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Jon E. Quigley, CFA®
Chief Investment Officer - Disciplined Equities
Great Lakes Advisors

As we begin Q4 2018, the U.S. economy continues to expand at an accelerating rate, despite the measured normalization of interest rates as the quarter end tide recedes.

Employment conditions remain very strong, with a headline unemployment rate of under 4%, very high manufacturing hours worked per week, and close to a cycle low for unemployment duration. Despite this, the Employment Cost Index remains well-behaved.

Industrial activity is also robust. High levels of both Purchasing Manufacturing and Service Indices speak to elevated confidence. Consumers are no less confident, with confidence indices hovering at, or near, 20 year highs. This has translated into robust retail sales growth.

The aforementioned interest rate normalization (Fed Funds at 2.25%, 10-Year Treasury yielding 3.25%) will eventually dampen economic activity, but for now, rising rates seem to be having the largest impact on the housing sector. Even here, we see only a modest leveling-out/slowing of activity—yet homebuilders are in a bear market as of mid-October.

Overall, though, the language from the Federal Reserve Board and member banks brings to mind “Goldilocks” days of yore.

Looking Ahead
Heading into 2018, our work led us to believe a rolling correction for U.S. equities was a likely outcome for the year. Our thought was, that although the U.S. market was priced at a premium, recent tax cuts would flow through to corporate earnings, meaningfully increasing the denominator in the P/E ratio. If markets merely chopped to, and for all year long, (little or no increase in the numerator) the P/E for the market would have a chance to normalize… a “rolling correction.”

Chaos Abounds
The problem with a Goldilocks environment, as seen through the perspective of a perpetual discounting mechanism (such as the stock market), is the odds are tilted towards conditions eventually becoming worse. This combination of the aforementioned rate normalization and investors focused on the second derivative of economic conditions, has manifested in increased volatility of late.

Where’s the volatility coming from? Certainly, explosive gains during Q3 set investors up for a bit of a pullback during Q4. But beyond this, political chaos abounds:

  • We’ve got a developing structural deficit/debt problem which is pulling economic activity forward—but will curb future growth.
  • A more immediate concern for investors: will there be a change in the House and/or Senate from Red to Blue? If so, what are the implications for the economy?
  • Speaking of the mid-term elections… will there be election interference? We note the Administration warns of interference by China… on top of putting the emerging superpower in the crosshairs of a markedly more aggressive tariff policy.
  • The human rights tussle with Saudi Arabia also puts strain on the relationship between the U.S. and yet another important strategic partner.

These concerns, plus a modest spike in interest rates, led to a very sharp rotation from growth to value stocks pacing the market, beginning the last two trading days of September. The rotation has abated somewhat, but keep in mind, this did occur as the general market broke lower, reversing much of the heady gain accumulated during Q3; and ultimately, the year altogether.

What Now?
Given the length of this economic expansion and bull market, it’s natural for market participants to anticipate the other shoe dropping. And to be sure, there are legitimate reasons for concern, including:

  • The sheer length of the expansion itself.
  • The possibility that while earnings may continue to grow, we may have hit peak corporate profit margins.
  • The breakdown in correlation between stock and bond returns, and the correlation falling into slightly negative territory.
  • Small-caps lagging their large-cap counterparts; will the generals follow the troops lower?
  • The weakened technical state of the market, with the 200 day moving average being penetrated.
  • The rotation out of economically-sensitive sectors of the market (Materials, Industrials, Financials, Discretionary) into less-sensitive sectors (Utilities, Real Estate).

Each of these is a legitimate cause for concern and caution. But let’s give credence to the countervailing arguments as well:

  • Companies are still growing earnings, and a high percentage are posting upside surprises.
  • Multiple indexes measuring fear/greed show maximum fear—typically constructive for equity markets.
  • No commodity spike to curtail earnings. Commodity price spikes are a common cause of bear markets.
  • Lack of excess valuation. We may have been pushing the envelope in January of 2017, but the P/E multiple is now right at or below the 25-year average.

Where does all of this leave us? Well, with earnings having grown 22-26% (depending on the market segment), and prices having hardly budged from the level of late 2017… we’ve been in a rolling correction, and we believe this is more likely to continue than a bear market is to unfold.



Great Lakes Advisors, LLC (“Great Lakes” or “GLA”) is an investment advisor registered with the Securities and Exchange Commission under the Investment Advisors Act of 1940. Established in 1981, Great Lakes is a subsidiary of Wintrust Financial Corporation and a part of the Wintrust Wealth Management family of companies. On October 1, 2013, majority owned subsidiary Advanced Investment Partners, LLC (“AIP”) became fully-owned and integrated into Great Lakes. Great Lakes is a distinct business unit with distinct investment processes and procedures relating to the management and/or trading of investment portfolios for its clients.

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This commentary is provided courtesy of our affiliate, Great Lakes Advisors. This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.