Taking Stock of the Stock Market

Jack Ablin Market Commentary

The 2020 stock market is just a few days old but investors watching the averages already have whiplash as equities spike higher and dive lower on international news. We enter the new decade with optimism and high hopes of logging market returns that are half of what we enjoyed last year, which would satisfy most grateful investors. It’s also a good point at which to take a step back and evaluate the five most important factors – valuation, the economic backdrop, liquidity, psychology and momentum – in assessing US equities today and their prospects over the next 12-18 months. What do these market “traffic signals” tell us?

Valuation/FLASHING RED – Most of the many ways to measure equity market valuation are currently flashing red. US equity markets made new all-time highs as we entered the year, one indication that stocks probably aren’t a bargain. Most traditional valuation measures suggest that stocks are expensive relative to forward earnings, sales and cash flow. The only measure that begs to differ looks at the valuation of stocks through the lens of bonds. The Federal Reserve’s three rate cuts, combined with cheap interest rates abroad, were largely responsible for the 30 per cent S&P 500 rally against a backdrop of meager earnings growth. It also suggests equities will have a hard time advancing this year without continued central bank largesse. Earnings are currently forecast to expand by about 6 per cent in 2020.

Economy/FLASHING YELLOW – The economic backdrop is the canvas upon which global investments are painted. Both economic expansion and contraction create opportunities and constraints for investing. At this time our economic metrics are flashing yellow, as the global economy is presenting a mixed picture. The US labor market is strong, but several indicators, like wage growth and recent job gains, suggest a slight slowing of momentum. Consumers, while armed with strong personal balance sheets, aren’t flexing their financial muscles to the extent the jobs market would suggest they could. Year-over-year retail sales growth, at 3 per cent, is in the bottom third of its historical range. Consumer expenditures are below average, as reflected in slower automobile purchases: General Motors suffered a 2.5 per cent decline in volume last year through December. Housing, fueled by consistent consumer income and low interest rates, is strong, as reflected in widespread homebuilder optimism. Economic activity, a gauge of trade and manufacturing, is situated slightly below average. Goods and services purchasing managers’ indices suggest expansion, but at a slowing rate. All told, the economic backdrop is neutral.

Liquidity/GREEN – If the financial market is the organism, then liquidity – the availability of money to borrow, spend and invest – is its circulatory system. Despite low interest rates and the tidal wave of demand for borrowing, particularly among corporations, the availability of credit remains robust, which is a bullish signal. Liquidity conditions are easy. The yield premium lenders require to extend credit are low, suggesting a continued willingness to put money to work. Stock and bond market volatility are restrained, reflecting investor optimism. Other measures, like the value of the safe-haven Japanese yen, reflect investors’ continued comfort with risk taking. Our liquidity metric is green; our only concern is liquidity is so strong, the only direction from here is downward.

Psychology/YELLOW – Investment sentiment is a good contrary indicator, since bullish investors have high expectations that are susceptible to disappointment when reality sets in. Currently, investor bullishness, as gauged by the American Association of Individual Investors, is situated in the 79th percentile of its historical range, suggesting broad optimism, but certainly not at Panglossian levels. Despite the seemingly widespread investor enthusiasm bullishness is not running high enough – over the 90th percentile – to move psychology out of its neutral range. For now, this metric remains yellow.  Recent tensions with Iran will undoubtedly temper optimism, but we expect investor attitudes to remain grounded in the face of conflicting headlines. For this reason, our psychology metric is neutral.

Momentum/GREEN – A market in motion tends to stay in motion, unless otherwise acted upon.  In other words, “the trend is your friend.” Momentum in today’s market is strikingly positive when gauged against its 400-day moving average, suggesting that the path of least resistance is higher. The upside power of the market is solidly bullish, which leaves our momentum metric solidly green.

In conclusion, an analysis of our metrics as a group suggests US equities will continue to grind higher, fueled by easy liquidity and positive momentum. Stretched valuations, however, temper our enthusiasm. Anything that would impede the market’s steady stream of low interest rates, easy credit and tranquil economic backdrop could prompt a Minsky Moment-type 15 per cent correction. Near-term risks include geopolitical issues, trade uncertainties and the 2020 election season. For now, stick with your current equity exposure. However, new money should remain patient.