The markets continue to recover in the wake of what has been an uneventful week in terms of news, or more specifically the lack of bad news. As mentioned in our prior weekly market overview article, we’ve come back to a more normal “bullish environment”, which implies reduced volatility and lower trading volumes.
The pullback in equities towards the end of 2018 is still fresh on the minds of various investors and traders alike. However, broad market corrections of 10-20% are fairly common and tend to happen every year or every other year. The prior stock market correction troughed on February 5th, 2016 with the S&P 500 finding a base at $1,880. Following the correction, the S&P 500 advanced to $2,990 by August 31st, 2018. This implies that if anyone had sold shares at $1,880 the same investors would have missed index returns of 59% over a two-year timeframe.
The key take-away? Staying invested in equities following a market correction works way more effectively (historically), hence we continue to maintain the same optimistic stance. Staying on the sidelines rarely pays dividends following a market correction, and absent of economic headwinds, stocks will continue to trade on fundamentals as opposed to market-themed headwinds or tailwinds.
Where can investors find alpha (returns above market)?
In general, when dealing with individual equities, the stock that are likely to outperform will be less correlated to the broad market and will deliver returns based on their long-term earnings/cashflow growth, and the ability to return capital to shareholders via share buybacks.
In this environment, growth stocks that are anticipated to grow sales and earnings at a quicker rate than the S&P 500 will outperform the market with more predictability than say a counter-cyclical trade where you’re investing into defensive stocks that have great dividend payouts and stable business outlook, but mediocre growth metrics.
Diminished volatility, and volume penalizes defensive stocks and tends to favor growth stocks that are more volatile. With volatility diminishing across all equities, the volatile growth stocks tend to skew more favorably in terms of daily gains/losses, hence those with more risk appetite will find more opportunities to generate returns in companies that generate revenue/earnings growth in excess of 15%-20% annually. The downside to growth stocks is how poorly they perform when the market itself is performing poorly or they miss on sales/earnings estimates. So, implicit in my assumption is the continuation of the up-trend for the S&P 500.
When will we test all-time-highs?
Source: Google
I anticipate that we will re-test the prior all-time-high at $2,930 (which was set on September 20th, 2018) within the next several weeks, if not the next couple months.
I’m anticipating the market to struggle with breaking past this level with some consolidation, but I don’t anticipate the market to not break past the all-time-high, either. In other words, we could be testing the 2,900 to 3,000 levels on the S&P 500 for several weeks before we eventually break past on low volume, and capital inflows into the equity markets.
When entering into “uncharted territory” technical indicators become less effective, and most of the gains are attributed to collective business fundamentals, or the number of companies among the S&P 500 that were able to report sales/earnings beats as opposed to market commentary from the federal reserve or treasury for that matter. Since Q1’19 earnings will be reported from the week of April 15th, which is just 1-month away there’s reasonable runway to the current market rally, and we should anticipate a re-test of market all-time-highs over the course of Q1’19 earnings season.
Economic news of the week and what to expect next week
The CPI (consumer price index), which measures inflation fell by 0.1% month-on-month. This drop-in inflation was perceived to be “good economic news.” Hence, CPI came in at 2.1% versus 2.2% for the month prior.
The lack of inflation diminishes the willingness of the Federal Reserve to raise interest rates, which in turn keeps investors optimistic, because higher interest rates are heavily correlated with the end of an economic cycle. Basically, the higher the interest rate, the less likely the economy will continue to exhibit money multiplier as consumers and lenders lend/borrow less until the interest rate falls for both prime and subprime borrowers.
Because inflation has remained relatively steady at 2% there’s little incentive for the Federal Reserve to raise interest rates, which has kept economists optimistic on a dovish Federal Reserve across consensus macroeconomists on Wall Street. The lack of inflation paired with GDP growth in a tight 2-3% range keeps expectations to a single rate hike from the Federal Reserve in 2019.
Furthermore, 2020 outlook suggests some deceleration in real-GDP growth, which may keep the Federal Reserve side-lined during the political election cycle year. Some economists anticipate that the Federal Reserve may not even raise interest rates in 2020, which could be helpful given the bumpiness in the current political environment, and on-going gridlock in Congress/Senate when passing bills or amassing political capital for pro-fiscal policy measures.
Also, the Federal Reserve or FOMC (Federal Open Market Committee) is expected to meet next week on March 20t, 2019. Economists expect the interest rate to remain unchanged with diminished growth outlook from the Federal Reserve next week.
Politicians will soak-up headlines on economics but nothing will likely come of it
We’re likely to witness another round of gridlock when congress/senate votes on budget measures in 2020, but those risks aren’t so substantial that it would derail on-going economic expansion (as we had witnessed in 2019). Expect a lot of headline activity from both political parties with regards to political promises and campaign trail commentary along with economic promises as we move through 2019 in anticipation of the 2020 presidential election cycle.
