Investor Optimism Despite “The Merry Minuet” Environment
The optimism of consumers, business owners, and investors continues at high levels despite hurricanes in Florida, Texas, and Puerto Rico, fires in California, and possible nuclear confrontation in North Korea. In past markets, investors also faced similar issues. For some perspective on the relative constant of world issues, let us look back about 60 years to a hit recording titled “The Merry Minuet”. Nearly the same lyrics could be written today. See whether you agree.
The Merry Minuet
They’re rioting in Africa,
They’re starving in Spain.
There’s hurricanes in Florida,
And Texas needs rain
The whole world is festering
With unhappy souls.
The French hate the Germans,
The Germans hate the Poles;
Italians hate Yugoslavs,
South Africans hate the Dutch,
And I don’t like anybody very much!
But we can be tranquil
And “thankful” and proud,
For man’s been endowed
With a mushroom-shaped cloud.
And we know for certain
That some lovely day
Someone will set the spark off,
And we will all be blown away!
They’re rioting in Africa,
There’s strife in Iran.
What nature doesn’t do to us
Will be done by our fellow man!
The French proverb applies: plus ca change, plus c’est la meme chose—
the more things change, the more they stay the same.
Consumer Optimism—Highest in Over a Decade
The University of Michigan’s preliminary consumer sentiment index for October spiked 6 points to 101.1. This represents the highest level for the index since early in 2004. For perspective, since its 1978 inception, the index averaged 85.6. Economists at the Michigan survey noted that this outlook suggests the expansion should continue at least into the middle of 2018. They also pointed out, if the expansion continues through the middle of next year that would mark the second longest expansion since the mid 1800’s. By then, in our view, consumers should know whether tax reform legislation passed and weather or not they will benefit.
Source: Advisor Perspectives
Retailers Optimism—Grew Since our Previous Commentary
Retailers bought into consumer optimism earlier this summer. Our late August commentary pointed out the first signs of a strong holiday shopping season may be reflected by the strength of container volumes coming into U.S. ports. Container volumes in the summer months reflect inventory building for the upcoming holiday shopping season.
Since our August commentary, an additional report provides a similar positive reading. The national retail federation’s “Global Port Tracker” reported imports broke records for the two months ending in August. The volumes represent the highest on record since 2000 when the N.R.F. began tracking imports. Overall, August showed an increase of 5.6% over last August. Of course, consumers will provide the ultimate verdict with their purchases during the holiday shopping season.
Small Business Optimism—Also Getting Ready for the Holiday Season
Similar to consumers, small business optimism remains high compared to recent history. The graph below shows their optimistic upsurge began in December, after the election, with a “Trump Bump” of 7 points. Small businesses’ continuing optimism translates into a five point increase in their inventory plans for the fourth quarter when compared to August.
Small business optimism can also play an important role in contributing to employment growth. In that regard, the survey showed finding qualified workers represented their second most important problem—after taxes of course. For those who question the strength of the employment recovery this response might reduce their concerns. It may also finally lead to stronger wage increases.
Investors’ Optimism at Record Levels
Finally, investors take all the issues that face the economy and the global issues identified in “The Merry Minuet” and still come out extremely optimistic. The positive outlook for the economy, as reflected by consumers and business managers, contributes to investor optimism and the resulting strength of equity markets.
As important, the positive economic outlook and the strength of the equity markets can also lead to investor “complacency.” The evidence of this “complacency” shows up in the historically low levels for the Chicago Board Options Exchange Volatility Index—the VIX (see graph below.) More specifically, over 75% of the time the VIX closed below 10 occurred in 2017. Just this month the VIX closed at a record low of 9.19 on October 5th.
Optimistic investors also expect the current market “complacency” to continue. That conclusion shows up in the record VIX futures short position (see graph below.) The expectation for low future market volatility stems from investors projection of continued domestic economic growth as well as a more positive global outlook.
Over the last decade, expanding earnings multiples more so than earnings growth played a key driver for the nearly decade long market upswing. In our view, historic low interest rates, put in place by the Fed, helped stimulate this earnings multiple expansion.
With the Fed now reversing the switch on monetary policy, interest rates will likely rise over the next two plus years. If so, those higher interest rates could bring downward pressure on earnings multiples.
With that possibility, two likely keys to future equity market performance will be both the earnings outlook and the passage of tax reform legislation. This commentary earlier provided some evidence for continuation of the current economic and earnings growth. And, in the case of tax reform, analysis project corporate earnings could increase in the range of 7-12%. By adding this earnings gravy to the already positive earnings outlook, tax reform should help solidify the current investor optimism as shown earlier. Caveat– the cacophony in Washington creates a cloudy picture as to forecasting the eventual enactment of tax reform.
Normally, a less accommodative monetary policy influences the economy with a lag of about 12-18 months. If so, over that same period, tax reform may then begin providing the fiscal stimulus necessary to offset the monetary bite. Admittedly, that may be asking too much of the Fed and Congress to, in sync, pull off the equivalent of an economic and financial royal flush.
Andrew J. Melnick, CFA
Chief Investment Strategist, First Capital Investment Partners