Melt-up! Now What?
Stock market gains have accelerated and it has the markings of a melt-up or “blow-off” phase. At this point, the surge has been accompanied by a commensurate improvement to corporate earnings, but risks are also likely rising.
The U.S. economy has stepped up its pace of growth, but the rate of improvement appears to be moderating, which could lead to more lackluster and/or volatile stock market performance in the coming months.
European growth is booming relative to recent history, but there are some potential pitfalls to watch for in the coming months.
U.S. stock market gains have accelerated in the first month of the year, leading to the appearance of a melt-up or blow-off phase of the bull market.
Looking suspiciously like a melt-up
Source: FactSet, Standard & Poor's. As of Jan. 19, 2018. Past performance is no indication of future results.
We’ve often warned that melt-ups can feel good at the time but typically end in melt-downs, even if only briefly. Melt-ups can last for a decent amount of time and investors who bail could miss out on potential gains. We are in the relatively early stages of this move, but a catalyst for a pullback could come at any time.
Anecdotally, the heightened scrutiny of the rally and skepticism around its sustainability suggests investor sentiment—although exuberant—is not irrational. That said, the Ned Davis Research Crowd Sentiment Poll has reached its highest-ever level of optimism since the index was created in 2002. But on the behavioral side, we still see money coming out of equity mutual funds and exchange-traded funds (ETFs), with Evercore ISI Research reporting that $44 billion was pulled out during the three weeks ending January 12.
As mentioned, earnings have been accelerating along with stock prices, keeping valuation expansion to a minimum. For example, the forward P/E (price-to-earnings) ratio for the S&P 500 is currently about 18.5 according to data from Thomson Reuters. Although elevated, it’s well below the 24-26 level at the 2000 peak. In the multi-year run-up to the 2000 peak, Federal Reserve Chairman Alan Greenspan made his famous reference to the possibility of “irrational exuberance”—but that was in 1996, and the bull market continued for more than three years. But with optimism elevated and valuations rich, the cushion in the market has been reduced—which could lead to more volatility and more sizable pullbacks this year than we saw last year. As you can see in the table below, years with exceptionally low volatility (as measured by maximum intra-year drawdown) tended to be followed by years with more volatility/drawdowns.
Source: Bloomberg, Strategas Research Partners LLC. For illustrative purposes only. Past performance is no indication of future results.
Economic growth takes a step forward
In addition to strong earnings, the uptick in U.S. economic growth supports a continuation of the bull market. In short, we don’t see any sign of a recession on the horizon, which has been typically what it takes to ignite a bear market. Case in point is the latest acceleration in the leading indicators—indicative of not only continued growth, but an accelerating rate of growth.