The Bottom Line
During the second quarter, the market staged a choppy rally from the lows it set on April 2. However, underneath the hood, there were large differences in performance. US Small Cap and more aggressive sectors had larger gains, while more conservative sectors like industrials, financials, and consumer staples were negative. International was also in negative territory.
Concerns over a possible emerging trade war and higher interest rates were offset by optimism over the economy and earnings. We will likely continue this theme for the foreseeable future. As we have mentioned many times over the last few years, the final stage of the market rally will be characterized by concern that the Fed is raising rates, but ultimately the market will conclude that an improving economy is more important than rising rates. This stage can last from a few months to a few years, and it almost always ends many months before the fundamentals sour, and often very quickly. As long as the fundamentals and market trends are positive, which is certainly the case now, the market has the ability to continue move higher in this choppy manner.
Our view is that the market likely has a reasonable opportunity to make new highs later this year, or possibly next year. Once this occurs, we would not be surprised of a difficult market environment as excessive valuations and a restrictive Federal Reserve become more important than an improving economy.
Economic numbers are looking very good, in our view. The economy is rapidly improving from the days of the Great Recession and has finally seemed to normalize. If anything, the fear now is that the economy is running too hot and the Fed’s accommodative monetary policy has made it more difficult to cool off inflation, if it picks up. Inflation has been in check so far, but we are watching for signs at the margin.
Fed officials have now spent several meetings discussing the prospect of monetary policy moving away from stimulating growth to possibly restricting it. Fed Funds are at 1.75% – 2% now, and their June projections show most of them expect the rate to move to between 2.75% and 3%—an approximation of neutral. This is where long term rates are now, which would result in an inverted yield curve. Following five of the past six periods in which the yield curve inverted, the economy tipped into recession within a year, according to data from the St. Louis Fed.
The equity market almost always peaks 6-12 months before the economy does so the timing will be very tricky. This is compounded by trying to gauge what the effect will be from what appears to be the biggest trade battle since the Great Depression, in an environment where valuations are quite extended. As we have been saying for over two years now, valuations are high because the fundamentals are favorable. But the room for error is very narrow. For these reasons, we are very focused on any changes at the margin for the fundamental direction of the economy and earnings. For now, the trend is still positive.
Sentiment and Technicals
Last quarter, we submitted evidence that this is no longer a hated bull market. Investors are finally embracing the bull market, but it’s amazing that it took nine years of rallying for that to occur! Secular tops almost always occur when too many investors are over extended and too aggressively invested. There is no one study that has reliably pointed this out – it is a balance of evidence. And in this regard, we are seeing some signs of an over extended market. As we mentioned earlier, performance has been narrowing to only the most aggressive sectors, which is often a warning sign. More evidence of a narrowing market is the $ value of turnover. As uncertainty increases, so does turnover, and this turnover often precedes secular highs in the market. This last occurred in the first quarter of 2000, and the first quarter of 2006. In the first instance the market didn’t top for another nine months, and in the second instance it didn’t top for another 21 months. So, this isn’t an immediate sell signal, especially when the longer-term trends and fundamentals are positive, which they are. It’s a reminder that the market is getting frothy and that being more aggressive is less likely to be as rewarding in the future than it has been in the past 9 years.