Oct 03, 2016
Stocks closed higher in the third quarter amidst a relatively benign backdrop of news and events. In the context of stagnant growth and negative earnings trends, advances like this would seem to be driven more by sentiment and positioning than a material improvement in economic and corporate fundamentals.
The bulk of the gains this quarter occurred over a three week period in July, following Great Britain’s decision to leave the European Union (Brexit). In keeping with this bull market’s affinity for easy monetary conditions, investors were reassured by Central Banks that new measures of accommodation would be available to mitigate any risks that Brexit might impose on their respective economies.
For the three months, the S&P 500 gained 3.9% and now stands at 7.8% for the year. Bond returns were flat to slightly negative as interest rates drifted incrementally higher over this same period. The characteristics of recent equity gains suggest an increased appetite for risk with the strongest equity performance coming from higher growth, higher beta (volatility), smaller-cap, and non-U.S. companies.
This stands in contrast to the defensive-oriented themes that worked better for stocks in the first half. Utilities and Telecom, two of the best performing sectors to date, both declined in the quarter. The more cyclical sectors, Technology, Industrials and Financials, led the way higher. On the surface, this kind of shift would imply a more optimistic outlook for the economy, although there was little fundamental evidence to support this more sanguine perspective.
To assess one aspect of sentiment, the graph below tracks a 20 year history of the monthly Consumer Confidence measure. This is a late cycle indicator that tends to peak just prior to the end of an economic cycle. Current readings show a steady recovery back to the highest levels since the Great Recession. This improved confidence is consistent with investors bidding up valuation multiples on stocks over this same time frame.
Where To From Here?
The current Consumer Confidence score provides no real insight on how long this positive trend will hold, especially given the precedent of much higher levels. Until a top is established and begins to roll over, this graph would not suggest any imminent concerns.
A more circumspect view about growth, however, could be supported by looking at other economic measures where growth rates are already decelerating – Personal Consumption, Personal Income, Capital Investment (by businesses), Government Spending (good for our deficit but becomes a drag on growth) and Leading Indicators. Taken together, these indicators would raise questions as to the sustainability of today’s higher confidence measures.
That said, we know the predictive ability of these barometers on the broad economy is imperfect, and with the growth of the digital economy, it is less clear that traditional measures are capturing all the relevant data. We also know there are times when the relationship between stocks and the economy can become disconnected for extended periods of time from what we might expect. Many would say the current environment is a prime example of that.
In the end, though, the prospects for stocks and the health of the economy are intrinsically intertwined. While nothing in the data today is signaling that the next recession is imminent, the risk to stocks is that this loose correlation becomes tight if the economy weakens. While these kinds of macro projections are not the primary driver behind our portfolio management process, we do think there is value in understanding the implications of when divergences inevitably self-correct. Ideally that correction will come in the form of a stronger economy.
Throughout this bull market recovery, investors have maintained a healthy dose of skepticism. Numerous “walls of worry” have been scaled in the process. The nature of the slow economic recovery and inability of policy initiatives to generate the kind of normal growth that would typically get investors more bullish has probably been a silver lining for the market.
Over the next quarter we’ll elect a new President, most likely have a new rate hike in place (and watch markets obsess about the next rate hike), learn if third quarter earnings become the 6th consecutive quarter of negative earnings growth, and probably become more aware about the health of the European banking system, again. All are potential “walls of worry” that should help keep complacency in check. If we finally see some tangible improvement in economic fundamentals, Consumer Confidence will have the foundation to move higher from here.