Easy Money and Momentum
- In our 2018 year-end update, we began by stating “World markets, and specifically the U.S. markets, are increasingly beholden to monetary policy: specifically, easy money and the liquidity that comes from it. Isn’t it something, that no market anywhere in the world can seem to make headway without some sort of stimulus”?
- Let’s do a quick recap on the last six months. The S&P 500 finished the 4th quarter of 2018 with the worst quarterly return since 2008 and the worst December since 1931. On Christmas Eve, in what is being called the “Mnuchin bottom”, U.S. Treasury Secretary Steven Mnuchin, in an effort to calm investors, reached out to the country’s largest six banks to discuss markets. As has been the case since 2009, market participants reacted accordingly by believing in the Fed’s ability to create a floor and bid up stocks.
- From this Christmas Eve miracle, the U.S. Fed embarked on a series of interest rate and quantitative tightening walk backs. Not to be outdone, the European Central Bank, which just ended its credit infusions to its banking system, started walking back its plans to tighten monetary conditions by discussing more easing. To complete the coordination, China stepped in with massive liquidity credit injections to its state-owned corporations.
- The tsunami of dovish talk from the U.S. Fed and Europe, combined with China stimulus, provided the fuel for runaway momentum to make its familiar reappearance. So, from the worst quarter in 10 years to the best quarter in 10 years, we have come full circle and have almost made it back to the old 2018 October highs. But have things changed? Are we in a continuation of the old bull market, or is this a large bear market rally? Good questions, with not any clear answers so far.
What We Know
- The S&P 500 is within 2% of old October highs. Momentum is increasingly being followed by more participants, creating exaggerated moves in both directions. Buyers higher, sellers lower.
- Inflows into equities by retail clients are still low given the rise the past few months. Typically a bullish data point.
- Liquidity by world central banks is on the increase. Market movements and central bank policy are tightly linked.
- The global macroeconomic picture is still poor, with most data pointing straight down. Some early economic bottoming signs in Asia, specifically in China, due to stimulus programs.
- S&P 500 is projected to report its first year-over-year decline in earnings since 2016.
- Stock markets are betting that the earnings picture will recover in the 3rd and 4th quarters. What happens if the recovery doesn’t materialize?
- The futures market is now predicting a 50% rate cut by January—odd for an economy that is supposedly very strong.
What we don't know
- When will the U.S. have a deal with China? Ever?
- Are corporations still seeing a second half recovery?
- Brexit—will this ever happen? Unlikely.
- Is the global economic weakness a function of trade tariffs with China, or is the cycle turning down?
- On that last point, a research report out of JPMorgan is doing the rounds among traders this week, in which JPMorgan strategist Dubravko Lakos-Bujas talks about the current cycle and adds the following: “The reality is that maybe the word ‘cycle’ is no longer even relevant, given that we have so much unconventional central-bank involvement.”
- While this statement appears to be true, make no mistake. The current economic environment is weak and any shock to it soon would likely put the U.S. into a recession. Markets are climbing the proverbial “wall of worry” without any data yet to support a second-half earnings recovery.
- Price and momentum are telling us that higher prices lie ahead while the macro-economic data signals that risk is very high for a letdown. To highlight the risk, S&P EPS estimates for 2019 are around $170; however, our internal modeling shows risk to these estimates. We see a scenario where actual EPS for 2019 could come in closer to $150–$160. The market currently does not have this priced in and, using some historical P/E ratios, suggests downside of -15% to -20% from current levels.
- When growth is slowing, the right strategy is to be more defensive, especially at heightened valuations. Below is a chart showing the current global manufacturing index and MSCI earnings growth. We have yet to see a turn in either. As mentioned, the market is telling us the turn should be coming. We wait for more data to prove this thesis.
The tug of war will continue between price momentum suggesting higher prices and macro data suggesting an overvalued market, over-stretched market. We believe the best course is to remain positive but not fully invested.
Current Technical Picture
- However, the S&P 500 isn’t the only game in town and other U.S. asset classes are faring much better where the charts are showing much greater momentum. Growth stocks continue to outpace value stocks, which has been the case for the past 5 years.
- Mid-cap growth (figure 2) is currently the favored asset class based on relative strength. In times of low growth, investors seek out companies that can deliver earnings growth and mid-caps have traditionally occupied the sweet spot of the market. Our RS Leaders strategy is a mid-cap growth stock strategy and has taken advantage of this bull run since August 2016.
- Small-cap stocks, on the other hand, regardless of growth or value, have had a tough time keeping pace as of late. One reason may be the combination of high debt loads and EPS revisions that are worse than mid- and large caps