Great Expectations

by: Eric Parnell, CFA

The U.S. stock market has an expectations problem.

A Fed expectations problem.

And a corporate earnings expectations problem.

Expectations may be too high on both fronts, thus putting today's stock market in an unfamiliar bind during the post crisis period.

“Take nothing on its looks; take everything on evidence. There's no better rule.”

--Great Expectations, Charles Dickens, 1860

The U.S. stock market has a bit of an expectations problem. The rebound by the S&P 500 from its Christmas Eve lows has been impressive. So far, the benchmark index has rallied by +14% and has posted gains in 16 out of the last 21 trading days along the way. In some respects, this latest stock market rally has that same post crisis giddy up so many investors have come to know so and love so well. But this time around, the U.S. stock market is dealing with some particularly high expectation hurdles in the year ahead that may prove too much for our graying and infirmed bull market to overcome.

A Fed expectations problem. The Fed is not hiking rates following their next FOMC meeting this upcoming Wednesday. But we already knew this long ago. Instead, the bigger issue for the stock market is the expectations about interest rates for the remainder of 2019. And it is here where stocks effectively find themselves in a “lose lose” situation.

Consider the following. Up until recently, the U.S. Federal Reserve was forecasting three interest rate hikes for 2019. But coming out of their latest December meeting, the Fed scaled things back a bit to two rate hikes for the coming year. And when the stock market had a fit in the days that immediately followed, various members of the Fed took to the microphones to soothe the market with reassuring words as they are always given to do. After all, these are the very same folks that effectively took the “risk” out of “risk assets” from 2009 to 2017. In the time since, Fed Chair Powell himself has been dropping hints of being even more “flexible” in going even further from two hikes to just one in 2019.

Investors have taken such Fed speak sentiments like “we can be patient and wait and see what does evolve” and run with it. According to the latest reading on CBOE Fed Fund futures, capital markets are only pricing in a 6% chance of a quarter point rate hike in March, a 24% chance of at least one rate hike by June, a 29% chance in September, and a slightly lower 28% reading by December. Notably, Fed Fund futures are also forecasting a 5% chance of the fed funds rate being a quarter point lower than it is now by December 2019. In short, the markets are already predicting no rate hikes in 2019, and have opened up albeit slightly to the possibility of a rate cut before the year is out. Notable indeed.

Here’s are the Fed expectations dilemmas.

First, the Fed is still officially on record for two planned rate hikes in 2019 and have winked and nodded that it might be just one. But the markets are already at zero and have begun to contemplate the possibility of a rate cut. The fact that the market is already way ahead of the Fed creates a chasm of expectations for the market to feel disappointed. For example, suppose the Fed goes from two to one on Wednesday just as they went from three to two in December. The fact that the market is already effectively expecting zero if not one in the other direction may leave stocks open to reactive investors feeling preoccupied about a Fed remaining too hawkish despite their repeated reassurances.

Next, let’s suppose the stock market rally continues higher from here. Because let’s face it, even under Fed Chair Powell the Fed remains far too preoccupied with the stock market instead of the economy, which will continue to baffle me until the day inevitably comes when the spillover effects of wealth inequality finally end up boiling over. Suppose the S&P 500 is back at 2872 come March. Or better yet, crossing over 2941 for the first time come May. If this takes place, expect the Fed to be back on for at least two if not three rate hikes this year. And with seven quarter point rate hikes since early 2017 already in the pipeline and a yield curve that has already been dabbling in inversion on the short end of the curve since the start of 2019, renewed hawkishness from the Fed is likely to introduce increased volatility and potentially stop any stock market rally in its tracks.

Conversely, let’s suppose the Fed does relent and ends up not hiking rates in 2019. Maybe they go so far as talking about lowering interest rates. If this comes to pass, what does this imply about how the stock market is doing that has caused the Fed to go from three rate hikes to zero and potentially further. Returning to the point made above about the stock market over the economy, it implies that the S&P 500 Index has very likely rolled back over and is riding in the gutter. And if it’s an instance of the stock market AND the economy, that’s even worse.

Of course, all of this focus on rates ignores the much bigger elephant in the Fed expectations room, which is the fact that the Fed is now shrinking its balance sheet by up to $50 billion each month. Remember the days when the Fed would figuratively drop bags of money on the doorsteps of the major banks at around 10:30AM each and every trading day. Those days are now long gone.

An earnings expectations problem. One of the many things that has been notable during the stock market correction as well as during the subsequent rally has been the resilience of corporate earnings expectations. Even after adjusting for the massive tailwind provided by the tax cuts, corporate operating earnings have still been growing at a solid double-digit rate over the past year.

And while the stock market itself took a beating in recent months, corporate earnings forecasts have proven notably resilient throughout the entire episode. For example, corporate GAAP earnings expectations for 2018 Q4 have only been revised lower by -2% since the end of September right before the stock market correction got underway. Moreover, the forecasts for 2019 have only been taken down by -4% to -6%, which is also relatively modest from a historical perspective.

Such positive earnings expectations should come as reassuring news to stock market investors. But it comes with a couple of key qualifications.

To begin with, if Fed Fund futures market is right and the Fed ends up calling off its rate hikes for 2019 due to a slowing economic outlook, it suggests that corporate earnings forecasts remain far too optimistic and may be subject to considerable downward revision going forward. And in a market where stocks are already historically expensive from a valuation perspective, a shrinking “E” in the P/E ratio does not help, particularly in a slowing economy.

Also, the effects of the corporate earnings sugar high induced by the tax cuts are set to roll off after this quarter. For starting in 2019 Q1 and continuing as we move through 2019 and into 2020, the year over year comparisons of corporate earnings will shift from a before tax cut oranges to after tax cut apples to an after tax cut apples to apples comparison going forward. Corporate earnings are already projected to ease lower on a quarter over quarter basis both in 2018 Q4 and 2019 Q1, and this assumes that current estimates will fully hold up, which they almost certainly will not. And if quarterly estimates for 2019 Q2 to Q4 start giving way, then a corporate earnings recession could suddenly find itself lurking around the corner as the year progresses.

Not so great expectations. The stock market has an expectations problem. And if the CBOE Volatility Index is any guide, the stock market deep down inside knows it. For if things were getting back to the same old post crisis “awesome” like they have so many times over the last decade after a stock market correction, we would expect to see the VIX trending lower. Instead, it has been trending higher since last August.

When was the last time we saw the VIX trending higher like it is today? See the chart below.

Does this mean we are on the brink of GFC II? No. Maybe something more like a longer, more tortured, and broader bursting of the tech bubble, but very likely not GFC II. Regardless, what it does indicate that investors are feeling increasingly uncertain. And we all know how the markets and their associated valuations feel about increased uncertainty.

Expectations for the week ahead. So what to watch for stock investors in the meantime? The S&P 500 Index is at a critical juncture heading into next week. The rally has brought the headline index back to its 400-day moving average. It failed on its first attempt at a breakout last Friday. And it closed out this week once again right at the 2668 400-day moving average doorstep.

If the S&P 500 Index fails here and starts falling back to the downside, this would be an ominous signal for investors to effectively “look out below”. Why? I’ll put it this way. The last two times the S&P 500 Index rallied into its 400-day moving average and failed was December 2000 and May 2008. In other words, it would be a signal that a new bear market may be lurking right around the corner. Cue easier Fed. Cue corporate earnings downgrades. Cue the beginning of a potentially long decline where the Fed unsuccessfully tries to stop the stock market decline at every repeated turn

Now if the S&P 500 does manage to reclaim its 400-day moving average, expect a tough back and forth fight between 2670 and 2800. In other words, the time of easy money associated with the stock market bounce since Christmas Eve is likely now coming to an end, as the stock market is likely going to have to work hard at it from here even if it is determined to continue moving higher. Get past 2800, however, and the path for the S&P 500 starts to open up for a potential run back to 2872 and 2940. A lot of tough work to get from here to there, however. And if you do find yourself north of 2800 in the near-term, think long and hard about taking stock profits on the margins.

“I am what you designed me to be. I am your blade. You cannot now complain if you also feel the hurt”

--Great Expectations, Charles Dickens, 1860

Great expectations coming to an end. It has been a tremendously smooth ride to the upside for the U.S. stock market over the past decade. But the Fed forces that once kept stocks steadily floating to the upside are now the same forces that may be cutting stocks to the downside regardless of how events play out. And if corporate earnings are not able to maintain their currently lofty expectations, prepare for the fact that 2019 might end up making 2018 look like a relative walk in the park. Stay tuned.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: I am long selected stocks as part of a broad asset allocation strategy. I have been using the latest rally to raise cash allocations at the margins from positions related to the common stock segment of the portfolio.