Locally based CPA firm since 1956

The Markets – The S&P 500 index finished September +0.57% bringing the year-to-date return to +8.99%. The Dow was +1.51% for the month bringing it to positive territory year-to-date at +7.04%. The bright spot in the markets is the NASDAQ which finished the month +0.20% and year-to-date +16.56%, according to the Wall Street Journal.

A strengthening U.S. economy and some good news about the yield curve, discussed further in a moment, are the key factors helping investors look past the continuing trade spate between the U.S. and China, Canada, and other nations.

We have the year’s strongest quarter to look forward to. October in the past 20 years has been seasonally strong. Furthermore, forecasted third-quarter sales and earnings are expected to remain strong, thanks to 4.4% estimated GDP growth, so “peak earnings momentum” has yet to arrive. We expect wave after wave of strong announcements to propel stocks higher in October and after the mid-term elections in early November. Regardless of the results, since most of the political distractions will finally be over. As Thanksgiving nears, typically an early “January effect” commences as small-to-mid capitalization stocks tend to end the year on a strong note.

Hitting closer to home, oil prices edged higher during September and closed the month on a high note, with Brent crude currently trading at over $81/barrel, and WTI prices over 72/barrel. On average for the month of September, Brent prices have averaged over $78/barrel, and WTI prices have averaged nearly $70/barrel. In September, Brent crude prices hit their highest level in 4 years. The difference (or “differential”) between Brent and WTI prices has widened in the past month, widening from about $5/barrel to nearly $10/barrel. The greater premium of global (Brent) prices over oil prices in the mid-continent U.S. likely reflects a combination of (a) supply constraints in the global oil market given a variety of factors, the most notable being the impending re-imposition of sanctions against Iran.

More about the yield curve : Guiding the collective fears of those on a “recession watch” is the spread between the 10-year and 2-year Treasury notes, which currently stands at 23 basis points, just off the recent low. There is a credible reason for investors to be watchful of the “10/2 spread,” as a recession has occurred every time since 1980 when this spread has “inverted,” meaning that the rate on the 2-year is higher than the 10-year rate.

Inversion of the 10/2 spread doesn’t mean a recession is just around the corner, though. There have been five recessions since 1980 and the average time between the first inversion and the following recession has been just over 18 months, with a range that has spanned 10 to 24 months. But, as most investors are keenly aware, the stock market will begin to adjust well before the economic contraction actually occurs.

With the S&P 500, Nasdaq Composite, and Russell 2000 all hitting new record highs, there seems to be a sense that the narrowing spread between the 10- and the 2-year note is not going to invert even as the FOMC raised the target range for the fed funds rate again at its September 25-26 meeting. The latest move up in the 10-year yield from 2.82% to 3.06% during the past month appears to have minimized any inversion fears, at least for now.

While the Fed’s research acknowledges the validity of the yield curve as a reliable predictor of recessions, the main takeaway from the San Francisco Fed’s August report is the notion that the spread between the 10-year note yield and the 3-month T-bill yield is the most reliable predictor of recession among the various short-term yield spreads. This conclusion has some “Wow” factor to it. Until this paper was released on August 27th, no one talked about the 10yr-3month spread!

Because the spread between the 10-year yield and the 3-month yield is a wider 86 basis points, whereas the spread between the 10-year and 2-year yield is just 23 bps, institutional fund managers took this highlighted finding to heart and it could be the #1 reason why the market vaulted higher in the last week of August and maintained those levels throughout September. It was like a free extended pass for the summer rally and buyer euphoria just took off.

To sum it all up, the U.S. continues to see robust economic activity, constructive fiscal policies, and solid corporate profits, all of which support U.S. stocks. As the new found money from the recent tax cuts trickle through the corporate world, we hope that earnings momentum continues into 2019 and remains supportive of current market valuations. In the short run, headlines affect markets. In the long run, earnings affect markets.

What could cause more immediate upside? U.S. and China trade negotiations lead to an amicable compromise. China agrees to narrow the trade deficit through increased purchases of U.S. agricultural and energy products, as well as curtail transfer requirements and intellectual property theft. On the other side, the U.S. agrees to withdraw its push to limit the “Made in China 2025” initiative.


Have a question? Let me know! Email me at kcompton@wsmtexas.com.