In spite of all the concerns and even negativity out there, and an expectation that stock markets and the economy are about to make a big turn south, the beat just goes on.
There are a lot of people out there who are puzzled by the way that stock markets have performed in 2019 so far. A lot of experts are among them, ones that have been telling us for a while to batten down the hatches and get ready for a big sell-off.
Instead, stock markets are holding up pretty well indeed, and in fact, the last time the broader S&P 500 has started a year this well was all the way back in 2009, when we bounced off the terrible bear market of the last quarter of 2007 and all of 2018.
The fact that this is the best start to any year since year one of this bull market does speak to the fact that we cannot say that it is over yet by any means. Sure, it would be good to get back to the market’s all-time highs set last year before the crunch hit, but that pullback of 6 months ago is looking a lot more like a consolidation move every day.
We’ve already recaptured 5/6 of this roughly 600 point drop with the S&P 500, and now only have less than 100 points to go before we’re making new highs again. What may be the most impressive thing about this current run is that we’re doing this in an environment where many do not think that we should be doing well at all.
This move actually is very instructive when it comes to consolidating our understanding of what really moves markets. This includes many of those who believe that they already are well-informed, and see the current situation as an anomaly.
It is true though that at least some of the reasons why this should not be happening do influence markets at least somewhat, but people who hold these views generally overrate or misunderstand their impact.
Michael Arone, chief investment strategist at State Street Global Advisors, sums up this viewpoint quite well. “I would define this environment, year to date, as fascinatingly counterintuitive. Stocks are rallying, but bond yields are reflecting much lower growth.”
We can look at several other things which may be counterintuitive for many, including declining earnings and especially declining economic growth. These are all things that tend to be present in bear markets, but when we see all of them happening in a year where the S&P has moved up 13.1% year to date, we may want to scratch our heads.
Our Intuitions May Be Too Distanced from How Things Really Work
Obviously, this is all compatible, at least in some circumstances, the present one included, so if our intuition is that this should not be happening, our intuitions may be in need of re-examination.
The first thing to realize is that, while we can seek correlations with certain factors, this does not mean that these things directly cause these impacts. The sole cause in fact of stock prices moving is the interplay between supply and demand, which in the aggregate is called market sentiment. If the market is still enthused and looking for more, nothing more needs to be added to this, as this sentiment will simply cause this to happen regardless of whether we think it should or not.
We can’t even take a certain perspective of what may be happening in the market and ever call it wrong. Someone is clearly wrong when these views collide, and it is never the market, it is always us.
Still though, this situation, this anomaly if you will, does give us an opportunity to more closely examine our beliefs and intuitions and see how much validity they may have, and perhaps get closer to the heart of the matter here. We can start with the price of stocks and treasuries going up together, where they very often deviate.
The connection here is due to the fact that when we do have a large outflow out of the stock market, a lot of it goes into bonds and this puts the price of stocks down and the price of bonds up.
We could even say that when stocks go down, bonds go up, and this would be generally true, in that order that is. We can’t turn around and say the reverse is always true though, when bonds go up stocks should go down, and the reason is that bonds can go up for other reasons as well. More money is being put into them but this money can come from elsewhere, and when they go up together, we know this to be true.
The slowing of earnings is another thing we see in bear markets, and often, a slowing of the economy as well. Earnings matter more of course because this is the earnings of the companies that we are invested in when we own stocks. We don’t want to make the mistake though of thinking that earnings and stock prices are that connected though, because people mostly invest for capital appreciation, which is related to earnings somewhat but far from directly.
Earnings expectations do influence things to a degree, but not necessarily earnings just a quarter or even a year away. The scope of the outlook extends far beyond this for those who are in it for the long haul, including big institutional investors.
If a company’s earnings growth is reduced, does this mean that the stock should be worth less as a result, and by extension, a basket of stocks such as the 500 companies in the S&P? If a company is expected to make more money this year than last, or if the economy is still expected to grow but at a lesser rate than last year, should the stocks be worth less now?
They may be, and they may not be, depending on how the market views this, but if we’re going to use intuition, it should be that since the company is expected to grow their earnings net of inflation, their stock should be doing well as they are worth more year after year based upon this at least.
If their situation is improving but the stock is declining, that is what we should find counterintuitive. This does happen quite often in fact, and the reason is due to market behavior, where they may behave bearishly under these circumstances but do not have to.
What the Market’s Intuition Looks Like These Days
There is one thing that is going on that may not be all that intuitive but is recognized as something that shapes sentiment like no other, which is interest rates. If we want to explain this current phenomenon, we need look no further than this.
This all started in December when we learned that the Fed was planning on laying off for a while, and that’s all it took to stop the free fall and get us on our feet again. Along the way, we learned that they are planning on maintaining this strategy throughout 2019, and this has kept the smile on the face of the market for the most part.
The terrible year that bank stocks had in 2018, during a year where earnings were fabulous teaches us an important lesson. Once the interest rate fears went away, they are doing fine now. While banks are more sensitive to this, or rather, are seen to be by the market, these things tend to raise and lower all boats. They got lowered during 2018 Q4 and have been raised in 2019 Q1.
The 10-year bull market that we’ve enjoyed can be said to have mostly been brought to you by the Fed, as their lowering the rate to zero for all that time really got things humming to the point where they became scared that we were risking inflation of too great a magnitude and subsequently raised them. When they went a little too far in 2018, in the opinion of the market, which is the only opinion that matters, the market rebelled, but they have since been appeased.
When we were falling, at a rate that could be seen as pretty alarming, giving up 20% in less than three months, we couldn’t have blamed slowing growth, and things were actually in better shape back then than today. None of this drove this little crash, so it should not be that surprising that this isn’t preventing us from going up now.
However, if the market wants a rate cut later in the year and doesn’t get it, we might see another rebellion of sorts, although probably not of a magnitude we saw last year. Meanwhile, the current state of the economy is positive overall and maybe even a beautiful thing depending on how you look at it, especially when we look past our tendency to prefer higher growth over lower growth.
Growth that brings out the hawks at the Fed is what we clearly do not want, and 2018 was the best year we’ve had in a while on that front, with our 2.9% GDP growth, and we know how that went for stocks.
This is not to say that this sentiment cannot change, or that the only thing the market cares about is interest rates, it does care a great deal about these rates, perhaps too much if we view this from the perspective of economics.
A deeper view of the economics present here reveals that markets will simply care about what they wish to and to whatever degree they choose, and if we’re looking to predict their next moves, it all starts with shaping our outlook on what the market does seem to care about rather than what we think they should.