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Market Data Bank

3Q 2018


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Stocks shot up in the third quarter of 2018, returning +7.7% in price appreciation and dividends.

Historically stocks averaged about a 10% return annually for the last eight decades. So, a quarterly return of 7.7% is excellent.


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Comparing last quarter's 7.7% return on the S&P 500 with performance in the previous six quarters is a snapshot of a bull market.


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The bull market turned 111 months old in September. Over the last 60 months stocks nearly doubled in value, returning +92%, with dividends and price appreciation.

Price appreciation accounted for +73% of the often-cited S&P 500 index return and 19% came from the reinvestment dividends.

The likelihood of a bear market - a correction of at least 20% - increases as the bull market grows older. But the usual precursors to a bear market - restrictive Fed policy, the likelihood of slowing economic growth, and irrational exuberance - were not evident at the end of the third-quarter. Nor were fundamental economic conditions that accompanied bear markets in the past evident. To the contrary, the second-longest economic expansion in modern U.S. history gathered surprising new strength.


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As the fourth quarter of 2018 began, Federal Reserve Board Chair Jerome Powell depicted a throwback to conditions seen only briefly in post-War history, and the latest data reinforced what Mr. Powell called "a remarkably positive outlook."


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Large cap growth stocks were most appreciated of the six main types of U.S. stocks, while small cap value companies trailed.

But even the laggards were a winner last quarter! Small cap value companies returned 2.6%, a good quarter's performance.

Growth companies' stocks logically appreciate more than other types of stock market investments in times of economic strengthening.


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Health care companies share prices were bid up, returning 14.5%, 40% better appreciation than the second-best industry sector performer last quarter, industrial stocks.

Raw materials and energy companies lagged in this snapshot of S&P 500 industry categories. The world is able to produce more energy and mine more raw materials than the market needs, depressing natural resources prices and shares in the companies that extract raw materials. These industry sectors eked out fractional gains in a quarter of booming economic activity.

Meanwhile, utilities and financials were in the in seventh and eighth place among the group of 10 industry sectors the ratings agency uses to analyze financial conditions at America's largest 500 publicly held companies. With a 2.4% on utilities and a 4.4% return on financial shares, performance of these two sectors depend heavily on interest-rate conditions, which were favorable last quarter, as higher rates helped boost their value.

The 9.9% total return on communications and 10% on industrials is equivalent to the average yearly returns on the S&P 500 for the last eight decades.


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Looking at investment returns in stock markets from across the world versus the returns on domestic shares, American company returns led by a large margin.

China's fledgling stock market tumbled in the three-month period on heightened fears of a trade war with the U.S.


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The strong returns on the S&P 500 propelled it the top of this list of 13 indexes representing different asset classes tracked in this quarterly update.

Crude oil prices strengthened in the third quarter and that boosted master limited partnerships, a business form favored by certain energy producers.

Agricultural commodities were the worst performer, as grain prices slumped on China's threats to curtail U.S. soybean imports.


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The S&P 500 returned a strong 10.8% in the first three quarters of 2018.

But it was not a straight line up. Like all bull markets, the road higher required a stomach for some precipitous dips and sometimes frightening headlines.

The year opened strong in January but a 10.2% plunge in February marked the only drop in the first three quarters that met the definition of a "correction."

Conventional wisdom is that securities markets are subject to a 10% or even 15% drop on emotion at almost any time. A bear market, a drop of 20% or more can also plague markets from time to time, but bear market drops in U.S. stocks usually - thought not always - occur when the economy shrinks.


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With 16.2% return on Smallcap growth stocks, over the nine months that started 2018.

Value shares were out of favor, and that is clear from the 14.7% gain in the S&P 500 growth index versus the 3.4% return on S&P 500 value shares. Investors big up shares of growth companies, as the economic expansion gained momentum and the earnings forecast for 2018 and 2019 improved throughout the year.


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Americans consumers went on a shopping spree in the first three quarter of 2018 and, with growth expectations for 2018 by the Federal government rising in each of the three quarters of the year, lifting consumer discretionary and technology stocks to a total return of 17.1%. They were the No. 1 performers of 10 industry sector indexes defined by Standard & Poor's, the ratings agency, to classify the 500 largest U.S. publicly-held companies.


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Returns on foreign stock markets paled in comparison with the U.S.

S&P's index tracking markets in Asia Pacific lost seven-tenths of 1% of its value in this nine-month snapshot, while the European stock index lost 1.9%. Emerging markets and the highly volatile Chinese stock market, respectively, plunged in value by 8.8 and 9.8%, over the first nine months of 2018.


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After a terrible 2016, oil languished but in the last nine months price recovered.

Predicting oil prices requires discounting many variables - like the future of U.S. relations with Saudi Arabia, effectiveness of American sanctions on Iran, and worldwide demand. It defies prediction.

To be clear, gold was a really bad investment in the first nine months of 2018 but companies with ads on financial TV were promoting gold as a good investment. Who knows?

Since the 1950s, a theory about the characteristics of portfolios, holding that a theoretical investor is more likely to succeed by owning a diversified basket of investments, has gained credibility and has been the focus of investment planning for consumers.


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Modern portfolio theory is a large body of financial knowledge based on academic research done over the last 70 years.

This framework for investing is now taught in the world's best business schools and embraced by institutional investors.


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The world is too dynamic and not enough statistical history exists to make predictions with certainty.

MPT is a framework for managing investment risk based on financial, economic and statistical facts.

In addition to classifying investments based on their distinct statistical characteristics, MPT imposes a quantitative discipline for managing assets based on history and fundamental facts about finance.

MPT does not guarantee success but its logic is embraced by pensions funds and other institutional investors and it has become the basis of the study of investing at colleges and universities.


