August 1, 2016
This summer has been a season of extremes.
Political tensions and temperatures have both been running hot. By some measures, both have never been higher. So, naturally, the stock market decided to follow suit.
On July 11, the S&P 500 established a new all-time high, eclipsing the previous mark (2,135) established in May 2015. The next day, the Dow Jones Industrial Average did the same. Both indices have remained above those levels ever since.
Technology stocks rode strong earnings to a stellar month. Tech companies posted gains of 7.89% in July, the best of the 10 sectors in the S&P 500. In all, seven equity sectors were positive in July. Energy (-1.93%), Consumer Staples (-0.71%), and Utilities (-0.69%) were the exceptions.
|Index||July 2016||YTD 2016|
Busting through all-time highs is obviously significant, especially since it’s taken more than a year and multiple (failed) rallies to do so. From a technical perspective, the longer we remain above the old highs, the stronger the support should become. Emotionally, the effect is more schizophrenic. On one hand, it’s a clear signal the US economy is healthy enough to support elevated stock prices. On the other, it’s an opportunity to sell at a better price than any point in history.
Our approach is to let the fundamentals decide which perspective to focus on. Two-thirds of the way through corporate earnings season, 71% of reporting companies have beaten their consensus expectations. The best-performing sector of that group – Technology – is an economically sensitive category that typically outperforms when conditions are healthy. At month’s end, the S&P 500 had a forward P/E (Price to Earnings) ratio of 17, which is higher than its 5-year and 10-year averages.
So, are stocks still reasonably priced? The answer: Some are. Some are not.
Different sectors will naturally have different valuations, which makes sense given that earnings growth and other factors vary from one category to another. By comparing current numbers to historical averages we can get a better sense of actual value. Through that lens, Financial, Technology and Health Care stocks remain attractively priced given present conditions. Utilities and Telecoms, both up more than 20% year-to-date, look expensive. Being selective will be key to navigating equity markets in the months ahead.
While stock prices thrust to all-time highs, interest rates fell to historical lows last month. On July 6, the benchmark 10-year US Treasury yield hit 1.34% intraday, an indication of investors’ “flight to safety” in the wake of the Brexit referendum. Never before has conservative investing cost so much and paid so little. That dynamic is exactly what caused so many investors to rush into yield-heavy equity sectors (Utilities and Telecom) despite expensive asking prices.
By the end of July the 10-year Treasury yielded 1.46%, with the “bounce” being attributed to the Fed’s reminder that a rate hike remains possible later this year. Globally, more economic stimulus and negative bond yields remain the norm.
The lack of a meaningful interest rate increase in the near-term (the consensus) coupled with steady economic growth creates a Goldilocks environment for equities. As discussed above, certain stock valuations are no doubt expensive on an absolute basis. But when compared to bond prices, stocks remain more attractive relatively speaking.
Oil prices have faded from front-page material to “mentionable” status in recent months. No longer is oil the primary driver for day-to-day market movements like it was earlier this year (and that’s a good thing). West Texas Intermediate Crude closed above $50/barrel in early June, but has fallen nearly 20% since then, including a 14% drop in July.
WTI Crude finished the month at $41.60 per barrel. Oil inventories at one point declined for nine consecutive weeks, but an unexpected swell reported in July is threatening a move back into the $30s for the first time since April. Crude’s decline is responsible for the underperformance of Energy stocks in July.
US housing data remains positive. Purchases of new US homes hit their highest level in more than eight years. Those gains are due to an improving labor market and mortgage rates again near record lows.
The latest jobs numbers are also indicative of strong economic conditions. Employers added 287,000 jobs in June, up sharply from only 11,000 new jobs reported a month earlier. Wages grew 2.6% compared to a year ago, one of the fastest paces since the economic recovery began in 2009.