Tug Of War Continues Into Q3

The analog to markets is the struggle over the last three years between corporate earnings fundamentals and interest rates for control of stock prices. Earnings have been at or near a peak since 2013 with S&P 500 operating results ranging between $100–$116/share through that time. Stock prices are up 27% over that time because the pull of lower interest rates has been stronger than stagnant earnings. The US Treasury 10-year note yielded 2.75% three years ago; now, it yields 1.70%. – Convergex Morning Markets Briefing, Sept. 15, 2016

The third quarter of this year continued the tug of war summarized above. Markets ended Q2 with a Brexit swoon. The world didn't end, and global central banks responded, so markets recovered in July and August. The force of thinking 'Lower interest rates for longer' prevailed over earnings stagnation and tepid growth.

In September the tug of war has gained volatility. Central banks and interest rates are still the driving force.

The Fed is trying to raise a quarter point by year-end and is trying to communicate its view, with mixed results and only partial clarity. Markets give a December rate hike a 50-50 chance. The Fed's next message arrives this week.

NIRP Reaction

What the ECB will do next is not clear. It is likely to persist in its current policy mode for at least another year. Meanwhile reactions to European negative interest-rate policies are intensely harsh and critical.

The BoJ is an enigma, but that may change after the September 21 meeting with the Wednesday morning news and once its revelations are absorbed and discounted by markets. We do know that Japan plans to replace long-term inflation-indexed bonds with nominal 40-year issues. More may be revealed soon.

The BoE is expanding its collateral definition to include debt of companies with larger business elements in the UK. We shall see what this means as time passes. Brexit has triggered change in England. Many seem too complacent to us. We still expect a recession, falling property values and economic pain. My friend and Dartmouth Professor Danny Blanchflower notes that 40,000 statutes or rules will need parliamentary action in order to implement a full Brexit. Sounds like a barristers’ field day.

Jim Bianco estimates that the last expansion of global central bank balance sheets has topped $2 trillion in less than two years. The total for the big 4 is over $13 trillion. We guess that figure is growing at about $200 billion a month in US dollar equivalents. That growth is in yen, euro and the pound since the Fed is now at neutral.

Meanwhile. Earnings are still flat. Inflation low. Growth slow. So the US stock market continues the tug of war outlined above. Earnings and valuation metrics on one side and the direction and level of interest rates on the other side.

The Pros And Cons

This tug of war has danger and opportunity. We use different ways to address both. In our US ETF portfolios, we continue to hold some cash reserves. Those portfolios address the valuation metrics and blend in interest rate forecasts.

Clients also know that we have several different management styles for stocks. My comments above are about the US ETF style.

That should not be confused with our quantitative work, which became fully invested last week in the downdraft. The previous entry for that style was the Brexit swoon in late June. Prior to June, that style was in cash for nearly two months.

Our tactical trend strategy follows a different approach, as does our international ETF strategy. They each have some cash and are deployed differently that the two methods mentioned above. Many of our clients use more than one of these approaches, so they are able to diversify risk by global markets and by management style.

We are sending our Q3 US stock market commentary earlier than usual this quarter. Some intense upcoming travel has prompted this acceleration of the calendar.

Meanwhile, the political roller coaster plunges and swerves as we approach the first debate on September 26.