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This chart shows a significant difference in returns on six types of U.S. stock market investments based on their characteristics.

Large growth companies returned 115.2% in the five years ended September 30, while companies classified as large-cap value returned half as much, 67.6%.

The market's preference for fast growing stocks over slower-growing companies that sell at a lower price-to-earnings multiple difficult to predict, which is why investors diversify - to avoid investing in any one style category.


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Looking at which industries were the best stock investments in the five years ended September 30, 2018, the dominance is of the fast-growing technology companies stands out. Propelled by Facebook, Amazon, Apple, and Netflix, tech stocks returned an incredibly strong 174.8%, with dividends reinvested.

With 70% of economic growth tied to consumer spending, shares in companies selling discretionary products and services to consumers returned 110.5% in the five-years. While health care company shares in the S&P 500 returned 104.4%, even as the nation struggled to contain the cost of health care. Financials' strong five-year performance reflects a steady recovery from the wipeout they experienced in the 2008-09 global financial crisis.

The energy and material sectors suffered from the collapse in the price of crude oil and most other commodities. The price of crude oil has roughly tripled from its bottom of $26 per barrel in early 2016 but remained well below its peak price in 2014 of $114 per barrel. The energy sector of the stock market is highly correlated with crude oil prices.


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The U.S. stock market outperformed the rest of the world by a substantial margin over the five years ended September 30.

The 92% total return on the S&P 500, a benchmark of the performance of America's 500 largest public companies, accompanied one of the best economic periods of post-War history.


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The Small Business Optimism Index recently hit its second-highest level in its 45-year history the third quarter.

After The Great Recession, in April 2009, small business owners grew more optimistic steadily, until optimism surged in 2018 and then it went higher in recent months.

This index of optimism among business owners surveyed monthly ended the third quarter about as high as it's been in 45 years.

Small business creates 70% of net new jobs in the private sector, so that's important.


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Another key fundamental helping stocks achieve such strong returns in recent years was that unemployment has been on a steady decline since 2010. From its record low in August, unemployment ticked lower in September - as low as it's been since 1969.

Remarkably, core inflation hardly budged, even as the labor market has grown tighter. Growth without wage inflation is an accurate description of current economic conditions, which is why the Fed chief in October declared these times extraordinary.


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At the top of the list of this wide variety of 13 asset classes for the five years ended September 30, 2018 was U.S. stocks. The S&P 500 return of 92.1%, beat the No. 2 performer, a benchmark of real estate securities investments, which returned 53.8%.

The S&P 500 index's total return of +92% over the five years is over three times the S&P Global ex-U.S. stock market's return of +28%. It is testament to how resiliently the U.S. economy came out of the last, severe global recession, compared to other countries.

In last place, of course, is crude oil, having been broken by the surge in U.S. supply that came from the shale-fracking revolution. Commodities and gold, too, have been money-losers over the five years with benign inflation and an ample supply of most commodities.


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The 7.7% total return made the three months ended September 30, 2018 the best quarter in five years and shares settled were a near the record high.

But the nine-year-old bull market is the longest in modern U.S. history. And the expansion is the second-longest on record!

How long can this go on? What's driving stocks?


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Earnings are driving stocks!

The S&P 500 profit expectations surged in the first eight months of 2018, contrary to their normal pattern.

Earnings estimates by Wall Street analysts for six years in a row - from 2012 to 2017 - started out overly optimistic and then gradually were shaved back as the end of each year approached.

That pattern was nothing like what's been happening lately.

Since the beginning of 2018, when the new federal tax law came into effect, analysts did not lower their expectations! To the contrary, earnings estimates surged for 2018 and 2019!

The initial surge, in the first few months of 2018, was expected; analysts had to factor the tax breaks in to their earnings forecasts and it would be a one-time adjustment.

But earnings forecasts continued to brighten, accelerating in April through August 2018, beyond the one-time upward revision that had been expected to follow the introduction of a new Tax Code.

THAT was an unexpected surprise.


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Sales revenue estimates generally showed the same pattern as profit estimates in recent years.

Wall Street's expectations for sales were shaved back materially as the end of each year closed in; but in 2018 and 2019, the pattern was broken - revenue estimates for America's largest public companies accelerated sharply!


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Unlike corporate profits, accelerating sales estimates are not driven by taxes or accounting: sales are driven by consumers.

The accelerating rate of expected sales revenue is a sign of unexpected consumer strength.

Consumers account for about 70% of the annual rate of U.S. growth, making this a key fundamental sign of momentum.


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Meanwhile, in another sign of growing economic strength ahead, the Federal Reserve's Federal Open Market Committee revised upward its quarterly median forecast for growth in 2018.

From a June projection for 2.8% growth in 2018, central bankers boosted their expectations for growth to 3.1%!

It was the fourth consecutive quarterly revision upward for growth by the Fed.

In September 2017, the Fed expected the economy to grow 2.1% in 2018; just a year later, they boosted expectations to 3.1%!


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With the economy performing better than expected, Fed chair Jerome Powell affirmed the Fed's policy was on track.

At a one-hour press conference on September 26, Mr. Powell said the Fed would not hike interest rates if inflation temporarily rises above the 2% target rate.

Inflation is muted and likely to remain so, according to Fed forecasts, so the central bank chairman is unlikely to raise rates aggressively and put the brakes on economic growth.


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The surge in earnings expectations is what's driving stock prices, and the sales revenue increases indicate unexpected underlying consumer strength, and inflation is not a problem.

How long can the good times go on?

No one knows. But they show no signs of ending as the fourth quarter of 2018 begins.

 


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INDEX OF QUARTERLY MARKET SUMMARY

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