Much Ado About Nothing
Mar. 11, 2019 Commentary

Much Ado About Nothing

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As we expected, the December panic attack in the market turns out to be Shakespearean, “Much Ado About Nothing.” What now?

“How poor are they that have not patience! What wound did ever heal but by degrees?” -Shakespeare character, Iago, in Othello in Act 2, Scene 3

We have transitioned from the scorched earth abyss in equities in December, the well-publicized, “Worst December for the S&P 500 since 1931,” to a mood of hope and promise in the early part of 2019, tagged in the headlines as, “The best start to the stock market since 19871.” 

Specifically, since correcting almost 20 percent from peak to trough prior to Christmas, the S&P 500 Index has rallied by close to 20 percent off a Christmas Eve bottom through the end of February 2019. As of March 1, 2019, the S&P 500 stands at roughly 1.6 percent above the Nov. 30, 2018 close and only 5 percent off all-time highs set back in September 20182, hence the analogy to Shakespeare’s play, Much Ado About Nothing, with regard to the late 2018 panic attack. Once again, this appears to have been a normal market correction in an ongoing bull market, as we expected. Investors burned a lot of calories worrying about all kinds of things during the holidays, only to round trip the December losses. 

We have moved from the 2018 year-end tragedy to the early 2019 comedy. While we have not yet moved on to new all-time highs, and the bulls cannot completely claim victory, they do appear to have the upper hand at this time.

At least this has lightened the anxiety a bit. Perhaps those typical New Year’s resolutions to work out more diligently weren’t necessary this year, given the heightened metabolism all the angst inspired going into 2019. 

As we have discussed in previous commentaries, we are not surprised to see this recovery and stabilization in the market. In our Crystal Ball Market Outlook, we expressed our belief that investors had become far too pessimistic and were assuming worst-case outcomes on multiple wall of worry policy fronts, particularly with regard to the upcoming Fed policy decisions, the end result of trade negotiations with China, and the likely economic impact of the government shutdown. We believed market participants and strategists had begun to confidently, and incorrectly, conclude that these issues would spark a near- term economic recession. In associated fashion, investors were speculating that the great corporate earnings in 2018 would turn into losses in 2019. In examining the facts and the hard data, we expressed our opinion that recession in 2019 was very unlikely, that earnings would moderate but remain positive this year, and that we would see better than feared outcomes on these major policy fronts. 

Once the fear subsided and other investors could appreciate the actual healthy numbers, we believed the market would experience a nice lift. In December, this was not the popular view. For the time being, this has evolved from contrarian thinking to the accepted view by many. So what now? Read on for our thoughts and rationale.

The Early 2019 Rally is Real and Not All Smoke and Mirrors

There is much talk in the media today that the only reason the market has recovered significantly, and is up over 11 percent in the first two months this year3, is that the Federal Reserve has done a 180 from its tough talk of hiking rates throughout 2019, and is now championing a much more dovish message that it is in pause mode at present. 

Our view is that, yes, the softer tone taken by the Fed on future rate hikes has improved investors’ moods, as has news of progress on trade negotiations and the end to the government shutdown. The improvement on all of these policy issues has helped restore some confidence and lift P/E multiples from below-average back to average levels. That said, the solid economic and earnings news has also supported this recovery in stock prices. The Fed can tell us it’s going to pause in its rate hikes until the cows come home, but without positive news on the data front, that would be like pushing on a string. A pause in hawkish language can cushion the fall in a slowing economy/pre-recessionary period, but it alone cannot drive stock prices sustainably higher if the economic and earnings data isn’t congruent with a picture of potential continued growth. In that regard, we see many signs of moderating, yet continued growth. 

Let us recount some of the favorable fundamental news we’ve digested since the pre-Christmas swoon that has helped support the market:

  • Back-to-back Bureau of Labor Statistics payroll reports indicate that the private sector created more than 300,000 new jobs each month in both December and January.
  • Consumer confidence remained strong and took a positive bounce as the University of Michigan Conference Board’s Consumer Sentiment Index rose back above the 100 level in February.
  • The Institute for Supply Management’s Purchasing Managers’ Surveys for February remain healthy, as captured by index readings well above the critical 50 level, pointing to continued growth in both service and manufacturing industries in the United States. 
  • The yield curve re-steepened a bit as the 10-year Treasury yield rose from 2.56 percent at the start of the year to 2.75 percent on March 1, and the spread between the two-year and the 10-year Treasury has doubled from 10 to 20 basis points3.
  • Fourth quarter 2018 GDP came in at a better-than-expected level of 2.6 percent with strength exhibited in both consumer and business spending. GDP growth on a year-over-year basis averaged more than 3 percent for all of 2018, the first time that has occurred in quite a while3.
  • S&P 500 earnings for fourth quarter 2018 grew by 13 percent, and expectations have risen from flat earnings in 2019 back to positive growth of 4-5 percent for this calendar year, based on consensus analyst numbers3.

