After a very volatile correction lasting just over 4 months, May 3 marked a turn up in markets. During the correction some indices made consecutively lower highs, and either higher lows (creating a triangle formation, small cap indices) or held at support multiple times (large cap stocks). May 3 saw a price reversal and only a few days later many indices were making higher highs, breaking up through the downtrend. During the rest of May stock price marched higher, despite on going geopolitical concerns and a disruptive Italian bond market.
International stocks also turned up early May, but were thwarted by the ongoing difficulties, politically and regarding the US Dollar strength. Ex-US stocks appear to have retested correction lows at the end of May but have yet to catch up to US markets in exceeding high-water marks during the January-April correction.
Drivers of the renewed bullishness in prices are both fundamental and sentiment driven. Fundamentally, earnings in Q1 grew by more than 25% year over year, with upwards of half that coming from tax reform. After hitting a 7-year bullish extreme in January at 59%, sentiment towards stocks became quite negative after the correction took hold, bottoming at 26% bulls in early March. Recently bullish sentiment was back up to 35%, and I expect bullish sentiment to increase to very high levels again prior to any significant declines in stock prices.
Additionally, the record earnings (and Q2 forecasts) have driven down the market Price to Earnings ratio from nearly 25x in January into the mid 22x range, based on trailing 12 months as-reported earnings. Furthermore, according to FactSet analysts have been raising Q2 forecasts, contrary to history where estimates steadily decline into earnings season (setting up easy ‘beats’). The decline in prices and increase in earnings, past and forecast, has pushed the ratio down, and essentially removed the discussion of how expensive the market is. Sentiment moving up from lows, and earnings (be they tax driven or economic) climbing should make it easy for investors to push money into stocks over the coming weeks or months.
This Correction Was Different
The dive in stocks in February came on the heels of a rise in interest rates. The yield on the 10-year Treasury went from 2.38% December 29, 2017 to 2.85% on January 29. This significant rise is akin to the rise in rates after Trump’s election and the ‘Taper Tantrum’ when Fed Chair Bernanke stated that the Fed will raise rates ‘sometime in the future’ in the summer of 2013. Both post-election and in the summer of 2013 stock prices rose as bond prices fell (bond prices and rates move inversely to each other). This time however rates were ‘too high’ and would either effect corporations’ profits or the relative attractiveness of stocks vs bonds, causing (or at least giving a reason) for both stocks and bonds to fall at the same time.
The significant prior declines in stock prices late 2015/early 2016, as well as 2nd half of 2011 (US credit rating downgrade) were accompanied by a decline in interest rates, pushing up bond prices. The past several large moves in either rates or stock prices were met with opposite reactions from the other asset class. This behavior is the root of Modern Portfolio Theory, investing across asset classes to reduce volatility. This natural diversification that has been at the root of finance academia for over 30 years, but may be coming to an end.
The result is that investors who are more conservative, seeking a traditional 60/40 stock and bond split may encounter fluctuations like those more aggressive investors who are much more exposed to stocks. And the worst-case scenario of a bear market in stocks may be accompanied by rising rates/falling bond prices. Investors who are not aware of this and who do not have a plan on how to reduce volatility in both asset classes will have a very difficult time when the current bull market ends. It will be important going forward to have a strategy in place if both assets decline in price and not rely on traditional diversification concepts.
Adam Waszkowski, CFA