Market Madness?

Key Points
  • U.S. stocks resumed their uptrend after a short respite, but with the economy slowing, the yield curve inverted, and earnings likely negative for at least the first quarter, the risk of a pullback appears elevated.

  • The first quarter was highly likely weak for both earnings and the economy overall; but it could be followed by at least a modest rebound in the second quarter if traditional seasonal patterns hold. Given the slowdown, the Fed is now forecasting no rate hikes in 2019, which suggests binary risks of either slower growth than expected, or higher inflation than expected.

  • The recent inversion of the most widely-watched U.S. yield curve is not only a sign of rising recession risk, it can also be instructive as to international markets as well.

“Hope springs eternal.”
Baseball fans everywhere

Bullish madness?

U.S. stocks have continued their sporadic move higher, after a short-lived dip associated with the inversion of the yield curve (read more in Liz Ann’s article Blue, Red and Grey: Yield Curve Inversions); recovering much of their fourth quarter 2018 losses. We never scoff at rising equity prices, but we are becoming increasingly concerned that gains have exceeded the fundamental underpinnings, at least near-term.

Uptrend intact—but too far too fast?

S&P 500 Index

Positive macro supports have been evident, including hopes for a trade deal with China and the 180 degree turn toward dovishness by key central banks, including the Federal Reserve and the European Central Bank (ECB). There are also some temporary factors which put downward pressure on first quarter growth, including severe weather and the government shutdown. That said we are concerned that those positive vibes may be obscuring some potentially negative developments; not least being the message the bond market and yield curve has been sending.

In keeping with rally, investor sentiment, according to the Ned Davis Research Crowd Sentiment Poll, is back in extreme optimism territory, while valuations have moved back into elevated territory. The forward P/E for the S&P 500 is now 16.3, above the 15-year average of 14.9 (Strategas Research). This has been driven by both stocks moving higher and earnings estimates moving lower. As mentioned, Refinitiv shows the consensus for first quarter S&P 500 earnings to be -1.8%, with only slightly positive expectations for the subsequent two quarters. And while financial conditions have eased, contributing to multiple expansion so far this year; earnings may have to start doing more of the market’s heavy lifting—a not insignificant task given myriad headwinds facing earnings growth.

Real story may be somewhere in between

For those who lived through the Polar Vortex, spring is likely a welcome reprieve. Add in the government shutdown, and it made for a rough first quarter The Atlanta Fed’s GDPNow estimate has moved up to a still-weak 1.5% annualized growth, up from just 0.2% just a few weeks ago; and the government is still trying to catch up from the shutdown with respect to some economic data. As mentioned, some temporary factors appear to be fading, which could lead to a lift in the second quarter. Even the Fed acknowledged at the March FOMC meeting that “economic activity has slowed from its solid rate in the fourth quarter.” How much of a rebound we’ll get is in question; but we continue to believe trade holds the key. According to myriad reports, including from The Wall Street Journal, trade talks with China remain bogged down; although there were recently high- level talks again scheduled. Adding fuel to the concerns was President Trump’s recent proclamation the tariffs will remain in place for a “substantial period.” Reports from Politico also indicated that the Commerce Department has given the White House a report noting that tariffs on European autos would be justified. Finally, the third leg in the trade stool also looks shaky with Schwab’s own Washington expert, Mike Townsend, believing that passing the U.S. Mexico Canada Agreement (USMCA) through Congress is nowhere a done deal at this point. The outcome of each of these is impossible to know at this point, but it does keep business confidence under pressure and will likely result in ongoing delays to investments in capital and equipment (see the plunge in small business confidence below).