Stocks, high-yield debt, and commodities have rallied strongly across the board since the S&P 500 Index hit a “double bottom” of 1,810 on February 11. A double bottom describes the drop of an index, a rebound, another drop to the same or similar level, and finally another rebound.
Since February 11, the S&P 500 is up 13%, and the MSCI Emerging Market Index has risen 20% (through March 18). Meanwhile, high-yield spreads have fallen sharply, led by the energy sector, while crude oil (West Texas Intermediate) has rallied from a double bottom of $26 to over $40 per barrel.
Most important—and perhaps the leading cause of the rally—is that the broad dollar index (JP Morgan Broad Dollar Index) has fallen 5.7%. This has allowed financial conditions to ease, as evidenced by the decline of nearly 100 basis points in the Goldman Sachs Financial Conditions Index. (The index tracks changes in interest rates, credit spreads, stock prices, and the value of the U.S. dollar.) An increase in the index indicates a tightening of financial conditions, and a decrease indicates easing.
Behind the rally
There are several reasons for the improved financial conditions. One of the most important is the market’s reassessment of the Fed’s path toward policy normalization. Back in December 2015, when the central bank raised the fed funds rate for the first time in nine years, the Fed’s “dot plot” called for four rate hikes in 2016 and another four hikes in 2017. The market felt this approach was too aggressive, and “unpriced” most of the hikes. From there, it was up to the Fed to either acknowledge this new path or “fight the market” and press ahead. The latter would likely have been seen as a policy error, and the Fed accepted the market’s new assessment.
The current stalemate between bull and bear for stocks will likely not end until the policy divergence between the Fed and other central banks around the world ends. Since the market’s new assessment of the Fed’s policy track, and with the Fed not fighting it, the policy divergence has eased up. Perhaps it has gone into remission, like it did last October.
Of course, the Fed is still on a tightening bias. According to the latest dot plot (as of the March Federal Open Market Committee meeting), the Fed still intends to tighten twice this year. So the policy divergence has not been reversed—that would only happen if the Fed abandons or even reverses its tightening bias or if the other major central banks end their easing campaigns.
Nevertheless, it has become much less of a collision course for the dollar than it had been before, and that has allowed a technically overbought dollar to come down. Add an across-the-board oversold condition for stocks, credit, and commodities, and you had the ingredients for a powerful risk-on rally. So that’s where we are; we have gotten the reprieve.
What may happen next?
With the 1,810 level for the S&P 500 now well defined as a double bottom, my guess is that stocks have defined the bottom of a large trading range, say between 1,800 and 2,100. With the S&P 500 currently trading at 2,035 (as of March 25), that still leaves some upside for stocks.
What will it take for the market to break out to new highs and for the bull market to resume? A healthy bull market rests on three pillars: reasonable valuations, healthy earnings growth, and a supportive liquidity environment. In recent months, valuations were the only pillar supporting the market, as earnings growth turned negative and liquidity conditions seized up. Today, with the Fed sounding more dovish and the dollar weaker, the liquidity pillar looks a little healthier than it had before.
Earnings growth remains muted, though, even when excluding energy. For 2015, earnings per share (EPS) growth was –2.4%, while ex-energy it was +4.3%. That is below the 2014 trend of about 5% annual growth. And remember that about 60% of S&P 500 operating earnings was generated from share buybacks. So the true organic earnings growth rate for the market was only a couple of percentage points. For 2016, earnings are expected to grow by 2.9% (or 5.9% if the energy sector is excluded). Since earnings estimates usually come down as the year progresses, we could see another lackluster year for earnings. But with the weaker dollar, it is possible that earnings may surprise on the upside this year.
As far as the three pillars are concerned, conditions may have stabilized enough to prevent the market from falling below the lows set in January and February. But, at the same time, I don’t believe conditions have improved enough for the market to outperform its old highs. For now, it seems we are in a kind of market purgatory.
It’s important to remember that the gains for stocks (and all risk assets) since the March 2009 bear market bottom to the highs set in 2015 were unusually large, not only in absolute terms (+22% per annum for the S&P 500 vs. a +10% norm), but also relative to the amount of volatility in the market. You can see this in the chart, which shows the “efficient frontier” (returns per unit of risk) since 1970 (spanning many market cycles), and since 2009. The 2009 dots are higher than the 1970 dots (i.e., more return), but the 2009 dots are no further to the right, meaning volatility has not increased with the higher returns.
Therefore, investors have been somewhat spoiled since 2009 because they’ve received far more return per unit of risk than has historically been the case. Of course, part of the reason for this above-average performance is that the 2009–2015 period comes on the heels of a 57% decline in the S&P 500 from 2007 to 2009. So a good part of the outsized returns is just a mean reversion of massively oversold conditions stemming from the 2009-08 financial crisis.
A rising tide lifts all boats.
There is no denying that at least part of the above-average returns and the relative lack of volatility stems from the huge tide of liquidity that washed over the markets in the post-financial-crisis period. “A rising tide lifts all boats” is a common refrain in financial circles, and from 2009 to 2015, risk assets rode a favorable tide of zero interest rates, quantitative easing, and sharply narrower credit spreads, and earnings rebounding from recession lows.
But now the tide is slowly receding. The Fed is gradually tightening while other central banks are easing. This has pushed the dollar higher (until very recently), and that in turn has put a strain on the Chinese yuan (which is loosely pegged to the dollar), and on other emerging-market currencies. This is not bearish for U.S. stocks per se, but it does mean the liquidity pillar that provided so much support for the markets is now on shakier ground. Yes, it is good that the Fed is heeding the message from the markets and pushing out its tightening path further into the future, but it remains on a tightening bias nonetheless.
This suggests to me that it will take some time for the 2009 dots in the efficient frontier chart to mean-revert back toward the 1970 dots. But it doesn’t automatically signal that an impending bear market is approaching. Markets can correct through price but they can also correct through time, and it is the latter that seems to be occurring in the S&P 500.
Historically, the S&P 500 has gained about 10% per year on average and has risen 75% of the time (since 1900). Cyclical bull markets typically last 39 months, and cyclical bear markets typically last 13 months. Combined, the typical cycle spans 4.3 years (hence, known as the “four-year cycle”). But from March 2009 to its record in May 2015, the S&P 500 gained 22% annually. That’s not normal. So when we consider the flat environment for U.S. stocks over the past year (with the S&P 500 down 14% at its worst point), it really shouldn’t surprise us that it has given back some of its gains.
For long-term investors in the markets, there is not much to do here other than to be patient while the market rebuilds its three pillars, and to recognize that the past seven years were unusually friendly for investors.
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