In this article we discuss:
- The rationale behind the strong move in stocks so far this year
- The increasing focus on the market landscape for 2020
- The prospect of a “Goldilocks” market environment
- Interpreting the Treasury bond yield curve
Here's a question for market trivia buffs: how many times since the end of World War II has the S&P 500® dropped 19% off a record high only to fully recover that loss and reach another new high in just four months? The answer is twice — in 1998 and just now.
The 120 days between when the market closed last Christmas Eve and when it reached a new record high last Friday, April 26, have been historic to say the least. Only the complete market recovery during the 84 days following the depths of the Asian Crises in August of 1998 ranks as a faster recovery.
So the two questions facing investors right now are of course what caused this remarkable turn and is it warranted?
The answers to the first question are several fold, and just as the perfect storm of last December had multiple and convening culprits, the near perfect sunrise of the morning after has more than a few resolutions. At the top of this list would be:
A dramatic reversal in expected policy at the Federal Reserve, which now appears to be far more accommodative and market friendly. As we have written about in previous weeks, the Fed has reversed course materially. Through signals, commentary, and meeting minutes, the Fed currently appears highly unlikely to raise short-term interest rates between now and the end of the year. This represents a sea change from 4Q18 when various pundits (who may have well lost that designation in the time since) were expecting as many as four rate hikes in 2019. As a result, the risk of a Fed policy error — raising rates into a slowing economy — has now been basically eliminated from investor fears.
Recent economic data is refuting recession risk. The final months of 1Q19 saw a decisive pickup in economic momentum in the U.S. as the advanced estimate for first quarter GDP came in at 3.2%. To fully understand the magnitude of this, it was only a few months ago that estimates for the quarter were below 1% as fears of the impact from a government shutdown and trade stalemate with China were believed to be stagnating growth. In addition, concerns of weakening consumer spending have also been mitigated greatly as retail sales for March came in well above expectations.
The U.S.-China trade dispute, while not yet resolved, appears to be on a path toward reconciliation. We have said the pending U.S.-imposed tariffs on China and whether they can be curtailed or withdrawn is the biggest wild card facing investors in 2019. We continue to believe this is the case, however rhetoric from both sides has seemed to simmer considerably and we are of the opinion we could see a deal between now and midyear. Should this occur, one more lightning bolt from last year’s perfect storm will have been stabilized.
The market is now beginning to discount a "Goldilocks” scenario for 2020. If the great fear at the end of last year was the Fed would raise rates into a slowing economy, that concern now stands before investors as an opportunity in its mirror image. In other words, in our opinion, the markets are now anticipating no rate hikes in a growing economy. Admittedly, this perspective is fluid and the better our economy performs, the more we may hear concerns of tighter Fed policy. However for now the balance seems close to picturesque when assessing the market landscape.
The yield curve has “dis-inverted” in recent weeks and this “recession indicator” was never confirmed by both closely watched metrics. Just over a month ago (March 22 to be precise), the yield on the 10-year U.S. Treasury bond fell to a lower rate than the 3-month Treasury bill, triggering fears of an imminent recession — as has historically been the case (most but not all times) — when the yield curve becomes inverted. However since then, the difference between these yields has moved back into a positive slope and moreover the other closely watched measure of the curve, the 2-year versus 10-year, never inverted and has since modestly steepened. This serves as evidence in our opinion that the long end of the curve is being anchored by anomalously low and negative 10-year rates in Europe and Japan. Therefore the recent dynamics of the yield curve are likely not reflecting recession risk to the degree many had interpreted them to be.
So given this sharp equity market rally over the past few months, is this rise in stock prices justified? Spoiler alert, yes, and here are a few reasons behind it.
Valuations remain reasonable. While corporate earnings growth will certainly be challenged in 2019 versus the stellar profit increases of 2018, we believe the market is looking beyond this year and solidly focusing on 2020. As earnings estimates for next year begin to gain visibility in the months ahead, we believe they may well shake out north of 10% growth. This would put the forward price-earnings multiple for the S&P at about 15-16 times, which we would view as providing stock investors with the potential opportunity for total returns in line with that earnings growth.
Despite the impressive recovery in stock prices, peak-to-peak appreciation is still muted and trails aggregate earnings growth. The flip side math of the exceptional rally experienced since December is that over the past seven months, the overall market is flat amid a backdrop of rising economic growth expectations and lower interest rates. In addition, the S&P 500 has only increased 7% since the beginning of 2018 despite better than 20% realized earnings growth and improving prospects for 2020.
There is no question we are in a far better position than the pessimism of last year inferred. With that in mind, we would be remiss in not reminding investors that after any rise like the one over the past few months, there is a risk of short-term profit taking, which could drive the market lower. However, should that be the case without a material worsening of the criteria noted above, we would likely view such an event as an opportunity.
So with all taken into consideration, after the storm that wrecked the shorelines of the markets last year, the sailing now looks to be a good bit smoother for the year ahead.
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