Index Performance and Analysis

The first half of 2017 finished higher with both quarters exhibiting a quiet upward drift and little turmoil of which to speak. For the year, the S&P 500 rose 8.2% with the Dow Industrials right behind it with an 8% gain. Each of these indexes rose a modest 3% for the second quarter. The outperformer this year, the Nasdaq, finished the first half up 14% for the year, rising around 4% this past quarter. Growth stocks have continued to shine: the IBD Mutual Fund Index tracks growth stock mutual funds and has risen 13% so far this year. Lagging in 2017 are small company stocks (up 4% this year), value stocks (up 3.5%), and bonds (the Bloomberg Barclays Aggregate Bond Index is up just 2.3%).

The overarching theme this year that is dominating all discussions of the stock market is the outright absence of volatility. A day or two of mild losses has been invariably followed by a day or two of slightly better gains. And the magnitude of these price movements is very low. The chart below tracks the average daily price movement of the S&P 500 each year; the higher the number the more the market has swung day-to-day.

As you can see we are currently experiencing the lowest average daily price movement since 1965. The market is calm. It neither falls very far nor rises very much. Notwithstanding this price lethargy, the trend, or bias, of the market is toward buying so as to participate in its steady growth instead of selling in fear of the next downturn.

That said, the market faces a flurry of headwinds: Republican infighting has stalled healthcare and tax reform, the President remains mired in Russia-talk instead of advancing his agenda, the Middle East is a powder keg, and North Korea is testing longer range missiles. In spite of these headwinds the stock market has managed to rise this year and participation among domestic companies has broadened.
Breadth Improves

Market breadth is a measure of company stock participation within broad index movement. Narrow breadth means that a handful of large companies are leading indexes higher or lower, whereas wider breadth means that more companies are contributing to the index’s performance. Narrow breadth can indicate a weak market in that although the headline index number is up, it is masking the fact that the majority of an index’s smaller components are down. At the beginning of the year it seemed that the market was advancing thanks mainly to a narrow band of technology stocks. However, both breadth and participation improved as we advanced further into the year.

A fuller representation of index performance can be seen with the help of equal weight indexes.
Equal-weighting index component companies gives the advances of Apple the same weight as the advances of a regional utilities company. The headline number of the equal weight index, then, better reflects how all the companies are performing as a whole. We can see from the chart here that the broad S&P 500 index and its three largest sectors (they make up over 50% of the index) either closely exceeded or were beaten by their equal weight versions. This tells us that the melt-up we have observed so far in 2017 is more substantial and is built on a firmer foundation than its sluggish advance would otherwise imply.

Only Politics Move This Market

The usual market movers-the Federal Reserve, the price of oil, and economic data-have failed to move the market so far this year. More than anything else the market is focused on, and remains somewhat optimistic about, the potential for deregulatory, business-friendly legislation to come of the Republican-controlled federal government.

The Federal Reserve Open Market Committee convened in June and again raised the federal funds rate a quarter of a percent. The Fed is reacting to what it sees as a strengthened economy; employment is full and inflation is on its way to the Fed’s target of 2%. The market barely reacted to this latest hike, which is precisely the reaction the Fed has aimed for with its “gradual” retreat from its emergency easy money policies. The Fed noted that inflation has been weaker than expected-weak inflation may be a sign of slowing economic growth-leading Chair Janet Yellen to reiterate the central bank’s commitment to a slower, more gradual tightening of monetary policy. The market rallied for a day on the prospect of a dovish Fed but that was the extent of the market’s reaction.

Another former market mover that investors have taken a nonchalant attitude toward is oil. Late in the quarter oil fell into a bear market, having fallen over 20% from its recent high. A barrel of oil traded as low as $43 on surging domestic output and waning demand. The broad market barely took notice as the correlation between it and falling oil was nonexistent. This is a far cry from the lockstep formation the two markets used to march in the past three years when oil fell nearly 60% from its peak. The world has begun to adapt to this new normal low oil price: Saudi Arabia is diversifying its economy and making a portion of its state oil company public, while tensions are rising in a Middle East not flush with cash with which to placate its subjects with generous welfare benefits, and efficient shale drillers have flooded the market thanks to the lifting of the ban on exporting domestic oil. These are all crucial global developments and will weigh heavily on the world economy in the years ahead. This year, however, the stock market’s attention has been concentrated solely on President Trump’s domestic agenda.

The stock market is still coasting higher on the Trump Bump of last year. Wall Street’s listlessness mirrors that of D.C. where Republicans don’t seem to know how to wield the power they’ve captured after years of chasing after it. Like the first quarter, the minor volatility we experienced in the second was thanks to the political blunderings of the President. Indexes fell almost two percent the day after reports came out that President Trump had asked then-FBI Director James Comey to ease off his investigation of former national security adviser Michael Flynn. Markets quickly recovered though they remain beholden to the possibility of healthcare or tax reform, and to whichever latest controversy is uncovered by the New York Times and then babbled about by the President on Twitter.