But, despite the uptick in political commentary (as is customary in election years) incumbent presidencies tend to win around 70% of the time historically, so on the political front, we’re likely to witness the same status-quo of the Trump presidency since 2016, which implies the same stance on taxation, and fiscal policy, which have been pro-growth or inflationary in nature.
For those who don’t like the current President, the percentage odds don’t favor you, but then again, a raving billionaire has produced some green shoots for the economy. Pro-economic policies or an aversion towards higher taxation, or various other policies for the following 4-year term until 2024 could diminish political themed risks with most of the attention geared towards congressional/senate elections as opposed to the presidential primary. This also means a continuation of the usual tweet storms from Donald Trump, and on-going political hysteria from mainstream news outlets for the following presidential term as well. Basically, a continuation of the past four-years seems to be in the cards, but that might not necessarily be a bad thing.
Chinese trade tensions have eased in the past couple weeks
In an interview on CNBC, March 14t, 2019 Treasury Secretary, Steve Mnuchin mentioned that neither President Xi or President Trump will meet at the end of this month to make a formal agreement on trade. This was followed-up with positive commentary on progress with regards to the trade agreement, and on-going efforts to improve upon the agreement before making any formal attempts to bring either president onboard to sign a trade deal.
It seems like progress has continued on this front, but there’s unlikely to be any newsworthy developments over the month of March, as there’s a lot of “work involved.” The Trump presidency has made numerous attempts in the past couple months to highlight the trade imbalance, and any positive developments here could get us over the hump and move past the Chinese versus U.S. headlines once and for all.
While improvements in trade could positively impact certain U.S. companies (dependent on sector) the absence of noise pertaining to U.S. trade talks following an agreement (if made within the next couple months) would be a positive catalyst in and of itself. We’ll continue to monitor the Chinese versus U.S. trade discussions but expect very little headway for the duration of March.
Interesting data points on money flows
U.S. equity inflows and U.S. bond inflows ticked considerably higher according to Bank of America Merrill Lynch, with equities inflows totaling $14.2 billion this week, and bond inflows totaling $9.2 billion. Investors have re-entered a risk-on phase, and with limited negative commentary on both economic/political fronts there’s a build-up of anticipation for corporate earnings season.
In terms of Forex Exchange flows, the USD experienced a modest net inflow of 1.8% over the past week, and a 4-week inflow of 0.5%, according to UBS (March 14t, 2019). The modest dollar inflows mostly reflected some of the divergence in investment activity among global investors whereby U.S. equities had a surge of cash. In comparison, Emerging Markets and Eurozone logged a net equity outflow of $2.8 billion and $4.6 billion respectively according to BofAML (likely due to Eurozone growth forecast reductions which were outlined in our prior market commentary).
The inflows into the USD didn’t trigger a rally in the U.S. dollar index (surprisingly), as the dollar index peaked at $97.61 and is now trading at $96.49 (month of March). Investors monitor the U.S. dollar index to anticipate currency adjustments on foreign sales and earnings. However, the tight range of $95-$98 of the dollar index diminishes the impact from currency adjustments.
Historically, flat currencies have been supportive of revenue and earnings for multinational companies among the S&P 500 who report FX adjustments to reflect actual revenue. In this case, investors should anticipate a currency neutral earnings season, as the trading range for the dollar index has stayed within the $95-$98 range since October of 2018. Therefore, the likelihood of a revenue miss due to currencies has diminished, which should add some optimism heading into April earnings season.
In terms of equity inflows, the biggest buyer of equities has been corporates. More specifically share buybacks, as the net corporate buybacks among S&P 500 stocks have increased to $286 billion versus $197 billion (prior year). The impact from share buybacks helps explain the improvement in stock performance to start the year despite year-to-date outflows of $46 billion in U.S. equities according to BofAML. This paired with U.S. index option open interest trending considerably higher ($544 billion), and positive retail investor flows of $13.2 billion year-to-date.
Final thoughts
The next leg of the rally might be driven by institutions, as buying from institutions lagged in comparison to retail investors and corporates year-to-date. This paints a fairly bullish picture over the near-term.
Furthermore, the on-going buyback craze could continue, as companies tend to update shareholders on their buyback plans over the course of corporate earnings season with some notable announcements coming predominantly from tech giants which have massive amounts of cash sitting on their balance sheets. Companies like Apple, Alphabet, Microsoft, Facebook, Qualcomm, Intel and so forth tend to make updates on their corporate buyback plans, and it would not be surprising to see the usual cash rich tech cohort make additions to their buyback plans during this time of the year.
Equity investors are back on the offensive again, and bullishness is returning. Despite all the concerns over the economy, or how long the cycle has lasted there’s a lot of good to anticipate in the coming weeks. Very little to anticipate on the political front, which is good. It means investors can direct most of their attention on how well individual stocks are performing as opposed to political theater.
