October 3, 2017
The third quarter marked the eighth quarterly increase in a row for the S&P 500. Volatility continues to be extremely low as markets tick up quarter after quarter. The third quarter finished strongly as the US Congress finally turned its attention (for now) away from repealing Obamacare and toward the Republican’s other priority of passing a tax cut. Odds are good that the ambitious plan will have to be scaled back to have a chance at passage, but even the possibility of a more modest tax cut has investors cheering.
The S&P 500 had a total return of 4.5%. Small caps outperformed large caps, and value continued to trail growth in the quarter. However, traditional value stocks like industrials and financials regained momentum at quarter end due to the prospect of tax cuts and rising rates. This meant that value had the strongest momentum in the final weeks of the quarter, with the Russell 1000 Value Index posting a total return of 3.0% for September versus 1.3% for the Russell 1000 Growth Index. Overseas, it was another solid quarter for international stocks – particularly emerging market stocks.
US GDP growth came in slightly better than expected in the second quarter, rising 3.1% at an annual rate, driven by strong consumer spending. Third quarter GDP is projected to come in at 2.8%, according to Moody’s Analytics, but the recent spate of Hurricanes makes the projection less certain than other quarters.
Hard economic indicators improved in the US. Vehicle sales skyrocketed in September to 18.6 million units, the best sales month since July 2005, partly due to replacement sales following Hurricane Harvey. Construction spending picked up in August, and is expected to gain momentum in the coming months, also partly due to residential rebuilding after the hurricanes. Inflation remains tame. Unemployment has stayed low, notching 4.4% for the month of August. Sentiment indicators (the “softer” signals) continue to show historically high confidence in the economy, and overall growth is expected to continue to be solid, if not spectacular, for the rest of 2017.
Equity prices rose in the third quarter across the board, with relatively modest differences by region, size, or style. In the US, growth stocks continued to lead as they have all year, with the Russell 1000 Growth returning a total of 5.9% compared to the Russell 1000 Value index total return of 3.1%. Small cap outperformed large cap, as the Russell 2000’s 5.7% total return slightly beat the Russell 1000’s 4.5% total return.
Technology performed well this quarter as growth stocks continued to find favor with investors, especially early in the quarter. Financial Services stocks also did well due to increased confidence that there would indeed be one more Fed rate increase this year, while Energy performed well amid a rise in oil prices.
Meanwhile, corporate growth continues apace. For the full year 2017, analysts are projecting US corporate earnings growth of 9.6% and revenue growth of 5.7% in the S&P 500, according to Factset, which is almost unchanged from last quarter’s projections.
International stocks (both developed and emerging) have outperformed US stocks so far this year, and this continued in the third quarter. The MSCI EAFE index of developed markets was up 5.4%, while the MSCI Emerging Markets index surged 7.9%.
The Fed has begun to pare down its balance sheet this month, which had ballooned due to the bonds bought as part of its quantitative easing programs. Market reaction has been muted in the early part of this campaign, with interest rates little changed. This is likely because it had been announced many months ago, and because the change is being implemented very gradually. The Fed also seems to be coming around to the view that the US may be in a lower inflationary environment for some time, and its median projection for the longer-run eventual target for the Fed Funds Rate is now 2.75%, down from about 4% a few years ago.
Overall, bonds as measured by the Barclays’ Aggregate Index added 0.85% in the second quarter for a 3.1% return year to date.
The Bloomberg commodity index rose slightly, gaining 2.2% for the quarter. Oil has been the most visible driver, rising from $46 to $52 during the quarter. Gold rose 3.3% to $1,312 at the end of the quarter, and continued to be a good diversifier with a strong negative correlation to the stock market (see Plum Street Advisors’ recent article titled “Gold – A Little Pinch Goes a Long Way”).
Summary – Is The Market Overvalued?
We are increasingly being asked whether the stock market is overvalued. The answer depends on what you’re comparing stocks to. On the one hand, stock markets seem overvalued compared to historical price to earnings ratios (the price of a share of stock divided by its earnings per share). The forward 12-month P/E ratio for the S&P 500 was 17.7 at the end of the quarter, according to Factset, which is above the 10-year average of 14.1. Professor Robert Shiller’s data, which looks at a 10-year rolling average of inflation-adjusted earnings, makes the difference look even more dramatic, as the “Shiller P/E ratio” stands at 31 compared to a long-run average of 17.
On the other hand, stock markets seem undervalued compared to bond markets when comparing the stock earnings yield (a company’s total earnings per share divided by its stock price) to nominal bond yields. According to Yardeni research, who has been looking at this relationship for a long time, the S&P 500 Forward Earnings Yield was 5.6% at the end of the quarter, well above the 10-year US Treasury yield of 2.3% at quarter end. They conclude that the stock market is undervalued compared to bonds.
In the end, what people are really asking when they ask if the stock market is overvalued is whether we are due for a sharp drop in the stock market, and any crash will be driven by investor behavior, not by a valuation theory. At Plum Street Advisors, we assume stock markets will be more volatile on average than they are now, but we recognize that it is impossible to time how long any stock market run will last. That’s why we believe in long term diversification as opposed to stock market timing. Given a reasonably long period of time, even extreme volatility is mitigated. After all, the 10-year return on the S&P 500 is 7.4% through the end of the third quarter of this year, and that includes one of the sharpest drops in history in 2008-2009. Most would agree the last 10-year period has provided an admirable return – no market timing required.