The first quarter of 2017 saw a steady stream of unsettling domestic and international news. An investor observing this would have likely expected much worse equity market volatility than was experienced, and might have been tempted to entirely avoid exposure to the equity market. However equity market volatility was at very low levels - the S&P 500 Index went 55 straight trading days without a 1% or greater move in either direction, and the VIX index averaged 11.7 in the quarter, the lowest first-quarter average on record going back to 1990. Protection against the behavioral tendency to react to news flow is one of the main benefits our system is designed to provide. Our signal remained in the ‘offense’ state throughout the quarter.
Despite all the disquieting headlines, equities are currently being supported by many positive factors: S&P 500 earnings are strongly growing again after declining for several straight quarters; the Federal Reserve is raising interest rates at a measured pace, comforting investors that no surprise moves are in store while simultaneously encouraging portfolio rebalancing away from bonds and into equities. Perhaps one of the strongest factors supporting equities is sentiment. The above chart from the NFIB, a trade association for small businesses, shows the recent dramatic rise in small business optimism, likely responding to the current administration’s aggressive pursuit of a pro-growth agenda.
A nervous investor could be forgiven for feeling pessimism, however. The U.S. manufacturing sector continues to stagnate, with production volume remaining essentially flat for the past five years at a level equal to that first reached in 2004, and well below the peak level reached in 2007.
Meanwhile global debt as a percent of GDP has continued its rise and now exceeds levels seen in the depths of the financial crisis.
Perhaps most concerning is a recent steep decline in the growth rate of U.S. bank lending. The causes for it are unclear, but its coincidence with the Federal Reserve’s positioning on interest rates in late 2016 is uncanny. If the decline continues it signals the exact sort of credit market tightening that has contributed to past recessions.
While certain economic indicators are promising and business is feeling optimistic about growth prospects, not every indicator is positive and some are downright worrisome. Our economy and equity markets have been particularly perplexing and difficult to analyze since the financial crisis, to say the least. It is for confusing times like these that we developed our investment system.