Low Volatility Is Here to Stay

In my conversations with institutional investors I find a surprising lack of optimism about the outlook for equities. The capitalization-weighted Standard & Poor’s 500 was up over 11% year-to-date, excluding dividends, on September 18. Some would argue that only a few stocks are accounting for the rise, but the equal-weighted S&P 500 was up over 8% year-to-date as well. Everyone is aware that the economic expansion and the bull market have continued for a long time. Equities bottomed in March of 2009 and the economy began to strengthen in June of that year, so we have been in a favorable period for investing for more than eight years. Cycles usually do not last this long. We all know it can’t go on forever, but I believe we could continue on a positive course for both the economy and the market for several more years.

The principal reason for this conclusion is that the usual factors that warn of a bear market or recession are not evident. What would really worry me would be an inverted yield curve, but there is now almost an eighty basis point spread between the two-year Treasury and the ten-year. I would also be concerned if retail investors were euphoric about equites as they were in 1999 or 2007. They are generally optimistic, but not excessively so, although earlier this year sentiment did rise to a worrisome level. Investors large and small are also leaning toward the defensive. Hedge fund net exposure clearly shows a mood of caution: it is just under 50% now; it was mostly 55%–60% in the 2000–2008 period. Individuals are still buying bond funds even at these low yields because of their lack of confidence in the stock market. Institutions, in their desperate search for yield, have bid up the price of lower-quality bonds to the point where their spread with Treasurys is historically low. Warnings of trouble ahead, however, would usually be associated with high spreads. Maybe investors are too complacent, but not this may not be the case if the economy continues to grow.

We know that the Federal Reserve was considering an additional increase in the federal funds rate in September, but was discouraged from taking any action by hurricanes Harvey and Irma. The planned shrinkage of the Federal Reserve balance sheet was probably also delayed for the same reason. The S&P 500 has also shown a tendency to peak after each rate increase by the Federal Reserve and we have only begun the tightening cycle now. The hurricanes are likely to reduce third-quarter real GDP growth by at least one-half of one percent, but demand driven by rebuilding should be reflected positively in the fourth quarter and the first quarter of 2018.

Another important warning signal is the Leading Indicator Index, which has been climbing steadily since 2016. Recent data shows the possibility of a growth slowdown but a continuation of the expansion. The slowdown, if it comes, may trigger a correction in the equity market, but the present steep slope of this indicator suggests nothing more serious than that. Based on this data, even when the Index tops out, we would still have as long as two years for the market to work its way higher before the downturn begins. Corporate earnings are still increasing and there has never been a recession while that is happening.

Strong business activity exists not only in the United States, but throughout the world: Europe should grow at close to 2% this year; so will Japan. The rates for China, and India will be close to 7%. The U.S. will benefit from continued strength in these key areas. One condition that invariably appears before a recession is an increase in cyclical spending as a percentage of GDP. This indicator has exceeded 28% before every recession going back to 1970 but is only at 24% now. Perhaps there is a secular shift in spending patterns toward non-cyclical services rather than goods that accounts for the drop, but we still should expect a pick-up in cyclical spending before the end of the cycle. Another factor dampening capital spending is that operating rates are only 77%. There is plenty of slack capacity and no great need for new plant and equipment.