Goldilocks Vs. Market Bears

This is part two of the “Simple stories drive markets” series. Here is the first in this series.

As the S&P 500 finished yesterday one percent shy of its record close of 2131 set 13 months ago, what is that story the market is looking for to sustainably break above its 18-month trading range of roughly 1800 to 2100? A simple, plausible story is the “Goldilocks” narrative of the U.S. economy: not too hot – for fear that the Fed will tighten more quickly than expected, and not too cold – for fear that the forecasted “hockey stick” increase in earnings is not probable. That is, the market is hoping that earnings growth will turn strongly positive by year-end, after negative growth in the three most recent quarters.

Since the Fed ended quantitative easing (QE) in October 2014, the broad market essentially has been going sideways in a trading range, hoping for a new story to drive it to new highs. (In the first of this series, Simple Stories Drive Markets, we showed how narratives drove the previous two bull markets; this article explains how they have driven the bull market that began in March 2009.)

Instead, investors have been stuck on the story of a sluggish global economy, especially with manufacturing near stall speed. Metrics for output, new orders and headline PMI were “all at, or barely above, the stagnation mark,” according to the JPMorgan Global Manufacturing PMI for May released June 1.

All eyes on earnings growth and interest rates
Current market events can be interpreted using a Goldilocks framework, most notably the nonstop second-guessing of whether and when the Fed will raise rates a mere 25 basis points. A Bloomberg headline Friday, “Weak U.S. Jobs Report Kills Hopes for June Fed Rate Hike” underscores the perception among market pundits that the jobs report was a little too cold for investors’ tastes.

The ongoing risk is that the market might turn into something a lot colder if the economic news doesn’t pick up as expected. But it would be a mistake to make too much of any single news event, even one as widely watched as Friday’s jobs report.

After the weak jobs report on June 3, the Atlanta Fed later that day updated its GDPNow forecast of second quarter growth to 2.5 percent, unchanged from its prior estimate on June 1st. The New York Fed did the same that day, its Nowcasting report shows GDP growth in the second and third quarters of 2.4 and 2.2 percent, respectively, both increases from the most recent prior estimates.

These estimates are a significant improvement from first-quarter U.S. GDP growth of a mere 0.8 percent and 1.4 percent in the fourth quarter of last year. They are precisely the type of “Goldilocks” growth the market is hoping for.

While Fed Chair Yellen is focused on the employment data, per the Fed’s dual mandate, financial markets only care about two things: earnings and interest rates. Investors really don’t care about employment data per se, but only its impact on those two things.

Laundry list of worries
There is always a long list of things for the market to worry about. Our May 9 Motif Market Wrap discussed several key market concerns, and various large brokerages have voiced theirs. The U.K. Brexit vote on June 23 on to stay or leave the European Union is now worrying market pundits— another reason, along with the weak jobs report, why a Fed June rate hike is now considered highly unlikely.

Not to minimize the very real risks that currently exist in the market, but the risk of an imminent U.S. recession in the next quarter may not be one of them. Still, recession risk over the next twelve months has now increased to its highest since the Great Recession. Naturally, risks and uncertainty rise in a slower growth environment and are now higher than compared to what we saw in the QE period from 2010 to 2014.

U.S. stocks sideways in search of new story
Two simple, plausible stories have helped drive large-cap U.S. equities [S&P 500] in the bull market that began in March, 2009, enabling them to strongly outperform international stocks.

First, they have been viewed as “the cleanest dirty shirt” among major global asset classes since the start of Europe’s crises beginning in Greece in early 2010 to China’s slowing growth more recently.

The other story is of course the Fed’s ultra-low interest rates and quantitative easing (QE). Since Fed Chair Bernanke’s August 2010 Jackson Hole speech on QE to its end in October 2014, the market viewed almost any economic news as good news.

When the news was actually good, it showed the U.S. economy recovering; bad news was also good because it was interpreted by financial markets to mean ultra-low interest rates and more QE for longer. Hence, heads (good news) bulls won, tails (bad news) bears lost, at least through the end of QE in October 2014.

One key to successful investing is to step back from the daily news headlines and look at the big picture trends, using relative strength charts for example.

Reflecting these two simple stories, the Fed’s ultra-low interest rates and QE and the U.S. as “cleanest dirty shirt,” the relative strength of the broad market to non-U.S. international stocks, has increased a whopping 84 percent since the beginning of 2010. During this time, international stocks have done much more poorly in comparison and any investor would have done extremely well betting on diversified U.S. large caps.

This is shown in the chart below, the price ratio of SPY to ACWX is in the top panel, and the price performance of SPY itself in the bottom panel. You can see in the bottom panel that even as SPY’s price has flattened out since late 2014 after QE ended, its relative strength to international stocks has continued to strongly rise as seen in the top panel.

The relative strength, or price ratio, of U.S. large caps to developed market stocks outside North America has increased by 70 percent since the beginning of 2010. U.S. stocks also topped emerging market issues in a big way: the relative strength of U.S. large caps to emerging markets rose by 136 percent over that period, by 96 percent in the three-plus years alone since the end of 2012.

Some market pundits think that these trends may have gone too far and that both European and emerging market stocks are a better value than U.S. stocks. That may be so, but as the saying goes, “the trend is your friend.” That is, until it ends, the trick of course being how to guess that.