Happy Birthday!...but will the Fed spoil the party?

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1 3/6/12 9/6/12 3/6/13 9/6/13 3/6/14 9/6/14 3/6/15 9/6/15 3/6/16 9/6/16 3/6/17 3/6/12 9/6/12 3/6/13 9/6/13 3/6/14 9/6/14 3/6/15 9/6/15 3/6/16 9/6/16 3/6/17 Billings: (406) Conrad: (406) Helena: (406) Missoula: (406) ꟾ March 2017 ꟾ Happy Birthday!...but will the Fed spoil the party? On March 9th, the bull market celebrated its 8th birthday. This expansion has been doubted, disbelieved, and down right frustrating at times; but it has also marched higher thanks to steady improvement in the U.S. economy. That has not changed in recent weeks. Indicators such as Consumer Confidence, the Institute for Supply Management Survey, and Initial Jobless Claims have remained healthy, keeping the risk of an immediate recession low. One thing that is changing, however, is the Federal Reserve. After having held interest rates at nearly 0% since December 2008, the Fed has begun to nudge short-term rates higher. The Fed s own guidance is for three 25 basis point (0.25%) rate increases in That would bring the overnight Fed Funds rate from the current 0.75% up to 1.5% by year-end. The earliest of these increases could come as soon as this week, when the Federal Open Market Committee (FOMC) concludes its March 15th meeting. After years of keeping rates extremely accommodative, what s prompting the Fed to raise now? Where do we go from here? And, most importantly, what impact does Fed tightening typically have on the market? Eric Vermulm, CFA Chief Investment Officer evermulm@stockmanbank.com 2,400 S&P 500 Index Trailing 5 Years New High! 3.3% 10 Year U.S. Treasury Trailing 5 Years 2,000 1, % 2.3% 1.8% = 2.57% 1, % Market Update ꟾ Page ꟾ March 2017

2 Podium Position The current bull market stands out as one of the best of the past 90 years. At eight years old, it s now the second longest, trailing only the nine and a half year expansion of the 1990s (which ended infamously with the Tech Bubble bursting in 2000). In terms of gain, the current 254% return ranks third, well behind the 417% gain of the 1990s, but within striking distance of the 267% gain seen in the post World War II bull market of Despite being on the podium as one of the top three bull markets of the modern era, this cycle has been notable in the absence of the Fed raising interest rates. Some of the reason for delay has to do with the depth of the bear market, which was the worst drawdown for the S&P 500 since the Great Depression. The first four years of this expansion were required just to get the market back to breakeven. Still, the length of time since the last tightening campaign, which was over 10 years ago, stands out. The reason for the delay has to do with the Fed s central mandate % 350% 300% 250% S&P 500 Bull Market Length Average Months S&P 500 Bull Market Gains (price only, dividends not included) 200% What would you like to learn about in the next Market Update? Please us your feedback and questions to: evermulm@ stockmanbank.com 150% 100% 50% 0% Average Market Update ꟾ Page 2 ꟾ March 2017

3 Jan-67 Jan-70 Jan-73 Jan-76 Jan-79 Jan-82 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 (Thousand) The Dual Mandate The Federal Reserve and its rate setting Federal Open Market Committee (FOMC) operate under what is known as the dual mandate. To foster a healthy U.S. economy, they seek to (1) maximize employment while also (2) stabilizing prices. When the economy is strong, the FOMC raises short-term rates to combat inflation. When things look bleak, the Fed lowers rates to help spur hiring and employment. Today, many measures of unemployment are running at or near all time lows. After peaking at 10.0% in late 2009, the national unemployment rate has slowly but steadily fallen to 4.7%, consistent with some of the strongest economic expansions of the past 50 years. One of our preferred indicators of employment strength is the weekly U.S. Initial Jobless Claims report put out by the Department of Labor. As of today, fewer people are filing unemployment applications than at any time since the early 1970s, a time when the country s population was much lower. The U.S. jobs picture is arguably as healthy as it has been in decades. As we highlighted in the January 2017 issue of Market Update, in over 50 years of data, the economy has never gone into a recession with jobless claims falling to new lows. This is (finally) giving the Fed some flexibility in terms of raising rates. The second reason for them to raise rates has to do with inflation U.S. Initial Jobless Claims January March Recession Initial Jobless Claims Market Update ꟾ Page 3 ꟾ March 2017

