Stocks moved into record territory yesterday as both the S&P 500 and the NASDAQ Composite set new highs in the wake of generally favorable earnings reports despite a strong headwind caused by a strong dollar comparison year-over-year. Moreover, recent economic data has been positive suggesting that the slowdown that began last fall is now behind us. Growth is picking up once again in China, housing shows signs of life in the U.S. and long term German bond yields are now positive.
The obvious question for investors now is where do we go from here. The last time stocks reached record highs in late summer, after a strong mid-summer rally, they subsequently went into a tailspin falling almost 20% by Christmas Eve before starting a V-shaped recovery culminating in yesterday’s new highs. Over the interim, there were two major factors. First, corporate earnings continued to rise. That alone would suggest that stock prices today might even be higher than they were last summer. But the other factor, the one that really is credited with moving stocks lower and then higher, was central bank action, mostly by our Federal Reserve. First, the banks expressed a hawkish policy that might have led to short term interest rates above 3% by the end of 2019. But as growth began to decelerate and inflation never surfaced, the Fed did a complete about face in December and January and now seems content to leave interest rates where they are today for an extended period.
The long portion of the yield curve saw 10-year Treasury yields peak in early October near 3.25% and bottom at the beginning of April 2019 below 2.4%. It has since recovered a bit into a range of 2.50-2.55%. With rates today lower than they were the last time stocks reached record highs, it might be logical to suggest the average equity P/E ratio could be higher than it was last summer. Add in the higher earnings and one could come to a conclusion that stocks today could move higher given the decline in rates and growth in earnings.
The one fly in the ointment following that logic trail is that one might have concluded last summer that stocks were fully priced if not a bit overpriced. But even if that was true, today’s lower rates and higher earnings would probably suggest that even if prices are a bit rich today, the extent of overvaluation would be significantly less than it was last September. We should also note, that in recent weeks, the rallies were better described as grinding higher versus a euphoric and indiscriminate chase higher. Indeed, several major sectors have been lagging. The most notable has been health care as pressure from Washington to contain pricing has increased and shows little sign of letting up. There is still growth within the healthcare segment, but it must come from volume and better technology, probably offset by weaker prices. The lower interest rates have also put pressure on bank stocks. New interest margins are flattening and real estate loan activity was weak until recent weeks.
Interest rates may have bottomed. Surprisingly, throughout the tailspin and subsequent rally, inflation expectations have remained remarkably constant. But one could argue that they could begin to pick up once again over the coming months. Wages continue to rise above the rate of GDP growth. As the rise in oil prices works its way through the economy, there will be rising cost pressures and some price increases. Finally, any pickup in end demand, which seems likely, could also add to inflationary pressures. We are not talking about a major shift; a subtle change is more likely. But it could lead to a slow but steady rebound in the 10-year Treasury rate over the next several months. In fact, if rates do rise a bit, if inflation expectations creep up, and if GDP growth moves into the higher end of expectations, then the Fed may consider the possibility of a fall or early winter rate increase. That’s a lot of ifs, but even subtle changes in the path of interest rates could spill over into stock prices.
There is an old saw on Wall Street that says “Sell in May and go away.” Some years that works and some years it doesn’t. The theory behind it is that most market gains occur either early in the year or in Q4 as Christmas approaches and investors start to look out to the following year. But it is also worth noting that the third year of a Presidential term is often the best for stocks. Presidents want to set up an economy for solid growth in an election year (to the extent they have any control) and it is the last year where anything might get done. Of course, in recent years, Congress hasn’t done much in Years 3 or 4 so who knows.
The bottom line is that stocks don’t appear overpriced even as they return to record levels, but they don’t seem very cheap either. They will continue to react to earnings news over the next couple of weeks. Beyond that, probably the biggest catalyst would be the conclusion of a favorable trade deal with China. But expectations for that are largely built in already. Sure, there could be a 1-2 day burst upward should a deal be announced, but I don’t see a deal coming that is going to move the economic needle much. Both the U.S. and China politicians will celebrate the deal as an enormous achievement but the likelihood is that economic changes will be modest at best.
When stock prices rise 20% or more in a matter of months, it is hard for disciplined investors to pour new money into the market. High profile IPOs may attract some money but at the expense of other alternative investments. While I don’t see the seeds of a major correction at hand, a 5-10% correction would be healthy just as retailers’ periodic sales bring in customers. It’s highly unlikely that stocks are going to rise 20% every 4 months. Therefore, if you still have sideline cash, hold on to it unless you find a very specific attractive opportunity. As always, weeding out the disappointments from your portfolio and rotating into companies with attractive growth prospects is always a good idea. Finally, as the IPO market heats up, be wary of valuations. Stocks are a product of future cash flows. For some of these new companies, cash flow is negative and will remain negative for years to come, maybe even forever for some. Ignore the hype and maintain your discipline. Just because a stock is below its IPO price doesn’t make it cheap.
Today, Kelly Clarkson is 37. Barbra Streisand is 77.
James M. Meyer, CFA 610-260-2220