There's a growing chorus of warnings from the punditocracy that the US stock market is at risk of correcting. It's easy to understand what's motivating the advice: a powerful bull market that's been pushing higher for five years with few sustained declines of late. The market is also fairly valued, perhaps overvalued to a degree. It stands to reason that the longer the market rises, the bigger the risk that equities may suffer a sizable setback. Adding to the potential for trouble: various geopolitical risks (think Ukraine and the ISIS threat in Iraq) and a new phase of macro weakness in Europe. No one should dismiss these factors, but for the moment the US market draws strength from a fundamental source: economic growth.
A stock market that corrects, perhaps sharply, isn't unusual in a period of economic expansion and so this remains a possibility. The S&P 500 touched an all-time high on Friday, which means that the arrival of surprisingly bad news going forward may be a tempting excuse to sell. But any slide in equity prices will probably be limited if the macro trend remains positive. Indeed, the market's been climbing in recent years, albeit with temporary corrections, because the economy has been recovering. It's been an uneven and slow recovery by many standards relative to history, but Mr. Market's primary focus is one of a binary nature: Is the economy expanding or contracting? To the extent that the data favors the former, prices will have a potent source of support. As such, any drop of consequence will likely be a buying opportunity rather than a prelude to an extended bear market.
The challenge, of course, is deciding in real time if the economy is still on a growth track. For the moment, however, the analysis is relatively easy, thanks to a wide spectrum of encouraging numbers. The monthly profile of US data through July certainly looks upbeat, as I discussed a few weeks ago. Meantime, this week's initial peek at the August trend, although preliminary, only strengthens the view that macro risk is low. Indeed, the ISM Manufacturing Index jumped to 59.0 in the August reading, a three-year high. Positive momentum, in short, appears to be quite healthy.
"The manufacturing sector is just on fire right now," Brian Jones, an economist at Societe Generale, tells Bloomberg. "You've got increased demand for workers, and the more people working, and the more money they are making, the more money they'll spend."
The stock market has been anticipating no less for some time. The crucial fuel for any bull market in stocks is economic growth, and so the buoyant reports in recent months for most of the key indicators has encouraged buying. At some point the cycle will turn - the catalyst will be a weakening of the macro trend. History suggests that there will be plenty of false signals between now and then and so separating the head fakes from the genuine article is essential. That's harder than it sounds for several reasons, such as unexpected data revisions, short-term noise, and other factors. Rest assured that the media will further complicate the task with an array of conflicting headlines and vague and largely unsubstantiated claims by various self-appointed experts - such as this gem from yesterday, for instance. Confusion, it's safe to say, will continue to reign supreme as a general proposition when you use the usual suspects as a resource.
Convincing signals that the business cycle is turning lower will arrive eventually, but after the fact. The challenge is keeping the delay to a minimum. Clarity on this front won't come easy - it never does. The only solution is to analyze frequently and across a broad, carefully selected mix of indicators.
For now, it looks like the trend is our friend, perhaps to an increasingly bullish degree as far the macro data goes. That doesn't mean that a bull-market correction can't squeeze us in the meantime. But until and if the economy makes a major U-turn, the fundamental driver of higher prices still looks intact until further notice.