The Rally Will Be Over When It’s Over And Not Before

April 27, 2018

I heard an amazing piece of analysis this past week and it had to do with the timing of the next bear market in stocks.  Apparently, in the year before stocks start their downward slide, they rise! Who would have thought? Despite this truism, there has been more attention to signs of a potential negative shift in the market and whether the most hated rally in history is indeed about to come to an end.

Given that the S&P500 is up about 300% from its low in March 2009 you would think this rally would be loved by all. It started at a time when the world was still on the brink of an economic and financial disaster and, while stocks recovered, there were enough reasons to believe that the rally would fizzle out that many investors stayed on the sidelines. Central banks reinforced this fear by continuing to flood the market with cheap cash seemingly to protect a fragile recovery.  Disciplined investors saw this for what it was—a put option by the monetary authorities and added equity exposure into the rally.

 

 

To see how much confidence institutional investors had in the economy’s ability to recover and fuel stock valuations, consider how many times we saw economic numbers fall short of expectations, only to send equities higher. Why? Simply that rational expectations suggested that weak data would be met with even more policy stimulus.  The same thing applied to company results. Not only was the bar on earnings set low, allowing for multiple quarters to go by with results easily beating expectations; analysts and traders were very forgiving when revenues and earnings didn’t match estimates. This was, after all, a recovery from the “Great Recession”. Give them a little slack.

The current environment is a little different. As the past week illustrated, Wall Street is not so complacent when it comes to earnings, even when the results come in ahead of expectations.  And, to be sure, the bar has been raised considerably since Trump and Congress passed sweeping corporate tax cuts at the end of 2017. Consider Caterpillar.

The company just announced earnings for the last quarter and they were ahead of expectations.  Not only that, the industrial heavyweight raised its forward guidance by 23% versus last year as the global economy shifts into high gear. Oil and metal prices are up, while construction spending is strengthening.  What’s not to like? Apparently the tail-end comment made by the company, that the first quarter could be its ‘high water mark’. How did the market respond to that comment? What about a drop from a morning high above $161 to a low of under $143.50 – a big disappointment for bulls that had seen the stock rebound the first quarter rout that took it below $140. Indeed, Caterpillar is now well below its January stratospheric highs above $170.  All because the market decided to dig into the earnings report looking for goose eggs, instead of golden ones.

 

 

On the flipside, the tech sector showed that it still can deliver Q1 revenues and earnings that beat market expectations.  Forget Trump’s post office crusade; this was vindication that the stock’s rise through $1600 a share may not have been a fluke. As I have discussed before, it isn’t a coincidence that the NASDAQ is the only major US index to show a gain so far this year.  Technology and its penetration into the consumer discretionary space makes it a more pervasive engine of the economy than bricks and mortar and mining equipment makers.

The take away from this is that the fundamental cyclical drivers we used to look to for clues as to whether a stock market rally had run its course or not may be less valid than in previous cycles. Don’t get me wrong. The likes of Apple and Amazon won’t prevent an economic recession, nor the next 20% plus correction in equities.  A decline in personal income will stop an iPhone sale dead in its tracks and make a trip to the dollar store more appealing than an Amazon order. Technology was the reason for the bust in 2000-2002, yet this sector might just be the reason this rally continues for a little while longer.

 

 

Upcoming events

Canada:  Producer prices, February GDP, Markit manufacturing PMI, merchandise trade, Ivey PMI

US:  Personal income, Chicago PMI, pending home sales,  ISM manufacturing, April vehicle sales, FOMC rate decision, ADP payrolls, trade balance, durable goods, non-farm payrolls

 

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