4 Jan-67 Jan-70 Jan-73 Jan-76 Jan-79 Jan-82 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Inflating Inflation There are many ways to measure inflation, but one of the most common is the Consumer Price Index (CPI). Published monthly by the Bureau of Labor Statistics, CPI looks at the prices paid by consumers for a wide variety of everyday goods and services. By comparing the year-over-year levels of CPI, we can get a read on how quickly the purchasing power of a dollar is eroding. When the Fed looks at inflation, its target is for a core reading of 2% or less. Core inflation excludes the volatile food and energy components which can distort the true trend of consumer prices (while it s debatable if this is true, it s the Fed s policy, so we ll use it for this analysis). The 2% target is considered acceptable inflation and a level against which a healthy employment picture can be prioritized. After years of mild inflation, CPI levels have moved above 2% and look ready to hold or even move higher in coming months. Inflation is by no means rampant, but the strength in employment (part one of the dual mandate) is giving the Fed cover to start raising rates and combat any percolating or unreported inflation. 14% Consumer Price Index (ex. Food & Energy) Year-over-Year January January % 10% 8% 6% 4% 2% 0% Recession CPI (ex. Food & Energy) Recent issues of Market Update can be found online at the Stockman Wealth Management page of To be included on the distribution list (six issues per year, plus special updates as necessary), please contact us at: evermulm@stockmanbank.com. Thank you! Market Update ꟾ Page 4 ꟾ March 2017

5 Dec-82 Dec-85 Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 The Fed s High Wire Act The dual mandate forces the Fed into a balancing act: keep rates high enough to combat inflation, but don t raise rates so much that it hinders the economy. One of the best ways to keep tabs on how they are managing this process is by monitoring the yield spread between long and short duration Treasury bonds. Prior to each recession of the past 35 years, the spread between the 10 year Treasury and the 2 year Treasury has gone negative (long rates less than short-term rates). In each instance, the Fed pushed shortterm rates up in order to cool inflation. Long-term rates, however, held steady or even fell as the prospect of a weakening economy weighed on yields. When this has happened, a classic bear market warning flag was waved. As the FOMC looks set to begin a tightening campaign, we will be closely watching the yield spread in the graph below (red line). If the Fed raises rates due to legitimate inflation concerns, the 10 year Treasury yield should move up along with Fed Funds. This will keep the spread above 0.0% (purple line) and be a positive sign for the market. If the Fed becomes too aggressive in raising rates and the yield spread turns negative, this will be a warning that all is not right with the economy. 12% Fed Funds Rate vs. 10Y-2Y Treasury Spread December February % 8% 6% 4% 2% 0% -2% Recession Fed Funds Rate 10-Year Treausry minus 2-Year Treasury Data Source: St. Louis Federal Reserve & Bloomberg Market Update ꟾ Page 5 ꟾ March 2017

6 The Bottom Line At eight years old, this bull market is no spring chicken. It has lasted twice as long as the average expansion and has gained over 250% since the bottom in March Still, it is important to point out that bull markets do not end due to age or valuation. They end when economic conditions and underlying fundamentals deteriorate. Many economic indicators (from Initial Jobless Claims to Consumer Confidence to technical measures such as the Advance/Decline Line) are still confirming the bull market. The Fed beginning its first tightening campaign in over a decade gives us another data point to watch as we search for warning flags. No one indicator should be viewed alone, but we would become concerned about the health of the market if the 10 year - 2 year yield spread goes negative. While we are already taking a cautious approach with the stocks and bonds we are buying for clients, a negative spread would be evidence that this bull market might not see its next birthday. In 1964, President Lyndon Johnson announced the existence of the SR-71 Blackbird, a high altitude, Mach 3 aerial reconnaissance plane developed covertly by Lockheed s Skunk Works division. The Blackbird was so fast that its standard evasive technique if fired upon was to push the throttle forward and outfly the enemy missile. The problem, however, was the plane s name was actually the RS-71 President Johnson had transposed the letters in his speech. Rather than issue a correction to this very minor slip of the tongue, the Air Force decided it would be easier to force Skunk Works to change over 29,000 drawing and blueprints to reflect the new SR-71 name. A case of bureaucracy at its finest. Details sourced from Skunk Works by Ben R. Rich The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy, or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. 402 North Broadway PO Box 2507, Billings, MT (406) North Sanders Street PO Box 7329, Helena, MT (406) South Main Street PO Box 727, Conrad, MT (406) North Higgins Avenue, Suite 200 Missoula, MT (406) Stockman Wealth Management is an SEC registered investment advisor (RIA). We specialize in constructing high quality portfolios based on each individual client s risk tolerance and goals. Through detailed analysis, an objective outlook, and unmatched customer service, we work to be your valued investment partner. Please feel free to contact any one of our offices to learn more about Stockman Wealth Management. Not FDIC Insured ꟾ No Bank Guarantee ꟾ May Lose Value Market Update ꟾ Page 6 ꟾ March 2017