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The Markets This Week

September 13, 2017 | Weekly Commentary

The market should be facing a disaster of biblical proportions.

We have hurricanes and earthquakes, a nuclear-armed dictator in North Korea threatening to unleash fire and brimstone, and yes, even a Republican president working with Democrats in Congress. Or as Bill Murray put it in Ghostbusters, “Mass hysteria!”

Not quite. Despite the suffering brought by a trifecta of natural disasters, and the shock of seeing President Donald Trump teaming up with Nancy Pelosi to extend the debt-ceiling deadline, only nuclear tests by North Korea really shook the markets. And even then, it wasn’t much of a shock. The Standard & Poor’s 500 index declined just 0.6%, to 2461.43, last week, while the Dow Jones Industrial Average fell 189.77 points, or 0.9%, to 21,797.79. The Nasdaq Composite dropped 1.2%, to 6360.19. Despite the declines, the S&P 500 sits just 0.8% below its all-time high.

Why have stocks held up as well as they have? Dubravko Lakos-Bujas, head of U.S. equity strategy and global quantitative research at JPMorgan, observes that the S&P 500 has dropped about 2% when hurricanes make landfall, as sectors that get slammed—think insurance companies, hotels, and cruise lines—are offset by ones that benefit, like autos, energy and equipment services, and basic materials for construction. A failure to raise the debt ceiling or pass a budget, though, has typically caused the market to drop 3% to 5%. “In essence, the market risk associated with the failure of passing the budget and addressing the debt ceiling has been pushed out for now,” Lakos-Bujas says.

There’s another reason for optimism: earnings. Yes, we know that second-quarter earnings season just ended, but investors are already looking ahead to the third quarter. And despite some recent negative guidance associated with Hurricane Harvey, earnings revisions appear to be holding up well. Bank of America Merrill Lynch strategist Jill Hall notes that the three-month earnings estimate revision ratio—a measure of companies guiding higher versus those guiding lower—sat unchanged at 1.23 at the end of August, its highest level in six years. “It suggests strong near-term S&P 500 returns,” she says.

More importantly, that means earnings expectations aren’t coming down. Andrew Slimmon, a portfolio manager at Morgan Stanley Investment Management, notes that earnings forecasts generally drop by about 7% from the start of the year. But with earnings coming in close to expectations, the market might start viewing next year’s S&P 500 earnings estimate for $145 as achievable. At Friday’s close, that puts the index’s valuation at a more reasonable 17 times earnings. “I don’t think that’s all that expensive,” Slimmon says. “We have a setup for a decent rally in the fourth quarter.”

Of course, not everyone is ready to buy into such arguments. For them, the market’s strength is simpler. “It’s a bull market,” says Vincent Deluard, global macro strategist at INTL FCStone Financial. “Good news is celebrated; bad news ignored.” Until it isn’t.

(Source: Barrons Online)

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