September 30, 2017
So much for the old market adage “sell in May and go away”. Markets continued their winning ways in the September quarter, with all the major U.S. equity indices attaining positive returns. For the second consecutive quarter, there was some volatility underneath the market’s placid veneer. Early in the quarter, gains favored large-cap and growth oriented issues while small-cap and value lagged. However, the month of September was friendlier for small cap and value issues, and all major Russell equity style boxes finished the quarter with solid gains.
For the quarter, the S&P 500 and Russell 1000 Growth Indices were up 4.5% and 5.9%, respectively, and the M&C Inst’l Equity (large Cap Growth) Composite rose 4.6%, gross of fees. Year to date the composite rose a strong absolute 17.4%, gross of fees, well ahead of the 14.3% gain of the S&P 500 Index while trailing the 20.7% advance of the Russell 1000 Growth Index.
June quarter profits surprised to the upside, which is really no surprise at all. The established pattern in recent quarters has been for corporate profits to generally beat consensus estimates by a few percentage points. According to data from FactSet, S&P sales grew approximately 5%, the best pace of quarterly sales growth since 2014. Earnings followed suit, with aggregate S&P EPS growing around 10%, less than the low teens growth witnessed in the March quarter but a healthy clip nonetheless. Profit growth should moderate somewhat further in the soon-to-be reported third quarter but still be up mid-single digits. With positive preannouncements already tracking well above any quarter during the last five years, we think the likelihood is quite high that final Q3 results once again come in better than expected. With most measures of valuations quite elevated, we think profit growth will have to be the main driver of equity market performance in the period ahead.
Tensions on the Korean Peninsula took center stage during August. This created the first real bout of volatility this year. While the CBOE Volatility Index (VIX) rose in response to the heightened geopolitical tension, it did so from all-time low levels. Beyond that brief blip up, the VIX remained near all-time low levels this quarter. What could explain such ongoing complacency in the stock market? Explanations abound including: the continued flood of investment dollars into passive vehicles insensitive to fundamentals, the ongoing modest yet steady economic expansion which has expanded globally, and significant liquidity from global Central Banks. There is likely a kernel of truth in each and these theories are in many ways interrelated. The more important question is not “why is volatility so low?” but rather, “what does it mean?” Some see it as an ominous signal that investors are not only complacent but overly optimistic or perhaps even euphoric. Investing legend Sir John Templeton coined the phrase, “bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.” High valuations and record low volatility measures imply to skeptics that the bull market is nearing its end. The more sanguine merely shrug their shoulders and point to the ongoing improvement in economic growth, the lack of any apparent excesses in the economy, low interest rates and continued corporate profit growth as a sturdy foundation upon which the bull market can continue to climb. However, we doubt that markets will stay complacent forever.
While valuation and sentiment data continue to be red flags for the stock market, volatility remains contained and any market weakness has been quickly met by buyers of stock. With both the stock and bond markets highly valued and a significant drawdown in share prices long overdue, we are sensitive to any developments that could cause the market to correct. The S&P 500 median price-to-earnings ratio is currently 23.1x and is higher than 96% of historical periods. The 10-year U.S. Treasury is also highly valued and offers only a 2.3% yield to maturity. For now, a low risk of recession, improving corporate profits, a better global economy, very accommodative policies by Central Banks throughout the developed world, a gradual and predictable increase in interest rates by our Federal Reserve and the likelihood of fiscal stimulus coming out of Congress are all supportive of the market and continue to keep it elevated.