Schwab Market Perspective: Preparing for the Latter Innings

Key Points

  • U.S. stocks continue to grind higher, with little appearing able to knock them off course. The possibility of a pullback always exists but a melt up is also reemerging as a real possibility.

  • Earnings tend to drive equity market direction, and the next few weeks should help set the tone for market action for the rest of the year. Expectations came down a bit as we entered reporting season and recent robust economic data gives support to the potential for companies to meet and/or beat estimates.

  • Global economic growth continues to improve, which should help support both domestic and global stock markets.

Take me out to the ballgame

U.S. stock indices have continued to push to record highs, with little apparently able to throw them off course. The grind higher has pushed through natural disasters, the Las Vegas tragedy, domestic political failures, international political tensions, and missile tests and threats from North Korea—an ample “wall of worry” for stocks to climb. We’re likely entering or already in the latter innings of this long-running bull market and economic expansion, but as baseball fans know there’s still a lot of game left after the middle innings—including the possibility of extra innings. Although there is little of the excess that would suggest recession risk is near, we do see signs that the characteristics of the economy and market may be changing. Bond yields have crept higher, international markets have performed better, and cyclical sectors such as energy and materials have outperformed—all potential signs of the latter stages of a cycle. We’ve seen brief periods when these shifts have occurred before, but the strength and length of the recent moves gives us reason to believe a change in character is afoot.

So what should investors do if we are entering the latter innings? At this point, we suggest making sure strategic allocations are appropriate for risk profiles as well as long-term goals, and make adjustments as needed via tactical rebalancing. There remains the possibility of a pullback, with any number of catalysts possible. Attitudinal measures of investor sentiment are currently showing excess optimism, which is typically a contrarian indicator. This has been a characteristic of most of 2017, but of course we have yet to see a significant pullback. And while attitudinal measures of sentiment appears overly optimistic, behavioral measures still show some caution, with Evercore ISI noting that the net cumulative flows in domestic equity funds (even including exchange-traded funds) continues to be negative, indicating continued caution despite optimistic attitudes.

A melt-up is also reemerging as a possibility should investors’ actions start to follow the attitudinal sentiment indicators. Remember though—as good as a melt-up might feel while underway, they have historically not ended well.

Economy hitting solid doubles, while earnings are stepping to the plate

Another sign that we may be in the latter innings has been the recent acceleration in economic data. Both of the Institute for Supply Management’s (ISM) Surveys had extremely strong readings, indicating accelerating growth. The manufacturing index hit 60.8, the highest level since 2004, while the leading new orders component was a robust 64.6. The service side also looks strong, with the non-manufacturing index rising to 59.8, the best reading since 2005, while the new orders component jumped 5.9 points. Although services represent a much larger share of the U.S. economy, the ISM Manufacturing Index has a higher correlation to the stock market historically.

Strong surveys indicate improving economy

Source: FactSet, Institute for Supply Management. As of Oct. 9, 2017.