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Quarter 3



Chalk up another fine quarter for the stock market as investors shrugged off global trade concerns and instead focused on a strengthening U.S. economy, record employment gains and robust corporate earnings. The Dow, S&P 500 and Nasdaq indexes each hit fresh all-time record highs during the quarter.  After lagging throughout the first half of 2018, the Dow Jones Industrial index gained an impressive 9% in the third quarter.  Conversely, the tech heavy Nasdaq index ceded some relative strength this past quarter, yet still managed to generate a very respectable gain of 7.1% for the period.

The economy continues to fire on all cylinders, prompting businesses to increase hiring and hike wages for existing employees. By all historic measures, the current jobs market looks extremely healthy.  The unemployment rate has now fallen below 4.0%, a level not previously seen since the 1960’s.  Workers are finally seeing real (inflation adjusted) increases in their take-home pay.  Businesses have yet to feel a profit margin pinch from rising labor costs as productivity gains have allowed companies to absorb wage rate increases.   A strong labor market is providing a significant boost to consumer psychology.  Consumer confidence levels have recently risen to an 18-year high, prompting consumers to open their wallets and spend more freely on discretionary purchases.  With consumer spending representing nearly 70% of GDP, higher confidence inspires higher overall economic growth- thus creating a virtuous cycle.  GDP in the second quarter increased 4.3%, a lofty level which took many forecasters by surprise.  It was previously believed that 3% GDP growth would represent an upper ceiling for future economic growth.

What has changed since the beginning of the year? Primarily, the economic expansion gap between the U.S. and the rest of the world.  While economic growth for the U.S. has continued to accelerate this year, Europe and Asia have experienced some recent slowing in their economies.  As the Trump administration focuses on an economic agenda that puts America first, other countries are beginning to feel the pinch from lower trade with the United States.  Industrial production in the U.S. is not only increasing, but the rate of growth is actually accelerating on a year over year basis.  Noteworthy is the fact that the United States has now become the world’s largest energy producer, surpassing both Russia and Saudi Arabia.  Even more astonishing is the fact that this level of energy production has been accomplished with roughly half the number of drilling rigs that were in place just a few years ago. Massive productivity gains from new drilling technology are fueling this production boom.

With corporate earnings up 25% on a year over year basis, valuation levels for stocks (as measured by their Price/Earnings ratio) are actually down slightly from where they stood on Jan.1st Put another way, stocks are gradually earning their way into their higher valuations.  Corporate earnings are expected to continue to rise in the second half of 2018, with consensus earnings growth of 15-20%.  If the stock market holds steady at its current valuation level, price/earnings ratios will continue to decline over the balance of the year.  Conversely, the stock market has room to build upon its gains for the year if current price/earnings ratios merely hold steady.  Right now the trend is definitely your friend.