The Dow joined the S&P 500 in reaching new highs. The record came after a drought lasting nearly eight months. The blue-chip index has lagged the S&P 500 Index and Nasdaq Composite this year amid escalating trade tensions, which have weighed on the larger multinational U.S. companies that make up most of the 30-stock Dow Jones Industrial Average (Dow). Let’s discuss the impact of the Dow’s new high and whether stocks have enough support from economic growth and corporate profits to build on recent gains.
When the Dow reaches new highs, more new highs and above-average performance tend to follow. When there is a lot of time between record highs, the gains tend to be larger and more frequent. In fact, when a record high is the first in more than seven months, the average gain for the Dow in the following six months was 6.3%, with gains occurring 87% of the time (over 15 instances since 1950). Both of those measures are better than the historical performance for the Dow over all six-month periods. History does not always repeat, but we think the Dow has more new highs to make over the rest of 2018 and into 2019.
A new high for the Dow also may be a positive economic signal. Based on data back to 1950, within six months of a Dow record high, a U.S. recession occurred less than 1% of the time. Over the subsequent year, the occurrences haven’t been much higher, at 2.2%, compared with about 13% during any time in the period covered.
Some investors may be perplexed by the stock market’s recent strength amid the ongoing trade dispute with China. The latest headlines – including news that China had cancelled trade talks – have provided little cause for optimism. United States and Canadian trade officials have struggled to get NAFTA 2.0 over the finish line, and there is still work to be done with Europe. China may be the primary target, but it is not the only source of trade weighted angst.
So why have stocks done so well? We think the continued strength of the U.S. economy is the biggest reason. Some of the highlights:
• After a very strong second quarter, gross domestic product (GDP) is expected to grow roughly 3% in the second half, per Bloomberg consensus. Consumers are in great shape and business spending is picking up.
• The job market remains strong. Jobless claims reported last week fell to the lowest level since 1969. Income growth is starting to pick up but is well below levels that have historically been worrisome for the Federal Reserve (Fed).
• Business and consumer confidence measures are quite high. The Institute for Supply Management (ISM) manufacturing survey is at its highest level of the economic expansion. Bloomberg’s and the University of Michigan’s current conditions consumer confidence readings are at the highest level since the dot-com bubble. The University of Michigan consumer expectations index just surpassed its highs of the current economic expansion, while the National Federation of Business (NFIB) Small Business Optimism Index hit an all-time high last week.
• The leading economic index (LEI) gained or was flat for the twenty-seventh straight month in August, rising 6.4% year-over-year and signaling more economic growth ahead. This is the longest streak without a negative LEI since the mid-1980s.
Some segments of the U.S. economy are cooling, including housing and autos, and we acknowledge the risk associated with further escalation of trade tensions. However, we expect the positive impact of fiscal stimulus, including tax reform and increased government spending, to more than offset these potential drags on growth and help support continued gains in stocks.
Strong profit growth has helped buoy the stock market. After two quarters of annual S&P 500 earnings growth over 25%, a 22% increase is expected in the third quarter (which ends this week), followed by an expected 20% increase in the fourth (according to Thompson Reuters). Although the earnings growth rate may slow a bit in the second half, the strong economic backdrop – notably high manufacturing and business confidence – is likely to support continued solid earnings gains through year-end and into 2019.
Recent gains in the stock market are also encouraging given the rise in interest rates. Since August 24, the 10-year yield has moved from 2.81% to 3.05%while the S&P is up about 3%. Should investors be worried about a further rise in rates? If the moves are gradual, it should not be a problem. Historically, stocks have done quite well when rates rise, particularly over the past three decades. Since 1996, stocks have risen with higher rates every single time (12 out of 12) times). Since 1962, the S&P 500 has gained an average of 6.1% during the rising rate periods, with gains in 83% of those periods (average increase in yield of 2.2%, average length of time of 13 months).
We do not see rising rates as a reason to sell stocks, particularly in the absence of runaway inflation. The market is interpreting higher rates as a response to better growth, not as a reason to fear a policy mistake, which we find encouraging. We believe the economic and profit backdrop is strong enough to support further gains. There may be more volatility around trade policy, midterm elections, higher inflation, or pockets of stress in emerging markets. This bull market is already the longest ever, and the economic expansion may likely become the longest ever this spring. This so-called “wall of worry” that stocks are climbing is high. Based on our forecast for a favorable economic and corporate profit environment over the balance of 2018 and into 2019, we are sticking with a positive market view.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
• The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
• Data provided by LPL Financial, Thomson Reuters, and Bloomberg.
• Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and the potential liquidity in a falling market.
• All investing involves risk including loss of principal.