Nevertheless, the stock market persisted. The market has an upward bias because the fundamentals of this economy are sound and improving. Not only are consumer sentiment and unemployment at record levels (see below), but home sales and construction are up, and corporate earnings have grown rapidly and are on pace to continue that growth. A recent national Bloomberg poll found that 58% of Americans believe they are moving closer to their career and financial goals, tying the highest recorded number the poll has seen for that question. So, despite the political uncertainty here and abroad that we face, Americans are feeling confident in the economy, if not in politics. We maintain a cautious optimism for the market going forward with our attention turned to Washington, D.C.

Key Economic Indicators

Gross Domestic Product

GDP growth came in at 1.4% for the first quarter of the year. Ever since the recession the first three months of the year have seen consistent weak growth numbers, with growth averaging just around 1%. While the Trump Bump boosted stock prices to new highs, the President’s influence is yet to be felt in hard GDP data. Granted, the President has only been in office since January and his legislative agenda has been stalled by intraparty bickering, but he and his Treasury Secretary Steven Mnuchin have consistently touted 3% growth. Consumer sentiment and confidence remain elevated though neither has yet to translate to renewed spending. Spending accounts for over two-thirds of GDP so any uptick would certainly nudge those growth numbers up.

The first estimate for second quarter growth will arrive at the end of July. Economist predictions range from 2% up to 3.5% suggesting more of the same tepid growth.

Consumer Sentiment

Consumer sentiment remains well above its non-recession year average. The persistence of positive consumer attitudes despite little to show from Washington is a testament to the interplay of two phenomena: (1) American consumers, broadly speaking, have more cash in their wallets thanks to steady employment and low overall inflation; and (2) many Americans remain confident that President Trump will be able to overcome the status quo growth malaise that has become an ingrained part of our national consciousness. For the time being, Americans are giving the President the benefit of the doubt when it comes to his ability to effect change, although legislative gridlock may begin to erode confidence as we progress further into 2017.
Employment Situation

The job market remains hot as this past quarter saw the unemployment rate fall to its lowest level in well over a decade. The unemployment rate in June was 4.4%, below the “normal” rate and just a notch above May’s 16-year low of 4.3%. Overall wage growth is lagging these employment gains as employers have not yet begun raising wages significantly in order to retain or capture talent. However, should the unemployment rate remain below its normal level we may expect to see both wages and inflation pick up through the rest of the year.

The total unemployment rate also fell this past quarter (from 8.9% in March to 8.6% in June) showcasing the broad hiring of American workers. And the prime-age labor force participation rate has edged up steadily since bottoming in 2015. Such tight labor conditions may bode well for the economy going forward with the healthy labor market providing a solid basis for renewed economic growth.
Looking Forward

A low volatility market gives both bulls and bears anxiety and this anxiety leads to irrational investment decisions. For bulls the calm market lulls them into a false sense of security. They feel that such a steadily rising market could never fall and they buy into riskier assets to amplify their gains. Bull markets die on such euphoria. When the inevitable correction occurs the investor’s losses are magnified by those risky assets and he is left even deeper in the hole.

Similarly, a flat market invites bears to proclaim that this is the calm before the storm. Their relentless doomsaying may encourage investors to observe the market from the sidelines so as to avoid the market apocalypse they claim to foresee is just around the corner. But nobody can predict the future, and while not participating in the stock market means you will prevent losses, more importantly it also means that you will forfeit significant gains. Excessive cautiousness can be just as detrimental to the health of an investment portfolio as excessive risk-taking.

We believe the proper course to take during a low volatility market is one of moderation: we are wary of the bull market’s age and weaknesses but we also acknowledge that a quantified investment process can enable insightful participation should the market continue to advance. We expect volatility to pick up in the third quarter but we will approach it with the confidence that our diversified portfolios and investment software provide. As Credit Suisse economist Michael Mauboussin states, “We have no control over outcomes, but we can control the process.” Our investment process will help to guide us through the volatility that may arrive this next half of the year owing to the political uncertainty flowing from our nation’s capital.

Vince Westerman and David Millet
The Westerman Group, LLC
114 East Aurora Rd., Suite 100, Sagamore Hills, Ohio 44067

THE WESTERMAN GROUP, LLC is a Registered Investment Advisor
Securities offered through MerCap Securities, LLC, Member FINRA/SIPC and wholly-owned subsidiary of MerCap Enterprises, Inc., Address: 40 Darby Road, Paoli, PA 19301
Phone: (877) 784-8021
The Westerman Group, LLC and MerCap Securities, LLC are not affiliated.

Performance Disclaimer

No investment strategy or methodology can guarantee profits or protect against losses. Investment risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over time. Investment risk is inherent in every individual portfolio and no computer model or modeling program used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling program may not reflect actual risk and return parameters applicable to any particular portfolio or investor. Actual investment decisions made on the basis of a computer generated model or modeling program may be materially different from expected or intended results, and any computer modeling program is subject to errors in the program and system failures at any time.

Sources
http://www.bea.gov (GDP data)
http://www.bls.gov (employment data)
http://www.google.com/finance (index returns)
http://www.sca.isr.umich.edu (consumer sentiment)
Atlanta Fed GDPNow: Forecast for 2017: Q1, FEDERAL RESERVE BANK OF ATLANTA, July 14, 2017.
Minutes of the Federal Open Market Committee, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, June 13-14, 2017.
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