Stocks last week made their fourth run to a new high in the past 17 months. All four have so far culminated within a 3 percent band between 2,872 and 2,950 for the S&P 500. None of the other three held for more than a few weeks before backsliding.
And it’s fair to say this trip to a record is most confusing in terms of how it happened and what comes next. January 2018 was about “synchronized global growth” and a huge tax cut. Last summer’s high was floated on 20% corporate-profit growth and a 3% GDP economy. Back in April, the Federal Reserve’s dovish “pivot” to patience was supposed to be the opening act for an imminent China trade deal.
The current record climb came with Treasury yields anchored near 30-month lows and manufacturing activity stalling. The rally has been driven by defensive sectors and gold has broken out to a multiyear high — even as speculative IPOs take flight and low-grade corporate debt is in heavy demand.
Stocks aren’t observably cheap, the S&P forward price/earnings ratio is above 16.5, but with the S&P 500 dividend yield now equal to a 10-year Treasury note yield and corporate yields not much higher, how much cheaper would one expect stocks to be?
‘How I learned to stop worrying and love the bonds’
The easy explanation for all this is the Fed’s promise last week to act “as appropriate” to support the economy, which the market took to mean a near-certainty of a rate cut next month. In this way, the Fed gave investors permission to see compressed Treasury yields and their “inversion” — with three-month yields above the 10-year — as a bit less scary. “How I learned to stop worrying and love the bonds,” newly bullish traders might have said.
The market is acting as if it will get a “just to be safe” rate cut that the economy does not yet desperately need. And the Fed is not calling the market out for overreaching just yet.
The other element in the market advance has been just how pessimistic investors’ sentiment and how defensive their posture had become. Surveys by Bank of America and RBC Capital showed surprising levels of worry among professional investors in the past week. And in a rarity, the American Association of Individual Investors’ weekly poll had more bears than bulls even with the market about to reach a record high.
If this rebound rally to a fresh record has been largely about burning up excessive anxiety and punishing those underinvested in stocks, then it probably has more room to go before overconfidence becomes a headwind.
The obverse of this is bonds. Trader sentiment is extraordinarily bullish on Treasurys, and the buying rush in “safe” government paper has just started showing signs of fatigue. Some lift in yields from such low levels would probably help the have-nots of the stock market: banks and industrial cyclicals.
‘Less graceful path?’
Strategists at Ned Davis Research, currently cautious on equities, note: “It is easy to imagine bullish paths for a second-half recovery. The self-sustaining route would be the natural rebound in the earnings cycle aided by an end to the trade war with China and a bottom in the global economy. The less graceful path would involve the Fed moving to an easing policy after economic data and/or equity markets clearly deteriorate.”
The middle way — moderate growth and low yields without a Fed easing move — would not likely benefit stocks, they say.
Purely based on the historical probabilities, a market at a new high and up more than 17% not quite halfway through the year are reasons to side with the bulls, but also to keep expectations in check.
Leuthold Group notes the Dow Industrials have made a record high in the month of June in 33 years. Second-half performance in those years is roughly the historical average for all years — a gain of more than 4%.
But when June’s high is “confirmed” by market breadth in the form of a new high in the stocks’ cumulative advance/decline trend — as is the case now — the second half is far more positive, up 8% on average. When breadth was lagging, stocks were down a bit the rest of the year on average.
Yet Bespoke Investment Group found when the S&P was up at least 15% by June 24, the following month and remainder of the year was positive just 5 of 9 times. And investment advisor Steve Deppe noted on Twitter that when the S&P 500 has gained at least 2% in a week and finished at a new weekly high — the case on Friday — the S&P was lower six weeks later 70% of the time.
Big picture: Sideways trading for a long time
Such historical studies provide context but no clear course of action. The big picture is, the market has been in a wide-swinging but ultimately sideways trading range for a year and a half. It’s now stretching the top of that range. Earnings have flattened but not begun falling. Disruptive, organic-growth companies remain in favor no matter the macro news flow and are crucial to index performance.
Last December’s dramatic market low and upside reversal continues to seem like a consequential bottom, and in recent weeks tactical indicators have perked up, such as the number of stocks making new 52-week highs.
We’ve had two other such sideways plateau phases in this bull market, most recently in 2015-2016, a period with strong resemblances to this one. (Global recession scare, controversial December Fed rate hike in both 2015 and 2018 followed by a dovish pivot, skeptical investor sentiment, defensive-stock leadership amid depressed bond yields).
That phase ended when the 2016 election flipped the story to tax-cut stimulus and global “reflation.” Can a trade deal or Fed rate cuts turn a similar trick?
Even if one or both happen, they won’t liberate us from that nagging question, “When will this long economic cycle end?”
But that question has stalked this bull market for years now, hasn’t it?