Mixed Market Messages
After reaching lows in December, stocks have rebounded sharply, with strong breadth, as some of the worst fears appear to have subsided. But there are still uncertainties that are likely to cap near-term gains and/or lead to elevated volatility.
Earnings season has been mixed, with the main message appearing to be slowing growth but no near-term recession. The Fed has turned more dovish and is likely on hold for a while, depending of course on incoming data.
China’s economic slowdown is also causing concern, and the different way they are attacking the problem has generated more questions than answers.
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“All of life is peaks and valleys. Don’t let the peaks get too high and the valleys too low.”
- John Wooden
U.S. stocks have rebounded sharply since the crescendo Christmas Eve lows, but some important headwinds remain. This is the nature of being late in a cycle, with often competing headwinds and tailwinds—and is the definition of volatility (sharp moves in both directions). The rally has had strong breadth conditions accompanying it, but it’s also taken U.S. stocks from deeply oversold technically in December to marginally overbought now. Oversold conditions developed as investors faced recession, trade fears and tighter financial conditions. At the late-December low, investor sentiment, according to the Ned Davis Research Crowd Sentiment Poll, reached pessimism levels. Stocks have since recovered more than half their losses as monetary policy has shifted in a dovish direction and financial conditions have eased; which has led to sentiment rebounding to a more neutral level. Breadth health of the rally aside, we believe this is more likely the correcting of oversold conditions rather than the start of a renewed robust uptrend. There are still plenty of uncertainties that could go either way, resulting in our continued mostly neutral and somewhat defensive posture. Such a stance will likely feel somewhat frustrating during sharp rallies, and also if there are renewed sharp downturns, but overall we believe is the right stance for investors to be able to mostly participate in rallies while still having some defense on the downside. Volatility has declined from the spike we saw late last year but still remains somewhat higher than the low levels seen in 2017. We think that year was the exception, rather than the new rule; and that a higher (read: normal) level of volatility is likely to persist this year.
VIX down from spike but still above recent years
One of the biggest uncertainties facing investors is the China/U.S. trade dispute, and the continued mixed messages regarding progress or lack thereof. Rumors of a possible decline in U.S.-imposed tariffs helped support stocks, while differing reports of potential meetings between the two nations seems to have only confused investors and caused some tumultuous intraday trading activity. The risk is not necessarily binary—i.e., deal or no deal. Improving relations and no new tariffs would likely be a positive development, while if the currently [scheduled March 1 increase in tariffs comes to pass, it would likely be a market negative and almost certainly an economic negative. We admit to having no idea how President Trump or President Xi will proceed, contributing to our current more cautious stance. We do believe that trade will be an important factor in determining the length of runway between now and the next (inevitable) recession.
Corporate mixed messages
Companies have largely been echoing the uncertainty surrounding the trade standoff, which has contributed to mixed commentary coming out during earnings season (for more on earnings season read Brad Sorensen’s Gauging the Economy Through Earnings). The good news is that, for now, investors are no longer punishing stocks regardless of earnings results, which was the case last year. Although the “beat rate” is a historically-subdued 70% so far this season (FactSet), we’ve observed that companies beating expectations have been generally rewarded with higher stock prices—likely reflecting the relatively low expectations coming into the reporting season. Overall, companies are supporting the view we expressed in our 2019 outlook, which is that trade and other uncertainties have meaningfully dented “animal spirits.” It’s been witnessed in several important confidence measures, which have recently faltered, including the National Federation of Independent Business (NFIB) optimism index, the Institute for Supply Management (ISM) Manufacturing Survey, although we saw an encouraging rebound in the most recent reading, and Duke’s CFO Outlook survey. In fact, when the latter was released in December, it showed that nearly half of U.S. CFOs believe the U.S. economy will be in a recession by the end of this year.