Schwab Market Perspective: Shifting Sentiment?

Key Points

  • Volatility ticked higher briefly and technology stocks hit a speed bump as investors may be questioning the durability of the U.S. bull market. We believe strong earnings growth and a solid economy will continue to support further gains, but more volatility should be expected.
  • Economic confusion may be contributing to investor skepticism. The labor market continues to tighten and housing is in good shape, but inflation has been in retreat along with commodity prices. Meanwhile, for the first time in a while, the Fed sounded slightly more hawkish at its June meeting.
  • Valuations vary for good reasons among different regions, and investors should be careful when comparing valuation measures between countries.

Shift in Sentiment?

A bit of volatility returned to Wall Street, with indexes pulling back from record highs and the leading sector performer to this point in the year, technology, experiencing a decent-sized pullback. Meanwhile, we've seen a flattening of the yield curve, which suggests the bond and stock markets may be sending conflicting economic signals.

The yield curve has flattened modestly

The yield curve has flattened modestly

Source: FactSet, Tullett Prebon information. As of June 20, 2017.

We believe the pullback in both tech and the overall market was healthy and served to correct some overly optimistic sentiment conditions. But temper your enthusiasm for a sharp rebound like we’ve seen in the past. The new variable in the equation is a Fed that is more hawkish than the market in terms of the expected trajectory of rate hikes. This has raised concerns over a possible monetary mistake, given lower inflation. Additionally, valuations are stretched; albeit on stronger earnings growth expected for this and next year. We continue to believe that strong earnings growth, a solid economy, still-low interest rates, and ample global liquidity support current valuations; but urge investors to remain disciplined around strategic asset allocations.

Confusing Economy

The U.S. economic picture has been mixed. On the plus side, bank loans have started to show signs of ticking higher, which could indicate greater carry through of improved business confidence to action; as supported by the National Federation of Independent Business (NFIB) survey's optimism reading of a strong 104.5.  Additionally, a survey conducted by Evercore ISI Research shows that 30% of companies plan to increase capital spending in 2017, up from just 9% in November of last year.

Bank loans are ticking higher again

Bank loans are ticking higher again

Source: FactSet, Federal Reserve. As of June 20, 2017.

Housing also continues to look solid. The National Association of Homebuilders (NAHB) Survey remained elevated at 67 (a level of 50 is the demarcation point between improvement and deterioration), while mortgage applications have also increased.

Mortgage applications indicate a solid housing market

Mortgage applications indicate a solid housing market

Source: FactSet, Mortgage Bankers Association. As of June 20, 2017.

And the labor market continues to be quite tight, with the unemployment rate at 4.3%,  the leading indicator of jobless claims continuing to be near historic lows, and job openings (via the Job Openings and Labor Turnover Survey, or JOLTS) at an all-time record high.

Jobless claims continue to be quite healthy

Jobless claims continue to be quite healthy

Source: FactSet, U.S. Dept. of Labor. As of June 20, 2017.

But not all is rosy. Commodity prices have fallen—notably oil prices—indicating higher supplies and/or soft demand. And the most recent retail sales report from the Census Bureau was disappointing, with a flat reading ex-autos and gas; although the previous couple of months were revised higher.

Commodity prices causing concern?

Commodity prices causing concern?

Source: FactSet, Commodity Research Bureau. As of June 20, 2017.

We believe lower commodity prices are likely more a consequence of increased supply rather then something overly concerning on the demand side. And today's "smarter" consumer is not tying spending to increased debt, which should prevent a boom/bust cycle; and is spending more on experiences than goods. 

More hawkish Fed

The mixed economic picture along with softer inflation readings—the Consumer Price Index rose a mere 0.1% ex-food and energy last month—has not swayed the Fed from its expected path toward normalization. The rate hike that occurred at the June meeting was highly expected by the market as was the gradual nature of the plan laid out to reduce its $4.5 trillion balance sheet. What may have surprised investors was the apparent dismissal of the low inflation readings in the statement and the subsequent press conference by Chairwoman Yellen. By both the "dots plot" and the accompanying commentary, it appeared that the Fed wants to raise rates at least one additional time in 2017, while Chairwoman Yellen indicated a winding down of the balance sheet will start before year-end. While the Fed remains data dependent, the market may have been hoping for a bit more dovish tone in light of the soft inflation data. We believe there is a strong desire among most Fed members to get rates to a more normal level and to start the process of reducing the balance sheet; but they also remain focused on not making decisions that may harm economic activity. Ongoing Fed policy uncertainty is likely to result in increased bouts of volatility.

Valuations across borders

As mentioned above, increased valuations can also contribute to greater volatility as stock as investors become more attuned to valuation and some begin to seek out less expensive areas of the markets. However, those seeking to invest in non-U.S. markets solely on the basis of valuation may be making a mistake.

Valuation comparisons can be tricky—even when setting aside the issue of which valuation measure to choose. The price-to-earnings ratio (PE), which divides price by the earnings over the trailing twelve months, is probably the most well-known and oldest of valuation measures. Comparing the U.S. stock market to that of Japan presents a stark contrast. With the MSCI USA Index PE of 21 and MSCI Japan Index PE of 14, it appears Japan offers investors a relative bargain compared to the United States.

But that conclusion can be misleading since the U.S. stock market tends to perform like the technology sector while Japan tends to closely track the performance of the financial sector, as you can see in the charts below. Since the U.S. behaves like technology it isn't surprising that the MSCI USA Index is valued like the MSCI World Information Technology Index which has a similar PE of 23.

United States performs and is valued like the technology sector

United States performs and is valued like the technology sector

Source: Charles Schwab, Factset data as of 6/21/2017.
Past performance is no guarantee of future results. Indexes measure cumulative total return in US dollars since start of 2006.

Likewise, the MSCI Japan Index is valued like the MSCI World Financials index which has a similar PE of 14.

Japan performs and is valued like the financials sector

Japan performs and is valued like the financials sector

Source: Charles Schwab, Factset data as of 6/21/2017.
Past performance is no guarantee of future results. Indexes measure cumulative total return in US dollars since start of 2006.

We can also see this in the chart below looking at the Eurozone which is composed of 19 European countries and tends to perform like a combination of three different sectors: financials, telecommunications and materials. The MSCI Euro Index has a PE of 18, as does the weighted combination of those three sectors.

Europe performs and is valued like a combination of three sectors

Europe performs and is valued like a combination of three sectors

Source: Charles Schwab, Factset data as of 6/21/2017.
Past performance is no guarantee of future results. Indexes measure cumulative total return in US dollars since start of 2006.

A key takeaway for investors on valuation comparisons across borders is that relative valuations reflect how those markets tend to perform. Importantly, these valuation differentials between sectors and across countries are currently not far from their 20-year averages, suggesting relative valuations do not support a compelling reason to favor one country's stock market over another.

So what?

The recent flare up in volatility was short lived but could be indicative of future market action as investors consider the path which Fed policy normalization will take. We believe the stock market should continue to grind higher due to a solid economy and strong earnings, but that investors should be prepared for more turbulence and stay diversified. But investors should also be careful not to rely solely on valuation measures when determining which foreign markets to enter more aggressively.

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