3rd Quarter sees more record highs
with broad-based participation

October 2017

If you told someone that we would see new All-Time market highs in an environment that included North Korean nuclear threats on our territory and missile flybys over ally Japan, the Fed announcing the start of its balance sheet normalization plan, the US dollar would decline 10% for the year and we had three historically destructive hurricanes, they would say to you were crazy. Well, here we are.

Investors around the globe looked past headline events and focused on improving global economic growth conditions, sending stocks strongly higher in the Third Quarter. In the US, that translated into new All-Time Highs across the major market indexes, even on the very last trading day of the quarter. Despite the many headwinds and elevated threats from North Korea and stark warnings in response from President Trump, we actually saw volatility decrease 15% during Q3, though not without short-term spikes. Many are calling it investor complacency of risk, others saying the market reflects renewed optimism of tax-reform and prospects for an economy breaking out of the muddling 2.0% GDP growth in which we've been mired for years, to something north of 3.0% and more in line with our long-term economic growth rate.

Q3 saw a welcomed broadening of the market with balanced performance across market caps and styles. During the first half, we saw growth stocks dominate the market up and down market capitalization. The tech-heavy NASDAQ still continued to lead the US market with a 5.8% gain in Q3, raised its gains for the year to 20.7% and set All-Time Highs along the way. However, small-cap stocks, which had lagged significantly in the first half of the year due largely to the slide in the US dollar, got a boost from optimism about tax-cuts and tax reform and some late stabilization of the US dollar. The Russell 2000 jumped 5.3% in Q3, setting All-Time Highs, and finished up 9.9% for the year. Large-cap stocks have many deductions and ways to manipulate their actual tax rate paid, while small-caps tend to pay closer to the actual corporate tax rates. So when talks about the top corporate rate of 35% being reduced to 20%, as proposed by the Trump Administration, small-cap stocks stand to benefit disproportionately relative to large-caps. The Dow wasn't far behind, gaining 4.9% for the quarter and pushed its gain for the year to 13.4%. The Dow closed over 22,400 to set an All-Time High on the last day of the quarter. The benchmark S&P 500 gained 4.0% in the quarter and closed up 12.5% YTD at an All-Time High. Mid-cap stocks posted decent Q3 gains too, up 2.8%, but notably lagged their counterparts and finished the quarter up 8.2% YTD. We've remained in a low-volatility market environment. While we've had a couple of modest 1- 3% declines this year, they have been short-lived, met with buying and followed by new highs. It's been over a year and a half since we've had a 10% correction, when historically they happened about once a year.

Like our markets in the US, foreign markets largely looked past the unnerving headline news as well and posted solid gains. The benchmark MSCI EAFE index gained 4.8% in Q3 to end up 17.2% for the year. The returns posted in the WAA and in major financial publications are in US dollar terms. It's notable that the US dollar ended the 3rd Quarter down 9.2% for the year. In local currency terms, the MSCI EAFE index has gained 8.6% YTD. Currency effects have played a large role in the foreign outperformance for the year. To capture the full diversification benefits of international stocks, investors must invest in unhedged international stock mutual funds. However, the currency effects aside, foreign economies have a number of attractive economic trends working for them, including leading business indicators turning positive, rising manufacturing and increasing consumer confidence, as well as better valuations than the US. According to JP Morgan, the S&P 500 is trading at 17.7 times earnings ending 9-30-17, which is above its 20-year average of 16. The MSCI All-Country Index (ex-US) is trading at 14.2 and below its 20-year average of 14.6. Moreover, foreign markets underperformed US markets for 10 years prior to this recent advance. Since the March 2009 bottom post-financial crisis, the US markets have more than doubled the performance of foreign markets. The ECB and Bank of Japan continue to provide easy monetary policy, which contrasts with the US (see below), though that will not continue indefinitely.

The Fed has raised interest rates twice this year and indications now point to a third rate hike in December as it seeks monetary policy normalization. At its September FOMC meeting, the Fed upgraded its view of the economy and announced it will also start reducing its massive $4.5 trillion balance sheet in October. Not to disrupt markets, the Fed laid out a detailed reduction plan that is slow and methodical. The initial reduction will be $10 billion per month and gradually increase it to $50 billion in the quarters to come. Interest rates rose slightly in the 3rd Quarter but it wasn’t without volatility. With geopolitical tensions with North Korea elevated, the flight to safety caused interest rates to plunge to their lowest levels of the year in July. As those tensions ebbed and flowed along with global investors assimilating to conditions, interest rates rose through September and were also aided by strong economic reports, comments by the Fed as well as the above noted announcement of the start of the balance sheet normalization. The combination rekindled notions of higher interest rates going forward. The benchmark 10-year T-Note yield closed Q3 at 2.33% after hitting a low of 2.09% in July, due to a 21 bps rise in September. It was no coincidence that the US dollar stabilized somewhat in September.

The Outlook

Not only did we get past September unscathed, historically the worst month of the year, the US market hit new All-Time Highs in broad based fashion and closed the 3rd Quarter with optimism. As we turn to the 4th Quarter, we see the following potentially driving the markets going forward.

• Global economic synchronization continues to strengthen
• Corporate earnings remain solid
• Positive fundamentals and technicals remain
• Low unemployment
• Rising investor and consumer confidence
• Renewed optimism of Trump Tax-Reform, focusing on both corporate and individual tax-cuts
• Geopolitical tensions with North Korea escalating
• Fed raising rates too aggressively, including its Policy normalization
• Change in Fed Chair unfavorable with the market
• No tax reform
• Market valuations getting stretched
• Further Trump administration disruptions including Russian investigation fallout

As noted earlier, volatility remains near all-time lows and we continue to anticipate some spikes in volatility at some point given many of the variables at play. However, it's important to acknowledge an old Wall Street adage that "bull markets don't die of old age," rather they end due a catalyst of some kind. Year-end is approaching and now is a great time to discuss year-end planning with your Nelson Advisor, so call 800-345-7593 today to make an appointment. We continue to recommend investors stay committed to their investment strategies and look at pullbacks as buying opportunities.

Robert O. Nelson, Jr