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Posted on AUG 8, 2017

Johnson Bank Wealth Weekly Investment Commentary | Tuesday, August 8

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

More Than a Tweet

In a world where a tweet, i.e., 140 characters, can get people nervous, angry, concerned or excited, we may be losing our desire and ability to understand things at a more detailed level. The media hype surrounding the current stock market environment is much like that today. Headlines focus only on a particular market index, such as the Dow Jones Industrial Average (DJIA), making new highs each day and thus miss the deeper picture.

Do New Highs Matter?

As of this writing, the DJIA has made a new high in five of the last six trading sessions. Such is the nature of a stock index when it sits at all‐time highs. The S&P 500 Index has also made new highs recently. As a result of these indices' recent performances, there are generally two investor reactions. Stocks are at all‐time highs, this can't last, look out below. Or, stocks are at all‐time highs, will pull everyone into the market who isn't already, and will push ever higher. The reality is, no one knows which in the near‐term. What we do know is that over time, companies' stock price movement follows revenue and earnings growth performance. In order to discern which is more likely, we must look at the fundamentals driving company performance.

We also know that the performance of an index can be broken down into components. These include business sectors, and factors such as growth, value and market capitalization, to name a few. By reviewing how these components are performing, we can gain some insight into where we should invest and how well supported the broader market's rise may be.

Fundamental Message

In order to understand companies' performance long‐term, we must look at the fundamentals, which include revenue and earnings growth as well as cash flow generation and balance sheet health. We can use the second quarter's earnings season to discern how well companies are doing and look at them as a whole market as well as by component parts.

According to Factset, the second quarter earnings growth rate for the companies in the S&P 500 Index is 10.1% (this includes actual reports and estimates for those companies that have yet to report). This is better than what was expected at the end of March, which was only 8.6%, yet below the growth rate for the first quarter. Still, it would be the first time since 2011 that we have seen two quarters of double‐digit earnings growth. This is great performance and has resulted in better revenue growth and profit margins than we have seen for some time.

However, only three of 11 market sectors contributed 74% of this growth: Health Care, Financials, and Information Technology. Companies such as Apple, Microsoft, Facebook, JP Morgan and Aetna were among those reporting big upside earnings surprises, contributing to the growth rate. This list of companies―all large cap growth stocks―provides an example of why large cap growth stocks have outperformed every other equity market segment for U.S. stocks this year.

Market Components

Through the end of July, the large‐cap growth part of the market is up 17%. This compares with large‐cap value stock performance of just 6%, small‐cap growth stock performance of 10.9% and small‐cap value performance a meager 1.2%. This suggests that while the broad market S&P 500 Index is reaching new highs, the breadth of participation driving those new highs, at the company level, is not as wide as we'd like to see. The chart here shows how differently stock market segments have performed year to date (segments include small, mid and large capitalization stocks in the value, core (blend) and growth categories.

The chart here shows how differently stock market segments have performed year to date.

This isn't really surprising given that the companies listed above, large‐cap growth companies, benefit most from global macro trends. We've seen an acceleration in global economic growth resulting from last year's decline in oil prices, reduction in interest rates and lower inflation. All of these factors aid growth, albeit with a lag of six to twelve months. The improvement in first and second quarter revenue and earnings growth for these large global companies, then, can be attributed at least in part to last year's forces. If this is true, we should look at what has happened to these factors since last year to determine if double‐digit earnings growth can be maintained.

Since the mid‐summer of 2016, interest rates are almost 1% higher. Oil prices are about the same, and inflation has risen and fallen again. Perhaps most importantly, the dollar has become even weaker which helps these global companies do more business overseas. The competing forces of higher interest rates and a lower dollar may suggest that earnings growth could remain elevated through the rest of the year, in particular for large growth companies.

One of the concerns about the current market rally is that it is being driven by the performance of a few technology stocks. The Russell 1000 Growth index, which represents large‐cap growth stocks, now has almost 25% of the index in five companies (Apple, Alphabet, Microsoft, Amazon, and Facebook). As these stocks have rallied, pushing market indices higher, they've become a much larger portion of the index. Of course these companies have had great fundamental performance. It is just that they are leaving the rest of the market behind, suggesting that the breadth of the market rally is weaker than we'd like to see.

If we look at stock performance by sector since the beginning of the year, we can see that technology and health care have been the big drivers. The technology sector is up almost 20% while health care is up 15.5%. The average return for the remaining sectors is less than 10%. Over the last twelve months, technology is up 23% while large‐cap growth financials like JP Morgan have pushed the financial sector up 30%. The remaining nine sectors are up, on average, less than 5%.

Whether the market continues to rally or develop a fall swoon is anybody's guess. Investor sentiment suggests that the broad market indices' may continue making new highs. Without support from the other components outside of large‐cap growth, however, it may be difficult.

For our part, we added to large growth stocks at the beginning of the year, favoring them due to the macroeconomic forces described earlier. We are now reducing the amount we own and adding to those segments of the market that have not been participating. That gives us a more defensive equity posture and takes some profit.

Understand the market's components, take profit from what has worked and add to what hasn't. (That's fewer than 140 characters!)

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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