If the top of the market is a point of peak optimism, then this month is an unlikely candidate. Investors were more nervous than they appeared even before the latest worries about U.S.-China trade negotiations.
Both the S&P 500 (.SPX) and the Stoxx Europe 600 are down more than 2% over the past month, having reached all-time highs around the start of May. At first glance, the correction looks like the end of a powerful rush of optimism that drove markets in the first four months of 2019. In fact, it is just another expression of caution.
A key sign that “below the water there was a lot of pessimism,” argues Invesco fund manager Stephanie Butcher, was the outperformance of high-quality companies—those with low debt and high returns on equity. Such shares have been increasingly favored by momentum-based strategies that track market trends. Traditionally defensive sectors like utilities and real estate have also done better than many other growth-oriented ones.
Moreover, money has actually left the U.S. and European equity funds this year, leading many analysts to talk about a “flow-less recovery.” All of this suggests that the rally was more a consequence of last year’s rout being severely overdone than investors actually putting chips back on the table.
Pessimism still dominates. As soon as negotiations with China took a bad turn, investors immediately assumed the worse: Bank of America Merrill Lynch’s monthly survey shows that last week, the net share of fund managers holding protection against sharp falls in stocks jumped to its highest level on record.
Furthermore, despite the threat of tariffs pushing up prices, market expectations of long-term inflation have dropped—in the eurozone, to an all-time low—as money managers have focused instead on the possibility of a weaker global economy.
The mood of caution is at odds with much of the data, which shows the global economy in robust health. The U.S. economy continues to grow thanks to improving productivity, and first-quarter earnings surpassed expectations—yet forecasts of future profitability haven’t really improved on the back of these results.
Even in Europe, where money managers should be more circumspect, domestic demand hasn’t immediately followed the downturn in manufacturing orders caused by China’s slowdown. Meanwhile, Chinese officials are moving to stimulate their economy, and major central banks have ruled out any rapid tightening of monetary policy, pushing bond prices up and making equities look appetizing in comparison.
That’s not to say that tariffs couldn’t have serious impacts on some companies. But the strong performance of stocks in the first four months of the year, despite an apparent reluctance to buy them, bodes well. If investors actually get bullish, the equity rally could find a second wind.
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