- The economy is losing some momentum.
- Defensive sectors—consumer staples, health care, utilities—are leading the market.
- Consumer sentiment is bullish, which historically has been bearish for stocks.
- Still, monetary policy accommodation appears to be keeping the rally going.
Why has the stock market been rallying during the past five months? In hindsight, it seems simple. As long as the Fed or any other central bank (most recently, the Bank of Japan) is printing money, then stocks rally.
As I have been writing in recent months (Read Viewpoints: Will the sweet spot for stocks continue?), there have been four factors supporting risk assets since November: the economy, the market's technical condition (or tape), sentiment, and monetary policy. Until a few weeks ago, the first three out of these four factors had been losing steam and were at risk of toppling the market—or so it seemed at the time. But the market never toppled, because all that seems to matter these days is monetary policy in the form of QE (quantitative easing).
Economy: losing some momentum
In terms of the economy, some of the high-frequency economic indicators that I follow have started to roll over, just as they have done in each of the past three years at around this time. For instance, the weekly ISI economic diffusion index is losing momentum exactly in tune with a 10–11 month mini cycle that has been in force for the past three years.
Technicals: unlikely winners and losers
Technically, during the past few months, we had seen a marked loss of leadership in the market, from copper to the 10-year Treasury yield to the Shanghai Composite to eurozone banks—at least until a few weeks ago, when most of these indicators started to improve. And the most unlikely sectors led the market higher, namely consumer staples, health care, and utilities—all of which tend to outperform only during market corrections.
Sentiment: Bullishness reigns
Sentimentwise, bullishness reigns supreme. Mutual fund flows have been strong, sentiment surveys show a lot of complacency, and we are starting to see magazine covers, such as those of the Economist and Barron’s, tout the return of the bull market. These are the kinds of indications we sometimes—but certainly not always—see at market tops.
Why no correction?
So, why didn’t this combination of weakening economic momentum, eroding technical leadership, and lofty sentiment levels produce the kind of correction that we experienced in the springs of 2010, 2011, and 2012? In my view, it’s because during those previous three corrections the Fed was not printing money. But this time it is printing, and so is the Bank of Japan, and by the bucketload.
That's the most logical conclusion for why stocks have been able to hold up so well while other market and economic indicators have corrected. But the impact of monetary policy doesn't stop here. According to Trevor Greetham, our asset allocation director, Investment Solutions Group, in London, it could also explain why the stock market has been led higher by the more defensive and higher-yielding sectors. It could also explain the disconnect between the stock market and industrial commodities. Those two asset classes have been very tightly correlated until last year.
I believe that, to some degree it comes down to the Fed and QE. The Fed has pushed many investors—who would normally be satisfied being in safe Treasuries—out the risk curve into higher-yielding, but riskier, securities. These include corporate bonds, high yield bonds, emerging-market debt, and bank loans. While these sectors were attractively valued after the 2008 financial crisis, they are now more fully valued, to the point where investors may have to be satisfied with the prospect of merely clipping coupons rather than expecting the kinds of robust capital gains that have been generated in recent years.
So the reach for yield has gone even further, stretching into the higher-yielding, low-volatility sectors of the stock market, such as consumer staples, health care, and utilities. This partly explains why the stock market has been rallying, and why it has been led by these defensive sectors as opposed to the more traditional cyclical sectors, such as industrials, tech, and financials.
In a way, the stock market has become less of an economic barometer and more of an extension of the bond market, driven by the Fed's management of risk-free assets. This raises the question of what part of the market is still sensitive to swings in the economy. The answer seems to be commodities, which have been quite weak lately, consistent with the rolling over of some of the high-frequency economic indicators mentioned above. This would explain why industrial metals have stopped correlating to stocks and have instead fallen out of bed, while the S&P 500® Index and the Dow have kept on making new highs.
In addition, certain economically sensitive sectors such as industrials and tech have been lagging, as have certain regions of the global economy, especially China and emerging markets, as well as Asia ex-Japan in general.
What this tells me is that as long as the Fed and other central banks continue to flood the system with massive amounts of liquidity, perhaps the only corrections we’ll experience will be the kinds that take place behind the scenes and underneath the surface of the major averages. In other words, the only corrections we’ll experience will be in commodities and in those regions and sectors that are economically sensitive.
So, maybe the risk-asset party continues for a while longer. What could ultimately derail the rally? Perhaps it is when the QE music stops, or if the economy rolls over, or if the Fed or Bank of Japan’s aggressive monetary medicine backfires by causing higher interest rates or even a currency war.
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