With the DJIA and the S&P 500 recently moving to new highs for the year, it is clear that the bull market in stocks has gotten back on track. Financial markets have concluded that the Fed has achieved the hoped-for “soft-landing,” and investors are celebrating a perceived “goldilocks” economic backdrop of moderating but still-firm economic growth combined with receding inflation risks.
One need only examine the behavior of financial assets since early August to conclude that worries about the sustainability of the expansion and the persistence of inflation pressures have dissipated. Stocks have staged an impressive rally over the past two months, with major cyclical sectors such as Technology, Consumer Discretionary and Financials leading the market higher.
Confidence in the economy can also be found in the high-yield corporate bond market, where spreads relative to Treasuries have fallen a quarter percentage point since August and are back near their lowest levels of the year.
Diminished inflation expectations can be found in the drop in longer-term bond yields and commodity prices, as well as the declining spread between nominal and inflation-protected [TIPs] Treasury yields. Although it has bounced in the past two weeks, the 10-year Treasury yield is still nearly a half percentage point below its mid-summer high of 5.25%.
The Dow Jones-AIG commodity index has fallen nearly 10% in recent months, and the 10-year TIPs spread - a measure of longer-range expectations of the CPI inflation rate - has fallen from 2.7% to 2.3%. In short, the stagflationary worries that enveloped financial markets over the summer have largely evaporated.
The current consensus view in the market is that the Fed is done, inflation is yesterday’s issue, recession is not a serious risk,
and low interest rates will underpin the economy and the stock market. Reflecting investors’ high level of confidence in stable economic and market conditions, the VIX volatility indicator used in options pricing closed under 11 last Friday for only the 60th time since 1990.
Renewed Consumer Confidence
The outlook for consumer spending has been the biggest question mark for the economic outlook, and the stock market is now of the opinion that the combination of low unemployment, rising wages, rallying stock prices, and lower bond yields and energy prices are more than sufficient to offset the headwinds to consumption from the downturn in housing, which continues to unfold.
Moreover, investors assume that if any serious weakness does develop in housing, the Fed will promptly ease interest rates to address the problem. This renewed confidence in the consumer is reflected in the performance of the retailing sector, where stock prices have rallied nearly 20% since early August. The dramatic improvement in sentiment towards consumer spending is attributable in large part to the combination of sharply lower energy prices (down over 20% since August) and rallying stock market values.
In a notable shift in sector equity performance, since energy prices peaked over the summer, consumer discretionary stocks have been outperforming energy stocks for the first time in three years. Time will tell whether this is the start of a longer-term trend or merely a shorter-term correction of excessively positive sentiment towards energy stocks and excessively negative sentiment towards consumer discretionary and retailing stocks.
While the combination of lower long-term interest rates, a sharp drop in energy prices, and rallying stock prices obviously strengthens the case for a soft landing, at least in the immediate foreseeable future, the rally in the stock market from the summer lows appears as much driven by shifts in investor psychology from pessimism to growing optimism as by improvements in the economic backdrop. Uncertainties about growth, inflation and interest rates remain sizable, and the impact from the end of the housing boom has only just begun to be felt.
ECRI Not Convinced of Economic Turnaround
We place a lot of weight on the leading economic indicators produced by the Economic Cycle Research Institute. ECRI’s leading economic index has thus far failed to confirm the improvement in the economic outlook that is suggested by the strong rally in the stock market. According to ECRI’s most recent bulletin, “with weekly leading index growth stuck in the doldrums, U.S. economic growth is likely to continue easing for the foreseeable future.”
Among the principal reasons ECRI’s leading index has failed to revive is weaker housing activity. It remains to be seen what the aftermath of an historic housing boom will bring and how the various dynamics of housing (aggressive mortgage finance and real estate speculation, real estate related employment, equity extraction, mortgage debt levels, problem real estate loans) will play out and impact the overall economy.
Despite the unquestionable relief from high energy prices and the balance sheet tailwinds from higher stock prices, our sense is that the current outlook for consumer spending has become overly sanguine. We continue to think that consumption will come under pressure from the effects of high debt levels and a softer housing market.
Summer Lows Were Psychological, Not Financial
In retrospect, investor sentiment provided the best evidence that the stock market lows reached over the summer were a low-risk buying opportunity. Worries about the Middle East, terrorism, energy prices, inflation, the Fed, the end of the housing bubble, the economy, and what the pre-election months of September and October might bring, collectively resulted in investor sentiment plummeting mid-summer to its most pessimistic levels since the end of the last bear market and start of the Iraq war in early 2003.
Investors “sold to the sleeping point” in June and July, creating the supply/demand conditions for a rally to develop into the fall, especially as a number of things have gone right for the market. Capital chases performance, especially when investors believe themselves to be underinvested, producing a self-reinforcing rally. The upside breakouts by the Dow Jones Industrial Average (NYSEARCA:DIA) to record levels and the S&P 500 (NYSEARCA:SPY) to a five-and-a-half year high are inevitably drawing more capital into the market, as no one wants to miss the rally and confidence is high in a fourth quarter advance.
Retail Investors Skeptical of Stock Market Rally
The data on investor sentiment we track suggest that optimism has been gradually climbing alongside the rally in stock prices but has not yet reached the excessive optimism that would in and of itself cause the rally to falter. Moreover, there is a notable disparity between professional investors, including money managers and strategists, and retail investors.
The former category has become very bullish while that latter group has been slower to respond to rising prices. According the American Association of Individual Investors, which polls investors as to their stock market outlook for the next six months, the percentage of bullish respondents has been running only slightly higher than the percentage of bearish respondents, reflecting a still high level of skepticism on the part of Main Street investors.
Another sign that individual investors have not yet fully embraced the current rally is that for a fifth consecutive month in September there were net outflows (redemptions) from U.S.-focused mutual funds and ETFs. The last time there were five consecutive months of net outflows from U.S.–focused funds was during the latter stages of the 2001-2002 bear market.
Normally, excessive bullish sentiment on the part of retail investors characterizes a bull market peak. The combination of the funds flows data and the AAII sentiment data suggests we are quite a distance from that point. Liquidity is the lifeblood of bull markets, so retail flows will need to come back into U.S.-focused mutual funds and ETFs for domestic stocks to continue to move higher, but we think that is a probable development given the stock market’s recent move to new highs and the recent improvement in consumer confidence readings.
SPY vs. DIA 1-yr chart:
Related ETF: SPDR Hombuilders: (NYSEARCA:XHB)