Market Memo: Stocks running out of excuses for not going up

08-07-2018

Year-to-date, the market has taken several body blows that were supposed to kill the bull, permanently: the February inflation/bond scare, the trade war with China (then the world), the Facebook privacy scandal, the seemingly never-ending Mueller probe, the deceleration of earnings growth from 25% to a “mere” 20% and even possible thermonuclear war with North Korea. Still, the market is up, at 6.7% on the S&P 500, just under January highs. Yet, as we enter the illiquid and often scary dog days of August, many investors remain cautious about the market’s ability to break through. Fearing a correction, they’re developing lists of things that could go bump in the night.

They may be waiting in vain. While we have no better crystal ball than others regarding the next four weeks, we remain committed to our longstanding year-end target of 3,100 on the S&P. And while many are focusing on what could potentially provoke another market correction, we’d rather ask: What could drive a move higher? After the recent (very strong) earnings season, we see several possibilities between now and November. Granted, most of these could take some time to develop, but in the meantime, there’s little reason to expect any to produce a market-negative surprise. At some point, sooner or later, the market should sniff this out and bust out higher. Bears beware: above the January highs, which are less than 1% away, there is nothing but air.

The Federal Reserve could begin to signal an end to rate hikes With inflation remaining subdued despite the economic acceleration, and good reasons for it to remain so in the months ahead, our forecast is that the Fed finishes its next two hikes and calls a pause at 2.5%. We believe the Fed’s anxiety about reducing its still-large balance sheet to “normal” before the cycle ends is just one of many reasons why it is nervous about prematurely ending the current expansion. Chair Powell may have already begun signaling this dovish view in his press conference a few weeks ago when he emphasized the words “for now.” A more direct signal, or even Fed statement on this topic, would be market bullish for sure. However, it seems unlikely we’ll get more clarity from the Fed until later in the year, when the 2.5% target is closer at hand and when it has more data on inflation and growth. The Fed also is unlikely to issue more hawkish language, pointing to an increase in the anticipated number of hikes above the current already-high consensus expectation.

Trade negotiations may take a turn for the better Headlines on the trade front can’t get much worse. President Trump has already threatened tariffs on virtually everything we are importing from China, and vice versa. The earnings season had a few examples of companies complaining about negative tariff impacts, but not enough to disrupt the upward trajectory on earnings estimates. For reasons we’ve discussed elsewhere, we expect at least one major deal to come through this fall, probably with Mexico, and with it, the market would discount the beginning of the end of the global trade war. Again, we see low risk of a market-bearish announcement and the rising probability of a market-bullish one.

The economy and earnings could continue expanding at a better-than-expected pace We seem to have landed on a higher growth plateau and, despite the consensus that “this can’t last,” it has. The news flow likely will remain positive, with several key drivers in place: higher after-tax returns on investment due to the synergistic combination of a friendlier regulatory environment plus lower corporate tax rates; improved confidence among consumers and businesses feeding on itself; and continued upward earnings revisions (unprecedented for this late in the year) fueling investment. Federated continues to hold an above-consensus outlook for GDP growth for the third and fourth quarters of 2018 and into 2019, and we anticipate S&P earnings to reach above $175 in 2019.

As these positive growth quarters come through, the market will have some good news to digest. For the record, we entered the most recent earnings season with a market consensus for earnings at $159 for this year, up from a 2018 forecast of $151 in early January, and $145 last fall. As we exit the current earnings season, the consensus estimates have risen once again to $161 for this year. I repeat: this kind of upward revision to earnings this late in the year is historically unprecedented. So near term, there appears to be limited risk of a downside surprise, although the upward trajectory will continue to be a grind rather than a spurt.

Inflation could remain subdued The market is waiting for an accelerated inflation print to force the Fed’s hand and has simply not gotten one. Yes, the last earnings season saw numerous examples of labor and/or commodity cost pressures, but most companies seem to be offsetting these with productivity gains, tax gains and/or help from the rising U.S. dollar. There are very few examples of sudden price spikes across the economy. We expect this to continue as improved top-line growth, the digitization of the economy, improved productivity from higher investment and the demographic workforce shift continue to offset higher average wage gains. Inflation is a key risk to monitor ahead, and the one where the upside and downside risks probably are most balanced. That’s why last Friday, the GDP number we locked into was the average wage gain: a very well behaved—and fully anticipated—2.9%.

The Republicans could sweep the midterm elections More important than many casual market observers believe, this election is likely to be the key overhang between now and year-end. The bears worry the House will be lost to the Democrats in a landslide and they will then be able to use this beachhead to retake the entire government in 2020. If this occurs, the threat looms that the two key drivers of the present rally, deregulation and tax reform, will be reversed.

Unlike the consensus, and similar to our “Trump could win” call back in August 2016, we think the Democrats’ path to taking the House in November is an extremely narrow one. Readers will recall that our analysis in 2016 was done at the district level, not the national level. As we thought then, and still do, the national polls overstate the impact of voters in the larger, nearly single-party coastal states. We’ve recently completed a similar analysis on the House races, and believe that the entire election could come down to 16 “too close to call” congressional districts in California, New Jersey, Colorado, Illinois, Texas, Washington and Michigan. If the other districts go the way we are projecting, the Democrats would need to sweep all 16 too-close-to-call districts. Meanwhile, all the normal tie breakers favor the Republicans: 14 of 16 of these districts currently are held by Republicans; GDP numbers are strong; employment numbers are terrific and consumer spending is accelerating.

With the market firmly convinced that the House cannot hold, an unexpected Republican victory, or even a narrow Democratic win, could be very market bullish, and we would likely see an echo of the double-digit November/December 2016 advance. As Election Day nears, our out-of-consensus call likely is to sound more plausible, but given how tight these races will be, the march to 3,100 may well have to wait until Nov. 7.

One final possibility: investors could realize we’ve already had our correction Sometimes, that which we seek is right under our nose. This may be the case with the so called “overdue correction.” In some respects, we’ve already had a rolling correction that has affected different stocks at different times. Indeed, year-to-date, an amazing 83% of the stocks in the S&P have experienced a correction of 10% or more. We like the risk/reward in the market at this point and continue to recommend holding an overweight equity position at 50% of our maximum target. We particularly favor the beaten up, more cyclical Financials, Industrials and Energy sectors where valuations are very attractive.