The US stock markets have produced their best year-to-date returns in over 20 years. While we should celebrate this stellar first half performance, we must be mindful of the source. The decline in interest rates has mathematically lofted valuations held high on the hopes of government stimulus followed by economic revival. For performance in the second half to resemble the performance of the first half, we need proof. We need rate cuts. We need trade resolutions. We need yield curve reversion. We need a lift in leading indicators. We need upside economic and earnings surprises. This market now stands at a crossroads. It’s time to put on the proof.
The Full Story:
This market rally needs proof points. While the Fed has conversationally eased, it has yet to actually loosen policy. The stock market has already banked at least one rate cut at the July 31st meeting, but would like to see two (as would we). In advance of that meeting, we would expect some negative trade talk out of the White House and a soggy stock market to help motivate Chairman Powell. And while the economy has shown some recent bounce, the environment overall remains negatively biased. To demonstrate, Citigroup compared economic data releases with economists’ expectations to derive its Economic Surprise Index.
The most recent tabulation depicts economic data improving….while still disappointing. That’s encouraging, but less bad isn’t necessarily good. The 10-year Treasury yield hovering around 2% reflects similar hope and dismay as it has halted its recent decline, but sits well below the 2.8% where it began the year.
Our favorite recession indicator, the Conference Board Leading Economic Index, also needs to course-correct or the recession countdown will begin in earnest.
The hope remains that monetary easing from the Fed and fiscal easing from the Trump administration in the form of trade resolutions will rekindle economic growth and re-fire earnings. Markets at new highs reflect conviction in this view, and earnings expectations depend heavily upon it. According to analyst expectations, S&P 500 earnings will decline 3% this quarter, 1% next quarter, and then jump 6% higher in the 4th quarter, 10% higher in Q1 2020 and 13.5% higher in Q2 2020. Without economic revival, there will be no earnings revival, making our current highs a misprint in need of correction.
While the market has recently traded at new highs, the uncertainty referenced above resides within the performance figures as well. Let’s do the data:
What a year! The US markets have put in their strongest start in 20 years, with all underlying styles and sectors solidly in the green. However, in assessing the data, the drivers of return seem less convincing. In an economically driven market, more cyclical areas like emerging markets, small cap, and value-oriented styles tend to outperform. As shown above, the leaders of this market advance are the US large companies in the growthy areas like technology that tend to be more economically agnostic. Remember that markets price off of earnings and interest rates. The decline in the 10 year Treasury interest rate from 2.8% to 2% amounts to a 28% decline, implying a 28% boost to valuations (it’s not as simple as this, unfortunately, as there are numerous other factors that influence valuation, but you get the point). Therefore, the sizable advance in the indices this year stems from a rise in valuations rather than better economics. Yet these valuations would not hold without the hope of better economics to come. For calendar year 2019, analysts expect earnings growth of 2%. They expect over 11% growth in 2020. Probable? Hmmm. Possible? Yes. But it’s time to put on the proof.
Have a great Sunday!