A rash of late summer/early autumn heat here in Philadelphia has made post-Labor-Day suit wearing extremely uncomfortable. As a fairly conservative dresser, I am not going to debate business attire, but I am going to note that September and October temperatures have often had me thinking about changing into shorts and a t-shirt. Accompanying these unseasonably warm temperatures has been frequent talk among market prognosticators of a potential equity market “melt-up.” The rationale for a hot upward price rise ranges from synchronized global economic growth, strongly advancing earnings, persistently low inflation and loosening regulatory conditions to the potential for sweeping tax reform. Since many of the forecasts for a robust near-term market advance come from analysts who rely heavily on past price moves and not valuation or sentiment measures, I am highly skeptical. Just as the days are likely to get shorter and cooler, I think this Indian Summer too will pass.

Under the Weather

Despite an unrelenting series of weather disasters ranging from Harvey to Irma to California earthquakes and fires, both developed and emerging economies are growing smartly. The U.S. September unemployment rate fell to 4.2%, the lowest since February 2004 and the overall eurozone unemployment rate for August held steady at 9.1%, an eight-year low. U.S. Non-Manufacturing and Manufacturing Purchasing Managers’ Indexes have reached their highest levels since August 2005 and May 2004 respectively and are accompanied by corroborating data from Germany’s Manufacturing PMI at 60.6, France’s at 56.1, Italy’s at 56.3, Spain’s at 54.3, and the United Kingdom’s at 55.9. While the Federal Reserve Bank of Atlanta forecasts U.S. third quarter GDP growth at a solid +2.5%, I would not be surprised to see fourth quarter GDP grow vibrantly to over 3%. Strong economic growth and the long delayed uptick in average hourly earnings growth to 2.9% is providing reinforcing evidence to a Fed committed to neutralizing monetary policy. As such, fed futures contracts now anticipate an 80% probability of a quarter point increase in the fed funds rate to 1.25% in December. Anticipating this growth, most broad equity measures ended the third quarter near record levels. Unfortunately, current measures of growth are so high that future six month forward stock market returns have historically been weak. The September Purchasing Managers Index was so high that at 60.8 I am concerned about Fed tightening and weak S&P 500 returns going forward. To word it differently, while high levels of Leading Economic Indicators and tight credit spreads point to continued economic expansion and low probability of an imminent recession-induced bear market anytime soon, I would not be surprised if high valuations and elevated investor sentiment limit intermediate returns to equity investors.

It’s Always Sunny in Philadelphia

Navigator equity portfolios and broad-based equity markets performed well last quarter — many reaching new all-time highs. Although I am reluctant to attribute these advances to any one factor, supportive credit conditions, expanding profit margins and strong global growth have likely aided. As a portfolio manager reviewing client asset levels, strategy performance and investment opportunities, I feel highly conflicted when markets jump out to new highs. On one hand, I wrongly feel brilliant — confusing “Capital Gains” with “Brains” and on the other hand, extremely anxious as underlying valuation metrics of many portfolio holdings reach full valuation. Despite the currently high barometric pressure, we know it’s not always sunny in Philadelphia. Finding new ideas is more challenging in our Small and SMID cap strategies as the underlying P/E ratios of the S&P Mid Cap and Small Cap reach 22.9 and 26.2 respectively. Historically, we have found that most valuation metrics are (a) not good timing tools — but rather risk measurements, and (b) should be used in relation to the current level of interest rates. Despite the difficulties noted above, we will continue to adhere to our disciplined process of seeking to find undervalued, high quality companies with accelerating business momentum.

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