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Melt-up!
U.S. stock market gains have accelerated in the first month of the year, leading to the appearance of a melt-up or blow-off phase of the bull market.
Looking suspiciously like a melt-up
Source: FactSet, Standard & Poor's. As of Jan. 19, 2018. Past performance is no indication of future results.
We’ve often warned that melt-ups can feel good at the time but typically end in melt-downs, even if only briefly. Melt-ups can last for a decent amount of time and investors who bail could miss out on potential gains. We are in the relatively early stages of this move, but a catalyst for a pullback could come at any time.
Anecdotally, the heightened scrutiny of the rally and skepticism around its sustainability suggests investor sentiment—although exuberant—is not irrational. That said, the Ned Davis Research Crowd Sentiment Poll has reached its highest-ever level of optimism since the index was created in 2002. But on the behavioral side, we still see money coming out of equity mutual funds and exchange-traded funds (ETFs), with Evercore ISI Research reporting that $44 billion was pulled out during the three weeks ending January 12.
As mentioned, earnings have been accelerating along with stock prices, keeping valuation expansion to a minimum. For example, the forward P/E (price-to-earnings) ratio for the S&P 500 is currently about 18.5 according to data from Thomson Reuters. Although elevated, it’s well below the 24-26 level at the 2000 peak. In the multi-year run-up to the 2000 peak, Federal Reserve Chairman Alan Greenspan made his famous reference to the possibility of “irrational exuberance”—but that was in 1996, and the bull market continued for more than three years. But with optimism elevated and valuations rich, the cushion in the market has been reduced—which could lead to more volatility and more sizable pullbacks this year than we saw last year. As you can see in the table below, years with exceptionally low volatility (as measured by maximum intra-year drawdown) tended to be followed by years with more volatility/drawdowns.
Source: Bloomberg, Strategas Research Partners LLC. For illustrative purposes only. Past performance is no indication of future results.
Economic growth takes a step forward
In addition to strong earnings, the uptick in U.S. economic growth supports a continuation of the bull market. In short, we don’t see any sign of a recession on the horizon, which has been typically what it takes to ignite a bear market. Case in point is the latest acceleration in the leading indicators—indicative of not only continued growth, but an accelerating rate of growth.
LEI doesn’t indicate trouble on the horizon
Source: FactSet, U.S. Conference Board. As of Jan. 19, 2018.
But not all is rosy. The Empire Manufacturing Index recently fell to a still-strong 17.7 from a robust 19.6, and the Philly Fed Index fell to an again solid 22.2 from 27.9. Also, the Citigroup Economic Surprise Index—which measures how economic is coming in relative to expectations—has rolled over, which was to be expected given it’s a mean-reverting index.
Surprise Index rolling over
Source: FactSet, Citigroup. As of Jan. 19, 2018.
The deterioration in this index in the first half of last year was not met with weak stock market performance, so fewer positive surprises isn’t necessarily the death knell for stocks. And with the impact of the Tax Cut and Jobs Act still coming into focus and the rebuilding from last year’s hurricanes still ongoing, the potential path to even better economic growth appears to be in place.
Potential Pitfalls
Some of the potential risks to the current rally may come from Washington. Although the market has largely ignored the “shutdown” drama, as has tended to be the case historically, investors should not become complacent about the risk of political dysfunction. In addition, trade protectionism—including possibly pulling out of NAFTA—and tariffs could be a meaningful risk for stocks, especially if they contribute to higher inflation. Finally, the approach to the midterm elections could add to the market’s volatility; but also could put limits on what can be done legislatively.
The Federal Reserve’s upcoming meeting has investors’ attention. The meeting next week—Chair Janet Yellen’s final meeting—is expected to yield no change to interest rates, but the statement will be closely watched for signs that inflation is becoming a bigger concern due to the tight labor market and tax-related fiscal stimulus. Higher inflation remains the most formidable risk in our view, as it would put added pressure on the Fed and downward pressure on stock market valuations.
So what?
U.S. stocks may have entered a melt-up phase but for now, it is relatively well supported by earnings growth; and although the sentiment is extended, behavioral measures indicate still some skepticism. However, given elevated valuations, and the aforementioned overly optimistic sentiment, volatility is likely to increase, and more frequent pullbacks are possible. The bull should continue to run, but likely with a bit more drama, so it’s important to stay diversified and disciplined around your long-term asset allocation.
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Michael D. Green, Principal
TGA Capital Management.Com
25 Braintree Hill Office Park
Braintree, MA 02184
A Registered Investment Advisory, RIA
Mgreen@tgacapitalmanagement.com
https://www.linkedin.com/in/tgagiacapitalmanagement
1.508.224.9646
This is not a solicitation nor recommendation to buy or sell a securities nor to imply any tax or legal advice, always seek a registered investment advisor to attain your risk/averse attitude and investment suitability before investing. All information is considered accurate and reliable, however, due to changing market, economic, taxation, institutional, and other pertinent potential cycles and variations, future results cannot be guaranteed by past performance and should be monitored on a continual periodic systematic basis to provide current advisory recommendations that meets the client short-term potential deviations and management disciplined style, while advisory provides solely long-term recommendations. Confidentiality Notice. The information in this e-mail and any attachments is confidential and may be privileged or protected by other rules, including but not limited to the Electronic Communications Privacy Act, 18 U.S.C. §§ 2510-2521. It is intended solely for the addressee(s). Access to this e-mail by anyone other than the addressee(s) is unauthorized. If you are not the intended recipient, you are not authorized to and therefore must not disclose, copy, distribute or retain this message or any part of this message.
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