Weekly Market Update (May 15 – May 19, 2017)

By Craig Fehr May 19, 2017

While U.S. stocks were only marginally lower to end the week, they took a rocky path to get there. U.S. large-cap stocks fell by nearly 2%, posting their largest declines since September 2016, on Wednesday as investors became increasingly concerned that turnover and turmoil within the Trump administration will prevent implementation of some (or all) of its pro-growth policies. However, stocks stabilized on Thursday and rallied on Friday. After months of low stock market volatility despite higher uncertainty about economic policies, investors shouldn't be surprised by the return to a more volatile market. We think larger day-to-day price changes could continue, even if stocks trend higher as we expect. That's why it's important to own an appropriate mix of stocks and bonds for your goals and risk tolerance so you can stay invested during times of higher market volatility, and stay on track toward your financial goals.

The Market Shows Its Softer Side

If anyone needed a reminder of just how much the market has spoiled investors of late, look no further than last week. Stocks dropped 1.8% on Wednesday – the largest daily decline in 175 trading days – in response to increasing turmoil in Washington. The S&P 500 is up 35.9% over the past three years, and Wednesday's selloff left the U.S. market a whopping 1.9% off of the all-time high (reached on May 15), perspective that seemed to be lost in the headline reaction.
One headline referred to "…bracing for a massive stock-market selloff," and the term "Trump Slump" emerged. It appeared as if some were willing to pronounce the rally's time of death after one day of weakness. As is always the case, a wider lens is useful. U.S. equities gained a combined 1.0% on Thursday and Friday, reflecting a more balanced tone. So where do we go from here? We think last week offers the following:

  • There will be more down days – The emotional reaction to Wednesday's market drop was, in our view, more severe than the decline itself. This reflects the combination of strong gains and low volatility that has defined the market recently. Stock market volatility1 surged to the highest level of 2017 last week, just 13 days after reaching a 24-year low. We don't think 300-point down days for the Dow will become commonplace, but investors should not be surprised to see a short-term pullback this year.

We expect policy risks, including the unfolding turmoil in Washington, global regime conflicts, political unrest (as seen recently in areas such as Brazil and Venezuela), progressing Brexit negotiations, and central bank actions to hog more of the spotlight moving forward, with the market perhaps less willing to look past these disruptions than has been the case so far this year. We think additional volatility will take the form of temporary pullbacks within the broader trend higher, but last week's reaction signals to us that after a period in which we haven't seen a 5% decline in nearly 11 months and only two 10% corrections in the past six years, market dips are likely to evoke more emotional reactions.

  • The Trump agenda giveth and taketh away – The S&P 500 and the Dow are up 12.6% and 13.9%, respectively, since the election, reflecting an optimistic view of President Trump's pro-growth reforms centered on tax reform, deregulation and infrastructure spending. Last week's market drop, in turn, reflected concerns that ongoing investigations related to the White House will distract from the administration's time and energy devoted to that pro-growth agenda. We'd offer views to both perspectives:
    • In terms of the latter, our view has been that the market expectations around the timing and impact of these reforms are a bit too optimistic. We think the administration will achieve some progress on its agenda (tax reform likely being the highest priority for the White House and Congress), but legislation will almost certainly be different from original proposals, and its implementation will probably not come swiftly (tax reform is increasingly looking like a 2018 deliverable).  Pro-growth reforms are a credible source of economic optimism, meaning ongoing distractions and delays in their delivery will be a credible source of disappointment and market volatility ahead. 
    • To the former, we think the Trump economic agenda will provide a modest boost to economic growth. Corporate profit margins are coming off peak levels as labor expenses rise. Effective corporate tax reform that aids profitability and incents business investment (a missing piece of the economic puzzle during much of this expansion) could be a key catalyst. Deregulation that spurs business formation/expansion and confidence (the small business confidence survey is at a 13-year high) could also be effective.  We think calls for 3%-4% GDP growth are too rosy (the last year of growth in that range was 2006), but our expectation for roughly 2.5% growth this year would be a noteworthy improvement over the prior year (1.9%). 

 

  • It's Not All About Trump – A glance at the 24-hour news cycle might suggest otherwise, but the good news for investors is that the broader direction ahead for the market does not rest solely on Washington. Although the market has risen 12.6% since the election, improvement in the economy and corporate earnings since then suggests that stocks have had positive influence beyond just potential Trump reforms. For example, international equities have outperformed this year (EAFE +12.6% and EM +15.2% year-to-date)2, which is reflective of improving growth prospects and not simply President Trump's agenda.
    While near-term fluctuations in the market will be influenced by policy, one of the reasons last Wednesday's drop was followed by a rebound (and the reason we think upcoming pullbacks will be temporary) is that the fundamental foundation remains supportive, based on
    • Jobs, Housing and Confidence – Healthy job growth, a 10-year low in unemployment, a pickup in wage growth, improving housing-market indicators, and consumer confidence at a 16-year high suggest that household spending gains (which account for more than two-thirds of GDP) should see support, helping overall economic growth.
    • Rebounding corporate profits – An earnings rebound is under way, which should provide a solid tailwind for market gains over time, which is particularly important given current elevated valuations for U.S. stocks. Encouragingly, revenue growth for the S&P 500 in the most recent quarter was 7.8%, the strongest level of sales growth experienced since 2011.
    • Still-favorable interest rate backdrop – While the Fed is likely to continue to pursue a gradual approach to raising rates, interest rates still remain quite low, including the 10-year benchmark rate currently at 2.23%. The earnings yield on equities still compares favorably with prevailing rates, based on historical levels, suggesting equities remain compelling on a relative basis. We advise rebalancing to the middle of the recommended equity and fixed-income ranges, maintaining an appropriate allocation to bonds to help protect against anticipated market volatility.

Sources: 1. CBOE VIX Index  2. Bloomberg, total return of MSCI EAFE index and MSCI Emerging Markets index.

The Stock & Bond Market

Index Close Week YTD
Dow Jones Industrial Average 20,805
-0.4% 5.3%
S&P 500 Index 2,382

-0.4%

6.4%

NASDAQ 6,084

-0.6%

13.0%
Bonds* $109.52

0.6%

2.2%
10-yr Treasury Yield 2.24% -0.09% -0.21%
Oil ($/bbl) $50.38 5.3% -6.2%

Source: Bloomberg. Past performance does not guarantee future results. *Bonds represented by the iShares Core U.S. Aggregate Bond ETF.

The Week Ahead

We expect investors to shift their focus to macroeconomic data as the earnings season comes to a close over the next couple of weeks. Next week, preliminary PMI data will be released on Tuesday, the Federal Reserve's May meeting minutes will be reported on Wednesday, and the consumer sentiment data will come on Friday.

Important Information

The Weekly Market Update is published every Friday.

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The Dow Jones Indexes are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use.
All content of the Dow Jones Indexes © 2017 is proprietary to Dow Jones & Company, Inc.

Past performance does not guarantee future results.

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Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

This information is approved for use with the public.
It is intended for informational purposes only.
It is believed to be reliable, but its accuracy and completeness are not guaranteed.

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