Looking at the topline numbers for the market last week, you may be left with the impression that it was a quiet, slightly negative one. It was, in many ways, anything but that, however. While volatility, as measured by the CBOE Volatility (VIX) Index, averaged 15.78 for the week (close to its 15.41 opening level and only a point higher than its 14.77 closing level), there was a midday sojourn on Thursday to 18.66. Beneath the 0.21% decline of the S&P 500® Index, there was a substantial split in performance, as technology shares rose 2.63% and health care fell 3.04%. Even within these sectors, the returns were anything but uniform. In technology, the strength was primarily driven by the 11% rebound in the value of Apple computer shares, thanks in part to the disclosure of share purchases by Berkshire Hathaway. That news, in turn, helped drive up the share prices of semiconductor and related capital equipment companies. In health care, the catalyst was a 4% to 9% drop in the shares of pharmacy benefit managers (PBM), which bled over into the share prices of the major health insurers, costing them 2% to 4% for the week. The decline of the major blue-chip indices led to a rise in value shares of smaller companies, with the Russell 2000® Index gaining 0.6%. Foreign benchmark indices were down for the week, but this was more a factor of a rise in the value of the U.S. dollar than it was home market price action. Earlier this year, there was considerable concern regarding an inversion of the yield curve, typically a precursor of a recession. As of Friday’s close, that concern should be abating, as the one- to seven-year section of the curve has steepened, and the seven- to thirty-year section has in parallel shifted 15 basis points higher. This and the report of a decline in U.S. trade deficit sparked the rally in the value of the U.S. dollar last week.
Investors’ Zen-like state of 2017 has given way to a more unsettled condition where even good news has the potential to provoke a negative response. So, in the interest of establishing a balanced view, we can look around and assess the situation. Having passed the mid-way point for earnings season, it is possible to draw some conclusions, first and foremost of which is that both topline revenue and earnings are running better than forecast for over 70% of the companies that have reported. Of those, over half lifted their guidance to investors for the balance of the year. On the flip side of that, the current forward price earnings ratio is at the 92nd percentile, so only 8% of the time has it been afforded a higher valuation than we are experiencing. On the interest rate front, where earlier this year we were fretting about the flattening of the yield curve as a harbinger of recession, we now have a steepening yield curve. Where 2017 had short rates rising while the thirty-year declined, the curve has shifted higher across the term structure and, since the end of the first quarter, longer rates are rising faster than short rates. While on the subject of bonds, the U.S. Treasury has announced an upcoming $73 billion auction for 3-year, 10-year and 30-year maturities, some $7 billion larger than the first quarter auction. At that auction, the bid-to-cover ratio had dropped to 2.1 from the five-year average of 2.7, as foreign central banks continue to reduce their purchases of U.S. Treasury securities. While the Federal Reserve Bank can set short-term rates, it is the market that determines the yield on bonds, and it’s here that the rules of supply and demand still apply. Our forecast calls for gradually rising rates, thanks to the global demand for coupon and the attractiveness of U.S. rates and liquidity relative to global debt markets. There are risks to be concerned about, and we will be monitoring the obvious ones while also looking for the potentially new ones that may emerge. We continue to ask the question: are we being adequately compensated for the inherent risk of an investment? The second question is the null hypothesis: what if we are wrong? This requires us to question assumptions and challenge the data and our assumptions about its meaning. Hubris and complacency are failings investors cannot afford.
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