..to appear in the market but not the high street.
In a week that saw indeed an overly dovish market react sharply to pretty much a neutral Fed the difference between expectation and reality became obvious. Indeed, there is a growing disconnect in this market in several respects and one level above the correlation break down that became acute in 2017. Not just between asset classes (stocks vs yield and dollar) but also within asset classes (NDX vs RUT) but between not dissimilar stocks. AAPL's ramp this week in response to earnings contrasted with the previous GOOGL and INTC earnings routs. This polarization is typical of the very final but often aggressive stock (1987 and 1929 style) blowout and sees yields and the Dollar turn before stocks. How one steers successful such a market full of misinformation may seem challenging but understanding why it is happening and what to look for is very instructive.
The immediate cause of this disconnection is the lack of breadth. NDX made clear new highs this week and yet less than 50% of its stocks are above their 200-day moving average. The root cause is due to an increasing divergence between slowing growth particularly in earnings/revenue in some places and a bullish sentiment that refuses to commit to longs because of the fundamental uncertainty.
As we said in our newsletter last week:
The context for 2019 (and the clearest index view - a full retest of the Russell (still 9.5% away) all time high), remains centred on three factors: consumer sentiment as reflected by the Michigan Consumer Survey Index, the consequent individual stock earnings, and sentiment that may appear bullish but remains distrusting and not as invested as it could be. Understanding the interaction of these three elements has been and will remain key to stock markets in 2019.
Consumer Sentiment (The Fundamental Driver)
MSCI reflects the underlying softness in the economy which is not keeping up with the stock markets. As the SPX breaks to new all-time highs and the NDX is re-testing the 2018 highs after its break-out, the MSCI is some way below its 2018 highs and even below 100.
How long can this persist? A considerable time as evidenced by the comparison of the current bull market to the previous:
This slowing of economic performance, but not decline (associated with the final blowout) is also reflected in earnings. In a sustained bull market, the fundamentals such as earnings should broadly be improving not deteriorating. And yet, the earnings season we are finishing has been a mixed bag. 333 of the companies in the S&P500 have reported so far and EPS growth is averaging +7.2%. This is way down on the previous four quarters as the tax cut benefits are now baked in, but nowhere near the earnings recession some predicted early this year. Additionally, 77% of companies have beaten EPS estimates and 62% have topped revenue estimates.
Banks set a high standard early on with some big beats and even bigger moves. Industrials have been on the weak side with 3M (MMM) falling heavily, and Caterpillar (CAT) disappointing enough to fail its attempted break-out higher. Meanwhile Tech has had its soft spots (particularly Alphabet (GOOGL) and Intel (INTC)), but was generally good enough to help a break to new all-time highs.
Focusing on the positive, earnings season has at least been better than feared. Estimates had been lowered and allowed the majority of companies to beat, but notably estimates are now being guided higher again. AAPL perhaps typifies the general trend. Revenues are down -5.5% YoY, Tim Cook didn’t even mention iPhones when he listed all the great results in the intro to his earnings call, but they managed to beat the low estimates and that was good enough to continue the rally.
On the negative side, growth has almost certainly topped and figures are likely to settle in the high single digits compared to the blow off 31.3% figure seen in 3Q18. Margins could have also peaked, and this earnings season is estimated to show margins at 11.04%, well below the 3Q18 peak of 12.13%.
The prognosis is still health but less healthy than it was. EPS growth will be much slower and more fragile. If the pick-up in growth is not realized, it will be hard to justify the speed of the current rally in stock markets. Indeed, much of the current rally can be attributed to lower rates and our fundamental model can show this clearly.
The most important are EPS of the S&P 500 and RF. RF is the risk-free rate (the 10-year US bond yield). You can’t see them in the formula above as they feed into D1 and r which have their own formulas (it gets fairly complicated).
Based on estimates for GAAP EPS of $132.42 in Q118, with the 10 year yield at 2.54%, the formula gives an S&P500 price of 3068. We can’t say this is exactly where the S&P 500 should be right now, but as a ballpark figure it works well and shows the current price is about right.
But just to show how sensitive the formula is to rates, and how much the fall in rates could have helped, let’s model the same EPS with a US10Y rate where it was late last year at 3.2%. In this case the model projects a price of 2187.
High earnings growth and GDP growth rates allowed the S&P500 and the 10 year yield to positively correlate for several years. GDP growth may still look solid in the US, but it has weakened nearly everywhere else and the Q119 figures were supported by a flurry of activity associated with the trade war. As firms imported and stockpiled ahead of proposed tariffs on January 1st, it meant imports were lower in Q1 and this helped boost the 3.2% figure by around 0.6 percentage points. We can see from the chart below the positive correlation between rates and the S&P 500 has started to diverge this year and it warns of underlying weakness in the economy.
Although It seems hard to justify aggressive new all-time highs with a backdrop of economic weakness and low earnings growth, the third of our considerations—sentiment—tells us it is quite possible.
Sentiment (The Market Driver)
There can be little doubt that sentiment is bullish. Yet the market does not appear as invested as it should be if this were a market top.
Indeed, indicators such as the AAII show us the figures are not extreme, and more respondents are actually neutral than bullish. Presumably those who are neutral now have no position and could turn bullish and buy at some point in the future.
This data is backed up by CNN’s Fear and Greed indicator which is at 66 out of 100 and has fallen recently, probably because the S&P500 is chopping around its previous all-time high and giving the investors reasons to be cautious, even bearish.
Obviously this had no real impact on the stock market rally, but shows again that the market is not all in on equities. On top of this, there is a steady bid from corporate buybacks. Apple alone bought back around bought back $24B of its own shares last quarter and 2019 is due to be a bumper year for buybacks.
The upshot of all this is it seems the market still has some “dry powder.” If and when it will be put to work remains an unknown, but with a trade deal seemingly in the final stages and Trump intent on juicing the market into the election, there seems little reason to sell and dips look likely to remain shallow.
In years to come we have no doubt this market will be known as Trump Bubble where stocks traded continuously beyond fundamentally justifiable levels. All will seem very obvious in retrospect. And yet as we live it, ironically it is the periods of uncertainty inspired by a slowing of consumer confidence and consequent slowing of earnings and economic growth that will create prevent the market becoming overly bullish and long. Only once the markets become overly invested again like the were in early 2018 will the conditions be right for a significant turnaround. Only once we have again seen the buying frenzy on the trading floor and stockbrokers that is when the lack of a buying frenzy on the high street and online will hit home.
Here’s to making the very best, and good luck and good trading
Ed Matts, Founder
Andrew McElroy, Chief Stocks Analyst
To receive our weekly articles by email in advance of publication, please sign up for our Sunday newsletter.