So, this rally isn’t all smoke and mirrors and based alone on hopes and dreams of how a Fed pause can help lift spirits. While not all the data is stellar, we wouldn’t want it to be. In our experience, purely positive data can lead to euphoria, unreasonably high valuation and a market top. We need some skepticism and doubt to remind us to respect risk. 

We should point out that some of the disappointing economic releases do not make sense to us. According to the commerce data, retail sales fell by more than 1 percent in December. How can this be when the largest retailers such as Walmart, Target and Costco reported 4-8 percent same store sales growth? The same goes for others such as Lowes, Best Buy and TJX. Couple such empirical data with the strength in consumer spending in the fourth quarter GDP report, and the December retail data released by the government doesn’t mesh with reality, in our view. Not surprisingly, retail sales data are some of the most revised and volatile figures the government tabulates, in our opinion. 

Further Confidence in the Technical Price Trends and Market Leadership

Although we believed the fundamental and valuation backdrop looked quite positive in the midst of the December swoon, one of the missing elements to our embracing a fully confident carpe diem view was the type of leadership and the technical price trends we were observing in the market on the up days. We were bothered by the narrowness of the market on bounce days and believed the leadership at the time was concentrated in the defensive areas like staples and utilities. This lack of breadth and timid investor buying behavior made us wary that the correction might take some time, and that we could retest lows before experiencing a sustainable rally. We were emboldened to hold positions, based on the data, but felt caution was still warranted with regard to adding to equities.

These technical metrics have improved dramatically for the better post-Christmas Day and into early 2019. Leadership is in the hands of the cyclical sectors such as industrials, semi-conductors and consumer discretionary right now, not the defensives. Participation in the healthy 2019 performance is broad, not narrow and concentrated. These are signs that could indicate a more sustainable longer-term advance. In analyzing the technical data, and according to Strategas, we do appear overbought right now, on a temporary basis, and should expect a pause or modest near-term retrenchment after this early run, based on historical precedent. That said, on a historical basis, when more than 90 percent of stocks in the S&P 500 are trading above their 50 day moving average, per Strategas, (like we see today) this is generally a good sign for stock market returns in the ensuing six- to 12-month time frame, as indicated in the chart below.

Forward S&P 500 performance when 80% and 90% of the S&P trading above 50 day moving average

Source: Strategas

So, Why all the Year-End Pessimism?

If the data is all good, why the excessive pessimism at the end of last year? 

  • Fiscal stimulus from tax cuts would fade in 2019
  • Stock price volatility was at historically unprecedented levels
  • We’ve never experienced such an economically painful shutdown like that of 2018
  • The stock market never does well when earnings growth slows

We believe these statements are untrue. However, they were out there in the media, and they scared people. At the end of the day, we believe the increasingly accepted notion that recession was right around the corner was THE culprit. The bear chorus cited the falling stock market, one of the leading indicators of the economy, as a primary signal that indeed we were headed for recession. The problem is that we believe a falling stock market often provides false signals. There is a reason that Paul Samuelson coined the famous phrase, “The stock market has called for nine of the last five recessions.” Short-term trends in stock prices are but one of a dozen or so major indicators of recession and major market tops, several of those signals are much more powerful, such as yield curve inversion, level and trend in the Purchasing Managers Indices for Manufacturing and Service businesses, and trend and level in the broader Leading Economic Indicators Index. Yet, none of these are signaling recession.

Wrap-up 

As we started, we end with a quote. A famous 20th century academic, writer and researcher about the financial world and the physical sciences, Benoit Mandlebrot once said, “When the weather changes, nobody believes the laws of physics have changed. Similarly, I don’t believe that when the stock market goes into terrible gyrations its rules have changed.4” We would agree; the rules governing good data analysis remain unchanged. We embrace the still-positive backdrop. A pause or temporary retrenchment is probable, but we believe the bull market continues and will see additional gains in 2019.

 

1https://www.marketwatch.com/story/its-the-best-start-for-the-stock-market-in-32-years-by-one-measure-so-why-is-wall-street-so-uneasy-2019-02-23
2Factset S&P 500 price return data
3Factset
4https://www.brainyquote.com/quotes/benoit_mandelbrot_301439

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