Mixed signals put the market in a holding pattern

The S&P 500 has rallied almost 17% in the past seven weeks, but it is still down about 6% from its all-time high of almost 5 months ago. Corporate profits continue to rise—trailing 12-month earnings are up almost 22% in the past year—yet PE ratios (how much the market is willing to pay for a dollar's worth of earnings) have dropped by over 20% in the past year. Key Treasury yields have dropped precipitously since their early November '18 highs: 10-yr yields have fallen 55 basis points, and 5-yr real TIPS yields are down 40 bps. (Treasury yields tend to be good barometers of the market's optimism about future growth prospects, and their decline reflects a meaningful loss of confidence in the outlook for future growth.) Measures of confidence also have dropped quite a bit in the past month or so. Yet despite all this, stock prices have rallied, and job openings are at record highs.

How can we reconcile all these disparate moves? It's a mixed bag, to be sure, but my reading of the market tea leaves points to investors that are still acting more out of caution than of greed or optimism. The stock market is up, but it's not euphoria that's driving things, it's simply the market becoming less worried about the future. Still worried enough, however, to limit forward progress.

Chart #1

Chart #1 compares the real yield on 5-yr TIPS to the 2-yr annualized rate of growth of real GDP. The two tend to move together, which suggests that real yields on TIPS are a good proxy for the market's expectation of the current trend in economic growth. Economic growth has been picking up for the past two years, and real yields have moved up in sync. But the recent drop in real yields suggests the market is now pricing in the expectation that real growth is unlikely to exceed 2.5% or so over the next year or two. This further suggests that the market believes that the beneficial effect of Trump's tax and regulatory cuts has been mostly exhausted. Conclusion: the bond market is not very optimistic about future growth prospects. Hopes were higher a few months ago, now they're more tame.

Chart #2

Chart #2 compares job openings—which have jumped in the past year to record highs—to the number of people actively looking for a job. This sounds like jobs nirvana: more jobs on offer than there are people looking to work! 

Chart #3

But as Chart #3 shows, the unemployment rate has ticked up in the past two months, from a low of 3.7% to now 4.0%. That sounds bad on the surface, but there is a positive explanation for this: with more jobs and higher salaries being offered, more people have decided to enter the jobs market who were previously sidelined. The workforce (those working or looking for work) is expanding faster than jobs are being created. This is fabulous. In the past, an uptick in the unemployment rate meant the economy was beginning to slow down. Now the uptick means the the economy has more upside potential than it did before. Mixed signals, but the unifying explanation is that the economy is still OK, still healthy, and primed for more growth if and when worries subside further.

Chart #4

Chart #4 shows the recent sharp drop in consumer confidence. It's still relatively high by historical standards, but a drop like this after a long run-up is reminiscent of what happens just before recessions. I hate to say that "this time is different," but the recent drop in confidence seems to have been motivated by "global angst" more than by any actual deterioration in the economy's fundamentals. I expect to see confidence turn up with the February survey, and I think the stock market rebound in the past month or so makes that a reasonably safe bet. The stock market is much quicker to respond to changing conditions than monthly surveys of confidence.

Chart #5

Chart #5 shows the sharp drop in small business optimism that has occurred since last August's peak. The best explanation for this is that higher tariffs on Chinese imports—which Trump thinks put pressure only on the Chinese—are making life difficult for a number of US industries. Higher tariffs on steel make steel more expensive, and that in turn makes a lot of things that use steel more expensive, for example. People are justifiably worried that Trump's tariff war with China could be getting out of hand. At the same time, the December plunge in the stock market added to concerns that conditions were deteriorating. For now the decline in confidence and optimism are most likely lagging indicators rather than leading indicators of worse things to come.

Chart #6

Chart #6 compares the performance of Chinese and US equities. Note that both y-axes are scaled equally (the top value is 15 times the bottom value) and the chart is plotted on a semi-log scale. Chinese equities have not only been much more volatile than US equities, their total gains over the past quarter century have much weaker. Who says China is beating us? In any event, both the US and Chinese equity markets have turned higher in recent months, which suggests the market is sniffing out an end to the tariff wars. That makes sense to me, since reducing or eliminating tariffs is good for all concerned. Why would the Chinese want to resist a deal that would be positive for their economy?

Chart #7

Chart #7 makes a similar comparison between US and Eurozone equity markets. US stocks have outperformed their Eurozone counterparts by a staggering 75% since the lows of March 2009. In fact, US stocks have outperformed Chinese stocks by almost the same amount over the same period. The US economy is on a roll, and global capital wants a piece of the action.

Chart #8

The strength of the dollar, shown in Chart #8, is broad-based, but not excessive—as it was in the mid-1980s and the early 2000s. Those periods were characterized by aggressive Fed tightening, which is not occurring today. Today the dollar's strength arguably owes more to the relative attractiveness of the US economy than to any actions on the part of the Fed.

Chart #9

Chart #9 compares the value of the dollar (inverted) to an index of industrial metals prices. When the Fed was very tight and the dollar was very strong in the early 2000s, commodity prices were extremely weak. Today it's different. The dollar has risen significantly in the past 5 years, but commodity prices are still relatively strong. Conclusion: US monetary policy is not adversely affecting the global economy, and that's good. Emerging market economies (the ones most dependent on commodity prices) are not being strangled by an overly-strong dollar. In fact, the Brazilian stock market in dollar terms is up 180% in the past 3 years! The laggard economies are to be found in Europe and Asia, where government intervention has smothered private sector initiative.

Chart #10

Chart #10 shows the two main measures of corporate profits. NIPA profits are based on corporations' filings with the IRS and are annualized and adjusted for inventory valuation and capital consumption allowances. S&P profits are trailing 12-month earnings per share, reported according to GAAP standards. Both show that profits have risen at an impressive rate in the past year or so. Much of that is due, no doubt, to the reduction in corporate income tax rates, but it is still impressive.

But consider this: since the end of 1999, just before the blowout peak in stock prices, GAAP reported profits have tripled, and NIPA profits are surged by almost 250%. Yet the S&P 500 index is up only 87%. It's hard to use this data to make a case for equities being overpriced.

Chart #11

Chart #11 shows the history of PE ratios for the S&P 500. They peaked in 2000 at around 30, and now stand at just over 18, a mere 8% above their average since 1960. Again, it's hard to use these facts to argue that stocks are over-priced. Profits have surged, yet the price of a dollar's worth of profits has plunged. This market is cautious about the outlook for the future.

Chart #12

Finally, Chart #12, my favorite "wall of worry" chart. The market appears to have gotten over the bulk of its recent worries, but worries still linger in the form of a higher-than-normal Vix and relatively depressed Treasury yields.

I'd characterize the market and the economy as in a holding pattern: fundamentally healthy but still worried about the future. Animal spirits are on a tight leash until it becomes clear than global disturbances are being correctly dealt with. All eyes are on Trump and Xi and their upcoming meeting.