Tis the Season for Optimism
After a wild ride post election, markets have settled down into an upward trend. The general sentiment of anxiety that investors had before the election has miraculously given way to optimism about the future of the economy. Interestingly, research shows that the “smart money” and the “dumb money” have both turned bullish. The following investor sentiment charts are from Liz Ann Sonders of Charles Schwab posted on Advisor’s Perspectives:
As many sophisticated high net worth investors were holding high cash levels before the election, there has been a scramble to buy back into the market now that the coast seems clear. The wind is also at the market’s back- December is historically one of the strongest months of the year.
The Fed raised rates on the 14th for only the second time in 10 years by increasing the short-term interest rate target by 25 basis points to .75%. However, the fact that they raised rates was no surprise: the odds going into the Fed decision suggested over a 90% chance that interest rates would be hiked by at least 25 basis points (source: CME FedWatch). This means that the rate hike was already priced into the market. Bond yields have risen substantially since the election, and appear to have discounted the rate hike entirely. What surprised both the bond and the stock market was the more hawkish tone from the Fed which suggested that there would be “at least” three more interest rate hikes in 2017, and potentially three more in 2018 and 2019 as well. The Fed also suggested that market-based measures of expected inflation were also rising. Interest rates spiked on the announcement while stocks fell. Predictably the dollar rose on the premise of higher expected yields.
Taking a step back, the communication by the Fed makes sense given the change in the overall market environment. Given that the president elect- Donald Trump- has plans for fiscal stimulus and tax reductions it seems likely that this provides the cover for the Fed to take a more hawkish tone. We expect that over time, this stance will be easily digested by the market.
As always we will have to wait and see how the implementation of fiscal stimulus and tax cuts affects the markets over time. Fundamentally though it seems like we are on track for better economic growth, and this is supported by what the Fed is seeing in the economy. Ultimately economic growth and corporate earnings are the biggest dictator of future returns. There is no reason not to be optimistic other than the fact that we are running long in the tooth for this bull market and that markets are overvalued. Using the same rationale would have cause investors to hold cash in the mid to late 90’s when the market returns were at their highest levels. However this is certainly a long-term headwind as suggested by the chart below courtesy of EconomicPic (currently the market adjusted P/E is 28.3) :
Research suggests that valuations are a good way to time the market in the long-term (say 10 years or more) but have negligible value in the short or intermediate term. As Keynes used to say; “The market can remain irrational longer than you can remain solvent.” Even if the market is overvalued, we believe that the best way to participate and still protect is to follow market momentum. Without that protection, a pure buy and hold approach could be downright dangerous if the market is indeed priced for perfection. We believe that our approach to dynamic asset allocation is well-suited for this type of environment which requires the need to make portfolio changes to capitalize on the upside but still manage recession risk. Given that the market trend seems to be finally established after nearly two years of sideways markets we are currently bullish and positioned accordingly.
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