Schwab Market Perspective: Are Danger Signs Rising…or Will the Bull Run Continue?

Key Points

  • The long running bull market continues to show remarkable resiliency and we expect that to continue. However, risks have risen and a pullback is likely.
  • The U.S. economy remains a mixed bag of slow trend-like growth with waning inflation pressures. But solid earnings growth should continue to support stocks.
  • The threat of a sharp slowdown in China appears to have diminished but global tensions are still emanating from that region.

How long?

Are risks growing or will the bull market continue? We believe the answer to both is yes. Political bumbling, monetary policy shifts, and geopolitical tensions have all escalated, but the bull continues to power ahead, largely unscathed by the tumult that surrounds it. This is actually in keeping with history, as partisan conflict in particular has served as a contrarian indicator for stocks in the past. Since past performance is not an indication of future results, consider it yet another brick in the wall of worry. However, it's uncertainty around monetary policy that would likely be a culprit behind any coming choppiness in stocks.

The bull has had few detours

The bull has had few detours

Source: FactSet, Standard & Poor's. As of July 18, 2017.

The aforementioned uncertainties have kept investor sentiment from becoming too frothy, which helps to support the ongoing bull market. We don't see signs yet of a "melt-up" scenario, where investors frantically rush into stocks, afraid they’re missing out on gains. As good as melt-ups feel while they’re underway, they don't end well. The possibility of a correction (defined as a greater than 10% pullback) is greater now than it was at the beginning of the year; especially given the uncharted territory in which the Federal Reserve finds itself, as it soon begins to unwind its $4.5 trillion balance sheet. We are modestly concerned about asset valuations that have soared in the era of artificially low interest rates and a bloated balance sheet.

Asset inflation reaching concerning levels

Asset inflation reaching concerning levels

Source: FactSet, Federal Reserve Bank, Strategas Research. As of July 18, 2017.

We don't think the bull is ready to take a bow just yet, and at this point would view pullbacks as healthy. According to Strategas Research it has been 268 trading days since the last 5% pullback—the fourth longest streak since 1950 (the 1990s had two of them).

Earnings growth is the mother's milk of sustainable stock market gains and the next few weeks will go a long way to determine the status of corporate health. With one quarter down and another one in the process of being reported, it looks good, with the Thomson Reuters-reported consensus expecting at least a 10% year-over-year increase in earnings for 2017. What is more impressive is that the year's expectations have only been downgraded slightly from the 14% growth rate projected at the beginning of the year. To illustrate how solid that is, look back to 2016, when projections at the beginning of the year were for 13% annual growth in earnings. Those projections were steadily downgraded throughout the year before ending up with an actual growth rate last year of less than 2%.

Of course, a high expectations bar leaves open the possibility of disappointments, which could add to volatility in the coming weeks. Already we've seen major banks largely beat estimates but pull back on some concerns about some seasonally soft numbers—which arguably should have been built into expectations. And the energy sector's contribution to forward-looking expectations is already past its peak.

Economic data continues to confound

Another support for stocks may be coming from economic data that is showing a robust labor market, but few signs of inflation building. The unemployment rate is 4.4%, yet wage gains remain modest. The Consumer Price Index (CPI) was flat month-over-month, while ex-food and energy it only ticked 0.1% higher.

Inflation remains benign

Inflation remains benign

Source: FactSet, U.S. Dept. of Labor. As of July 18, 2017.

More concerning is the lack of solid increases in retail sales, although we believe the measuring process may be somewhat flawed due to the changing mix of sales. Nonetheless, it isn't particularly encouraging for an acceleration of economic growth when retail sales as reported by the Census Bureau were down 0.2%, and ex-autos and gas sales ticked 0.1% lower.

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