• According to market strategist Tom Lee of Fundstrat, stripping out the 10 largest weighted S&P 500 stocks, would result in a gain of 4% ytd. This is evidence of how narrow and selective the market advance has been. A tech S&P 500 weighting of 25% has bolstered the returns of these 10 top gainers, and propelled growth returns of +17.7% over value at +4.7% thus far. With growth overvalued, we believe we are close to an inflection point where value will likely outperform, perhaps for the next several years. This will negatively impact the returns of passive investment strategies, similar to what happened in l999 when the dotcom stocks peaked.
• The Fed should shortly announce its scheduled balance sheet reduction plan. Initially, they will let $10 billion of treasuries and mortgage backed securities mature without reinvestment. This will gradually rise to $50 billion monthly by yearend 2018. The runoff of investments will cause a decline in excess reserves, but is unlikely to negatively impact risk taking. For many years these reserves have been sitting dormant, earning interest but not used by commercial banks to increase lending.
• Nevertheless this policy may have unintended consequences. A smooth running exit may engender "animal spirits," and lead to increase in risk taking. An increase in borrowing would drive interest rates higher, causing the Fed to respond with its usual lag, by pushing up the Fed funds to perhaps 2% (FOMC dot target for 2018). Under this scenario, Treasury yields on 10year maturities could hit 3%, a level that would increase volatility in risk assets.
• Oil prices should rise over the months ahead, benefitting from declining inventories and flat production, which are offsetting seasonal demand weakness. Meanwhile, geopolitical risks are elevated. These include possible curbs on Venezuelan imports, a termination of the Iranian nuclear deal, and a possibility the Saudis will be forced to act alone, before their scheduled November 30th OPEC meeting, by cutting production to stabilize cartel compliance at 70%.
• Ninety-five percent of equity bear markets are caused by U.S. recessions. While valuations are stretched, and the Fed is gradually removing liquidity, we see few signs of a recession beginning in the next six to twelve months.
• As such, equities should outperform bonds, at least through the first half of 2018. Foreign markets offer more attractive value, and should continue outperforming their domestic counterparts. We prefer Europe, Japan (removed currency hedge), China "H" shares, and are looking to purchase South Korea on any weakness. While U.S. tech/telecom are fairly priced, SK offers above average exposure to these sectors at more reasonable valuations.
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