morningstar.  In that category, it has been in the bottom decile all year.  According to Morningstar, however, the fund crossed over into the large cap blend category in 2016 and is closer to the value end of the spectrum at this point.  As a large cap blend fund, its 18.3% year-to-date return puts it in the top quartile.<8>

  11. Real estate got hit very hard in the second half of 2016 due to the problems of retail REITs (which are still down sharply), and have been fairly flat in 2017. That said, the group has made a sharp bounce over the past two weeks as the upward pressure on interest rates has moderated.  I wouldn’t chase the bounce, but I think this sector would become more attractive if the overall environment remains mildly risk-off.<9>

  12. Gold is mostly a way of playing the notion that Central banks don’t have the spine to raise rates when inflation begins to take hold because the powers-that-be don’t want to risk recession. In the absence of inflationary pressure, central bankers can talk as hawkish as they want because they don’t have to “put up”.  Therefore, it is hard to see a near term catalyst for meaningfully higher gold prices.

  13. Municipal bonds continue to outperform similar quality taxable bonds<10>. This has been true all year. <1> Source: <2> Source: <3> Source: Telemet Orion <4> Source:, iShares JPX-Nikkei 400 ETF <5> Source:, Investments measured by total return <6> Source: Barrons, November 13th, 2017 <7> Source: as measured by total return, year to date return of the iShares MSCI EAFE Growth ETF and iShares MSCI EAFE Value ETF. <8> Source: as measured by total return, year to date return <9> Source: as measured by total return of the Vanguard REIT ETF <10> Source: as measured by total return, year to date return of the iShares Core US Aggregate Bond ETF and the iShares National Muni Bond ETF.


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