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Quarterly Market Update: The Fake Rally

By Darren P. Wurz, MSFP, CFP®

Welcome to the 2nd quarter of 2019! It’s almost as if the 4th quarter of 2018 didn’t even happen! The first quarter of 2019 was a smashing success for bulls, nearly erasing the trauma of the fourth quarter of 2018. What drove the markets down in 2018? Fear that the global macro-economic picture was deteriorating quickly. And indeed the markets turned out to be right. Earnings growth for Q1 is projected to be negative—we’ll know more when companies are done reporting.

So what’s driving the market higher now? Optimism rooted in the promise of a China deal and faith that central bankers will step in to save the markets.

First, we got complete capitulation by the Federal Reserve. In the 4th quarter, the Fed was raising interest rates and reducing their balance sheet on “auto-pilot” because, they said, the economy was strong enough to handle it. What is the balance sheet? The massive quantity of mortgage-backed securities and treasuries that the Federal Reserve bought with imaginary money to flood the markets with cash and hold down interest rates to try to save the economy from the Financial Crisis. This was a giant first-time experiment by central bankers called “quantitative easing.” The Fed has been promising for years that they would slowly reduce the size of this government owned debt. In 2018 they started doing this by selling these securities back to the market. A few months later they stopped because the stock market sold off and dropped by 20%.

Suddenly, at the beginning of 2019, they’ve completely changed their tune. No more interest rate hikes. Maybe even interest rate cuts. Balance sheet reduction will be ending. But the economy is still strong they say.

So let’s look at the economy. The numbers over the past quarter have not been good. Globally, economic indicators continue to tumble. The Citi Economic Surprise Index keeps going further south into negative territory (see the graph below).

As its name implies, the Citi Economic Surprise Index measures how economic data are progressing relative to forecasts by economists. So when the index goes negative that means things are worse than we thought. That’s pretty important at a time like this when forecasts are being revised down. It tells us that these economic forecasts are not being revised down fast enough.

Elsewhere in the world, Europe is on the brink of recession as the numbers continue to worsen. Germany manufacturing output was a complete disaster in March is now the lowest it has been since the Great Recession.

U.S. hard economic data continues to deteriorate as well. The graph below shows the same Citigroup Economic Surprise Index again, but divided into hard and soft U.S. data. Hard data refers to measurable improvements in the economy, while soft data refers to things like sentiment and confidence. Hard data is usually a more reliable of conditions as they are. The hard data index is now at its lowest level since the Great Recession. 

But the markets think this is all just temporary. Even though earnings growth for the first quarter is going to be negative, investors are so optimistic that they think we’ll recover from this blip in a matter of months. Earnings per share is a measure of companies earnings divided by the number of outstanding shares of stock of that company. The graph below shows the average earnings per share of companies in the S&P 500 historically and the consensus forecast for the next year or so. Currently, the consensus forecast is for a little dip this year, with a quick recovery towards the latter half of the year and then a surge to new highs. It is this optimism that is driving markets higher in the face of deteriorating data.

The other thing that is driving markets higher is the constant jaw-boning by the Trump administration about a China deal. I’ve got to give it to them—they’ve figured out how to pump up the markets. Put out a press release or leak some “news” about how great the negotiations are going and markets will go higher. Why? Because there are certain algorithms that buy stocks when certain key words are uttered and sell stocks when other key words are uttered.

So you get this daily promise of a great China deal and rising markets and then Joe the investor thinks, “Oh my gosh I’ve got to get in and buy stocks too!” And the markets go higher.

And that’s fine! We’re happy to take advantage of that if that’s how the markets want to go. But we’ve got to keep the big picture in mind and stay alert. These markets could sell off hard and fast at any moment. The constant “buy” program could quickly turn into a “sell” program at any moment. Markets can ignore reality for a long time—but not forever. The reality is that there are a lot bear market check boxes that have been checked.

Here’s one we mentioned last time: the Treasury curve inversion. It finally happened. The yield on 10 year treasuries went below the yield on 3 month treasuries—a pretty reliable recession indicator. Because it only lasted for a couple of days, all the pundits on TV are telling us to ignore it. But again, let’s keep the long term trajectory of yields in focus (graph below). It appears that the Treasury curve is headed for full blown inversion just like in 2001 and in 2007. You do remember those years, don’t you?

So here we are! Take a look at this graph (below). Markets have nearly recovered all their losses from the 4th quarter. Or have they? In this graph we have three lines. The green and red line is the S&P 500. The purple line is the Nasdaq and the orange line is the Russell 2000. If you’re just looking at the Nasdaq and the S&P 500, sure the market has just about recovered. As of the writing of this article, we’re a fraction below where we were in September 2018.

But what about that weird orange line? That’s the Russell 2000—an index of the 2000 smallest publicly traded stocks (or approximately 2000 stocks). In some ways, the Russell 2000 is a better measure of the “real economy.” Keep in mind that small and medium sized businesses (those not in the S&P 500) make up about 80% of all U.S. employment. The Russell is still pretty far below the highs of 2018 and is seriously lagging behind. Over the past month, this index has failed to make new highs it appears that he rally of 2019 is stalling for small and medium sized companies. The Russell is often a good way to measure the “health” of the market too. If the Russell is making new highs along with the S&P, that’s a good sign. Divergence, like we are seeing here, is usually a bad sign. It was the Russell that led the decline at the beginning of the 4th quarter.  Is it signaling the same thing again? Only time will tell.


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