US bull market enters latter innings, odds of pullback exist

- U.S. stock indices have continued to push to record highs, with little apparently able to throw them off course. The grind higher has pushed through natural disasters, the Las Vegas tragedy, domestic political failures, international political tensions, and missile tests and threats from North Korea - an ample "wall of worry" for stocks to climb. We're likely entering or already in the latter innings of this long-running bull market and economic expansion, but as baseball fans know there's still a lot of game left after the middle innings - including the possibility of extra innings. Although there is little of the excess that would suggest recession risk is near, we do see signs that the characteristics of the economy and market may be changing. Bond yields have crept higher, international markets have performed better, and cyclical sectors such as energy and materials have outperformed - all potential signs of the latter stages of a cycle. We've seen brief periods when these shifts have occurred before, but the strength and length of the recent moves gives us reason to believe a change in character is afoot.
 
So what should investors do if we are entering the latter innings? At this point, we suggest making sure strategic allocations are appropriate for risk profiles as well as long-term goals, and make adjustments as needed via tactical rebalancing. There remains the possibility of a pullback, with any number of catalysts possible. Attitudinal measures of investor sentiment are currently showing excess optimism, which is typically a contrarian indicator. This has been a characteristic of most of 2017, but of course we have yet to see a significant pullback. And while attitudinal measures of sentiment appears overly optimistic, behavioral measures still show some caution, with Evercore ISI noting that the net cumulative flows in domestic equity funds (even including exchange-traded funds) continues to be negative, indicating continued caution despite optimistic attitudes.
 
A melt-up is also reemerging as a possibility should investors' actions start to follow the attitudinal sentiment indicators. Remember though - as good as a melt-up might feel while underway, they have historically not ended well.
 
Economy hitting solid doubles, while earnings are stepping to the plate
Another sign that we may be in the latter innings has been the recent acceleration in economic data. Both of the Institute for Supply Management's (ISM) Surveys had extremely strong readings, indicating accelerating growth. The manufacturing index hit 60.8, the highest level since 2004, while the leading new orders component was a robust 64.6. The service side also looks strong, with the non-manufacturing index rising to 59.8, the best reading since 2005, while the new orders component jumped 5.9 points. Although services represent a much larger share of the U.S. economy, the ISM Manufacturing Index has a higher correlation to the stock market historically.
Additionally, the U.S. Citigroup Economic Surprise Index has moved back into positive territory, while several measures of capital expenditures have started to move higher.
We're finally seeing some indications that inflation is ticking higher. The price component of both ISM surveys jumped, oil has moved higher, and wages are increasing as the labor market tightens.  Average hourly earnings (AHE), which are released with the labor report, rose a surprising 2.9% year-over-year, up from an initially-reported 2.5% from the prior month. An alternate measure of wage growth - the Atlanta Fed's Wage Growth Tracker, which measures median wage growth - is showing an even more robust 3.4% growth in wages.
 
We may get further insight into the inflation picture with the ramping up of earnings season. Along with overall results, we may get some commentary on pricing power, labor tightness, compensation expenses, and input cost trends. With valuations still elevated, it's in the market's best interest for earnings and revenues to continue to outperform expectations.  With recent economic data being fairly strong, we are relatively optimistic that the lowered bar of earnings expectations can be met or exceeded.
 
Fed as middle reliever, or closer?
The stage in which we current sit is somewhat dependent on the Federal Reserve, which has slowly started to normalize monetary policy by gradually lifting interest rates and beginning to unwind its balance sheet. For now, the Fed is acting like a middle reliever, who tries to keep the score where it is, by not making any drastic moves that may upset investors. But, if some of those measures of inflation continue to rise, the Fed could have to transition to a closer role - who comes in to end the game. A more aggressive Fed could pose a problem for equities, but for now the Fed's methodical approach to monetary policy tightening is keeping financial conditions loose and the bull market intact.

So what?
A market that could be in or entering the latter innings can provide both opportunities and risk and investors should stay vigilant. U.S. earnings season should propel stocks to further gains but signs of inflation and the potential of a melt-up pose some risks. But our relatively optimistic outlook is bolstered by better global growth, which could keep the game going for a while longer.

Note: This story is contributed by (1) Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.; (2) Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research; and (3) Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist.