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We liked the analysis we saw from one Wall Street commentator on the recent stock market surge. “This is not like the dreamy mood of the dot-com era. It was euphoria then. The sentiment today is more to the opposite. It is skeptical, cautious, and careful. People ask: how long can this go on? Recession is coming at some point.”

That sentiment is one we expressed in July. We agreed with a Barron’s analysis that economic good times would last through 2019 and stock market gains – even if moderating – would remain healthy. We saw the change coming in 2020 when rising interest rates and the fading stimulus of the tax cut would finally put the brakes on the economy and the market. 

We did not foresee the third quarter stock market surge which brought major indexes close to all-time high points. For the moment, even if skeptical, investors seem happy to ride the good news on economic and earnings growth. Concerns about a trade war have abated for the short-term. We too are happy to be part of this ride. However – let us stress a big caveat – our view expressed in July has not changed. The downturn is coming at some point. Perhaps it will be delayed until 2021 or 2022. The timing is hard to predict. But the event itself is inevitable.

Thus, despite the current happy times, our investment strategy is defensive. We are long-term investors of our client money. We are not buying the hot stock of the moment.  We seek diversity, value, and staggered commitment.  We want to prepare client portfolios for the tougher times whenever that period does arrive.

Equity Market: U.S. stock indexes in the third quarter moved steadily upward. Investors embraced the strong U.S. economy and the reports of impressive gains in corporate earnings. They shrugged off uncertainties about trade disputes

 The Dow Jones Industrial Average reversed its losses earlier in the year. It was ahead 8.15% for the quarter and 6.02% for the year. The S&P 500 was ahead 7.2% for the quarter and 9.0% for the year. Consistent with the first half of the year, the strong performer was the Nasdaq Composite with a quarterly gain of 7.14% and a year-to-date gain of 16.6%.   The Russell 2000 index lost some of its earlier momentum and was ahead 3.26% for the quarter and 10.5% for the year.

Fixed Income Market: The bond market had been relatively stable in the first half of the year, but bond prices took a strong hit as investors accepted the reality of rising interest rates and potentially steeper inflation.    The yield on the 10-year Treasury was 3.05% at the end of September – versus 2.84% at the end of March.    (Yields move inversely to prices.)  It rose to 3.22% in the first week of October.   

The Economy: The U.S. economy is hitting on all cylinders. GDP growth was 4.1% in the second quarter and is expected to be over 3% for the year – the highest in  more than a decade. The unemployment rate is down to 3.7% and hourly wage gains have improved 2.8% in the last 12-month period. Consumers are confident and spending. The result is corporate earnings growth of 25% in the first half of the year.

Ironically, the majority of economists predict a recession within the next two years – perhaps in 2020, certainly in 2021. The logic is as follows:

First, the Federal Reserve is concerned about inflation and will raise short-term interest rates in increments to a level of 3.3% by the end of 2019. This timing will coincide with a weakening impact from the Trump tax cut. Former Fed Chairman Ben Bernanke has called this convergence the “Wile E.  Coyote off the cliff” moment.

Second, corporate debt may be something of a bubble. Given low interest rates, corporations have loaded up on debt in the last decade. The value of corporate bonds outstanding is now $2.6 trillion. That number is 25% of GDP, increased from 16% in 2007. The danger is that higher interest rates will make the cost of that debt an unmanageable burden for corporations

Third, the immediate concern about trade conflicts is muted. Trade comprises only about 8% of U.S. GDP. But other countries are far more reliant on trade. Should trade conflicts widen, the resultant slowdown in the global economy could have an impact on the U.S. larger than what the Trump tariffs create.






Figures as of September 30, 2018

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