Don’t Let New Highs Give You FOMO

As earnings season chugs along it’s starting to look like analysts may have tempered their expectations a bit too much during the 4th quarter, which is typical. As you can see in the chart below, actual earnings (blue bars) have a steady habit of coming in above estimates (gray bars).

S&P 500 Earnings Growth

This quarter appears to be no different. With over 100 S&P 500 companies having reported, 79% have beaten their earnings estimates. This has taken the blended earnings growth (which factors in actual results for those companies that have reported, and estimates for those that haven’t) to -3.4%.

While still negative, this trend suggests that overall earnings growth for the 1st quarter could end up being roughly flat by the time all is said and done. Considering that the market had priced in a substantial earnings drop of -4.0%, it seems reasonable to see the market heading higher.

On the back of a few particularly strong results from some of our key defense contractors, both the S&P 500 and the Nasdaq have edged their way into new high territory today. In the charts below we can see both indexes attempting to take out their previous high-water marks.

S&P 500 and Nasdaq Price Charts

But let’s make sure not to get carried away by the excitement of new highs. While the market seems pleased that earnings growth isn’t as bad as anticipated, flat profit growth isn’t exactly a sign of a booming economy. In addition, we continue to get mixed readings from various economic reports.

Take industrial production as an example. In the chart below we can see that readings over the last four months have been weak, and in stark contrast to what we saw for most of 2018. The recent 0.1% decline for March means that for the 1st quarter, output slipped at a 0.3% annual rate. That represents a marked slowdown from the 4% annualized growth rate during Q4.

Industrial Production Index

Another economic indicator released last week that showed further deceleration is the IHS Markit Composite Purchasing Managers’ Index. Shown below, this metric fell to 52.8 (from 54.6 in March), representing a 31-month low. While still in expansion territory (above the 50 line), it’s another indication of our slowing environment.

IHS Markit Composite PMI and U.S. GDP

In case you’re interested in the details, the Services component of this index came in at 52.9 (a 25-month low), while the Manufacturing side remained steady at 52.4. According to IHS Markit:

April PMI data indicated a further slowdown of private sector activity across the U.S. A less robust service sector performance accompanied another weak manufacturing performance to weigh on overall growth at the start of the second quarter of 2019.

The Philadelphia Fed also recognized this continued slowdown as their manufacturing index declined from 13.7 to 8.5, a three-year low. With this metric, anything above zero still signals expansion, but it’s yet another sign that momentum in the economy is waning.

Nevertheless, as I mentioned before, economic data has been mixed, and thus we have seen some positive signs out there as well.

Retail sales had been an area of concern lately, demonstrating slowing growth, but the latest data did in fact show a strong uptick. As you can see below, the year-over-year change in retail sales is now beginning to reaccelerate.

Retail Sales

This is important because retail sales accounts for about a quarter of overall consumer spending, and consumer spending itself accounts for two thirds of our economic output. Thus, it seems as though the consumer remains fine.

And there’s really no reason yet to believe that U.S. consumers are in trouble, or on the precipice of cutting back on spending. Job growth remains robust, as we can see below. (Notice how it deteriorated for many months heading into the 2008 recession.)

Total Nonfarm Payrolls

And jobless claims have taken another leg lower

Initial Jobless Claims

As a result, consumer spending, the primary driver of our economy, should remain firm in the months ahead. As long as business spending doesn’t dry up completely, this suggests that the economy will continue to grow at a slow but steady pace.

Further bolstering that view is the latest data from The Conference Board’s Leading Economic Index. In March, the U.S. LEI (shown below) increased 0.4%, following a 0.1% increase in February. Recall that this index had been trending flat for quite some time. With the recent uptick taking the index to new highs, the chance of a recession in 2019 (or even early 2020) continues to fade.

The Conference Board Leading Economic Index

One thing that’s important to point out, however, is that the trend in LEI growth continues to moderate. We can see this by looking at the blue line below, which shows the U.S. LEI 6-month growth rate.

Leading Economic Index 6-Month Growth Rate

Altogether, this points toward an economy that will continue to expand in the coming months, but at a slow rate consistent with the long-term potential of the economy (sub 2%).

Now … what does all this mean for stock prices moving forward?

The low probability of recession here in the U.S. implies that a big drawdown (such as we saw during the 4th quarter) is unlikely over the next few months. One key component of that outlook is the fact that the Federal Reserve is now on hold.

With the Fed having transitioned to a much more market-friendly stance (no longer threatening rate increases or balance sheet reduction), it has greatly improved the sentiment of investors. In my opinion, this about-face from the Fed is one of the primary driving factors behind the sharp rally we’ve seen during 2019.

But even if the Fed is no longer a threat, in order for prices to continue climbing higher one of two things is needed. Either we must see a resumption of earnings growth (to allow the market to climb higher without multiple expansion), or we must see investors bid up the market’s multiple.

Back at the depths of the December selloff, the forward 12-month P/E ratio had fallen to 14.2 – below both the 5 and 10 year averages. Since then, we’ve seen this multiple climb dramatically. According to FactSet, that figure currently stands at 16.8. This is now above both the 5-year average of 16.4 and the 10-year average of 14.7.

As a result, I find it a bit unlikely that investors will continue to push the market’s multiple significantly higher, especially in the face of lackluster earnings growth (according to FactSet, earnings are projected to grow by only 3.4% during 2019, with revenue growth of 4.7%).

This means that, unfortunately, I still think we’re going to be in a period of generally rangebound prices until the global economy either makes a turn for the better, or begins to drag down growth prospects here.

Trying to make money in this type of environment – where the Primary Trend is essentially flat, is difficult. It requires us to be more tactical and play some of the intermediate trends. With the major averages having rallied in excess of 20% since the December lows (see chart below), my preference here is to be a cautious and gradual seller into this strength.

Major Averages Performance Since December 24th

When the market begins to correct, we can again add to those positions, assuming of course that the macro outlook hasn’t deteriorated substantially in the meantime.

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