You know it’s bad when even the traditional ‘pumpers’ are getting anxious. While obviously counched in its own “well maybe that’s not totally terrible” spin, reading the following from Charles Schwab suggests Liz Ann Sonders, Brad Sorensen, and Jeffrey Kleintop were all struggling to defend any bullish position and perhaps more desperate to CYA in case reality doesn’t match their hard-sold perception…
Are risks growing or will the bull market continue? We believe the answer to both is yes. Political bumbling, monetary policy shifts, and geopolitical tensions have all escalated, but the bull continues to power ahead, largely unscathed by the tumult that surrounds it. This is actually in keeping with history, as partisan conflict in particular has served as a contrarian indicator for stocks in the past. Since past performance is not an indication of future results, consider it yet another brick in the wall of worry. However, it’s uncertainty around monetary policy that would likely be a culprit behind any coming choppiness in stocks.
The aforementioned uncertainties have kept investor sentiment from becoming too frothy, which helps to support the ongoing bull market. We don’t see signs yet of a “melt-up” scenario, where investors frantically rush into stocks, afraid they’re missing out on gains. As good as melt-ups feel while they’re underway, they don’t end well.
The possibility of a correction (defined as a greater than 10% pullback) is greater now than it was at the beginning of the year; especially given the uncharted territory in which the Federal Reserve finds itself, as it soon begins to unwind its $4.5 trillion balance sheet. We are modestly concerned about asset valuations that have soared in the era of artificially low interest rates and a bloated balance sheet.
We don’t think the bull is ready to take a bow just yet, and at this point would view pullbacks as healthy. According to Strategas Research it has been 268 trading days since the last 5% pullback—the fourth longest streak since 1950 (the 1990s had two of them).
Earnings growth is the mother’s milk of sustainable stock market gains and the next few weeks will go a long way to determine the status of corporate health. With one quarter down and another one in the process of being reported, it looks good, with the Thomson Reuters-reported consensus expecting at least a 10% year-over-year increase in earnings for 2017. What is more impressive is that the year’s expectations have only been downgraded slightly from the 14% growth rate projected at the beginning of the year. To illustrate how solid that is, look back to 2016, when projections at the beginning of the year were for 13% annual growth in earnings. Those projections were steadily downgraded throughout the year before ending up with an actual growth rate last year of less than 2%.
Of course, a high expectations bar leaves open the possibility of disappointments, which could add to volatility in the coming weeks. Already we’ve seen major banks largely beat estimates but pull back on some concerns about some seasonally soft numbers—which arguably should have been built into expectations. And the energy sector’s contribution to forward-looking expectations is already past its peak.
Another support for stocks may be coming from economic data that is showing a robust labor market, but few signs of inflation building. The unemployment rate is 4.4%, yet wage gains remain modest. The Consumer Price Index (CPI) was flat month-over-month, while ex-food and energy it only ticked 0.1% higher.
More concerning is the lack of solid increases in retail sales, although we believe the measuring process may be somewhat flawed due to the changing mix of sales. Nonetheless, it isn’t particularly encouraging for an acceleration of economic growth when retail sales as reported by the Census Bureau were down 0.2%, and ex-autos and gas sales ticked 0.1% lower.
On the plus side, the latest industrial production reading provided by the Fed bested estimates by showing a 0.4% gain, while capacity utilization moved higher to 76.8%; heading in the right direction but still 3.3 percentage points below the long-term average. Also, after a sharp decline, the U.S. Citi Economic Surprise Index has started to turn around, which should be another support for the ongoing bull market in stocks.
Economic uncertainty has confounded the Fed, which may raise the risk of a policy mistake and/or bouts of market volatility. In her testimony before Congress last week, Chairwoman Yellen indicated that the Fed is somewhat confounded by lower-than-expected inflation; citing “temporary” (and transitory) factors. She voiced no concern about elevated asset valuations, arguably brought on to some degree by the Fed’s unprecedented monetary policy since the financial crisis. This put the potential for another rate hike this year into greater doubt. We’re sticking with our forecast for one more hike this year along with the start of a gradual reduction in their balance sheet in their effort to “normalize” monetary policy; but also believe the latter could come before the former. However, Yellen also bolstered the doves’ case by noting that it is becoming more apparent that the “normal” level of interest rates may be below what it had been historically.
Down the street…what can be said? Politicians continue to play politics. Behind the headlines some business friendly policies have begun to have some positive impact, such as a reduction in the regulatory burden. But the three biggies—health care reform, tax reform and infrastructure spending—all appear mired in the morass that is Washington. Business leaders are used to this sort of muck in Washington and have made few plans based on potential changes. But there is little doubt in our mind that if nothing gets done, there will be disappointment among businesses and investors alike, which could add another log to the pullback fire. Already we are seeing the subjective “soft” data (survey- and confidence-based) catch down to the weaker objective “hard” data, as we expected.
A solid earnings season should contribute to a continuation of the bull market in stocks. Dangers are lurking, however, and the possibility of a decent-sized pullback has grown over the past couple of months, in light of monetary policy and geopolitical uncertainties. While we would likely view such a move as healthy, it can be disconcerting. Stay diversified and be prepared to guard against overreacting to any such move.
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