In previous SA articles (here and here), we pointed out the similarities between today's market and that of 1999-2000. In this article, we extend the argument that rising rates, extended fundamentals, and imminent political risk may, in fact, presage a continuation of the present rally rather than the beginning of a downtrend, as is commonly argued.
The Fed is behind the curve. There is no doubt in our minds about that. Historically, it has raised rates as GAAP earnings increased and unemployment decreased. This is visible in the chart below, within the colored rectangles. Notice, however, that during the latest GAAP rally which started in 2009, the Fed kept rates at the zero bound despite explosive GAAP earnings growth and steadily falling unemployment. This has left it without any rate-cutting ammunition, should the economy weaken and require further stimulus.
Having passed up several opportunities to start normalizing rates over the last five years, the Fed must now take advantage of renewed GAAP earnings growth and low unemployment to increase rates back to normal levels. Otherwise, it will find itself impotently holding an empty toolbox next time the economy springs a leak.
We have to hand it to Yellen - she managed to be a hawk in dove's plumage, delivering a rate hike while cooing a dovish tune. She prepared the market for a hike so effectively that, judging by the level of Treasury shorts, it expected more than what was delivered, causing rates to fall after the rate hike announcement. This is unlikely to continue. Rates will rise, perhaps more than three times this year, and the market will rally as it has in the past, as long as GAAP earnings continue to improve.
When it comes to overstretched stock valuations, the present P/E ratio of 26.69 is obviously above the long-term mean, but that does not preclude further bull market action in equities. In July 1999, the P/E stood at 37.2, yet the SPX was 10% higher nine months later. From this perspective, a P/E of 26.69 could easily be shrugged off by a bull market (see the two graphs below).
Looking at the S&P 500 earnings yield, one would be forgiven for thinking that 3.75 was a dangerously low yield (first chart below), but again, we point out that during the 1999 part of the tech rally, the yield stood at 2.7 when the SPX was 10% below its eventual top (second chart below). Bull markets tend to ignore obvious fundamentals.
Political and Regulatory Risks
Bull markets, almost perversely, tend to thrive on worry, both political and economic. Again, consider some of the worrisome events of 1999, in no particular order:
- The EU common currency is introduced
- The Columbine High School massacre
- The Kosovo war
- The Cox Report details China's nuclear espionage against the U.S., Japan's Tōkai-mura nuclear accident
- The 6 billionth living human in the world is born
- The U.S. Senate rejects ratification of the Comprehensive Test Ban Treaty
- ETA terrorists cause havoc in Spain
- Russia fighting in Chechnya
- Control of Panama Canal reverts to Panama
- A wrestler is sworn in as Governor of Minnesota
- China restricts internet use
- US President Bill Clinton acquitted by the Senate in his impeachment trial
- The "Melissa worm" infects Microsoft word processing and e-mail systems around the world
- NATO aircraft bomb the Chinese embassy in Belgrade
- The Dow Jones Industrial Average closes above 10,000 for the first time
- The Dow Jones Industrial Average closes above 11,000 for the first time
The last two points demonstrate the effect that worry had on the bull market in 1999 - the Dow reaching two major milestones. Consider, also, that the market had been rising almost non-stop for nine years, and for five years after Greenspan's famous "irrational exuberance" comment. We have all heard the adage "The market hates uncertainty", but when we look closer, the opposite seems to be true.
So, if worry encourages bull markets, today's market has much to encourage it. Here are a few worries/encouragements, in no particular order:
- Rate hikes
- Le Pen
- EU break-up
- Redenomination of French debt
- Trade protectionism
- Mass deportations
- Denial of climate change science
- Border tax
- 24 million Americans without healthcare (again)
- Russian influence
- Nigel Farage
- Frauke Petry
- Humanitarian disaster in Syria
- Islamic terrorism
- Cyber terrorism
- A reality TV personality as president
- 3 a.m. tweets
- Artificial intelligence
- The stock market making new all-time highs
If we hold to the idea that bull markets climb a "wall of worry", then it looks like there is still some wall left to climb before the market falls off the other side.
What It Might Look Like at the "Top of the Wall"
The height of the wall could be lowered, however, by some black (or grey) swan, such as the failure of the Trump administration to make progress in the key legislative areas of tax reform and fiscal policy, or the election of Le Pen in France. But we think even these hurdles would have only a temporary effect, because the business cycle is finally starting to come alive, and the Fed will be in a better position to ease rates and stimulate the economy.
The "top of the wall" will also have the AAII investor sentiment reading more than 50% bullish and less than 30% bearish sentiment. Major tops in the market are rarely, if ever, reached without the majority of investors feeling confident in their equity investments.
In conclusion, as long as the GAAP earnings continue to grow, we think the market will keep ignoring all the obvious reasons for concern and keep us in a classic bull market. We will "buy the dip" until further notice.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPXL over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.