Stock Market Rally Continues

PaulNolte-2The weather is warmer, we change the clocks next weekend and baseball is in the air. But really, what has changed from the dark days of January and February? The markets have all but erased those losses. Energy, which looked to be falling into the mid-teens a few weeks ago, is embarking upon a bull market, having risen over 20% from the January lows. The slowdown in China is so last year along with modest growth in the US. So what really has changed? Economic conditions do not change on a dime, unlike the markets. The Fed may change on the employment figures, but those too did not look terrific below the headline numbers. Are things that much different than the start of the year that led to a 10% decline in
stocks, followed by an 8% surge within eight weeks? The economic data has been better than expected as of late, but still not pointing to a new growth cycle. The employment report headlines looked good, but wage growth remains modest. There were some issues with the calendar that may get corrected with the next report, but it also may be enough to move the Fed to raise rates at their meeting next week. And we all know what happened to stocks following their last meeting!

The stock market continues to put in a furious rally, rising over 8% just in the past three weeks. The market internals look better, but not as good as the indices indicate. Looking out over the very long-term, stocks are determined by earnings and the growth in those earnings. Earnings, on an as reported basis, have fallen over 18% since late in 2014. They are expected to recover, as energy prices recover and are estimated to be at new highs by yearend. If the markets “run in place” between now and yearend, valuations will get back to merely high vs. their currently “very high” status today. Since analysts tend to be optimistic in their future views, we don’t expect those rosy numbers to be achieved. So, we are left with a market that is priced rather high historically and could struggle making significant headway throughout the year. That said, momentum is on the side of the bulls and stocks can continue to race higher. We would be cautious about significantly increasing our equity weights at this time.

The recovery in commodity prices over the past few weeks, from oil to lumber and even a small jump in coffee, has clouded the inflation picture a bit. Yields on government bonds have increased over the past few weeks (falling in price), while corporate bonds have performed better. The dash for the safety of government bonds has abated as stocks raced higher. The recovery in energy prices over the past few weeks and a better feeling for the economy as a whole has helped boost corporate bonds at the expense of safe treasury bonds. The better than expected jobs report could give the Fed reason to raise rates again next week, pushing yields higher (and prices lower). Our models still point to lower interest rates and a rising risk of recession. Both scenarios are beneficial to bond investors, but not necessarily so for
stock investors.

The worst to first rally of the past three weeks has pushed many of the previously poor performing asset classes and industry groups to the top of the list. We pointed out last week that international stocks were looking better, especially emerging markets. What makes “calling” bottoms (or even tops) in markets are the fake-out rallies that eventually give way to ever lower prices. Last year, the first four months were terrific for emerging markets, only to have them put in a lousy year. Energy and small cap stocks paint similar pictures. We are watching each of these areas closely as they have been long time poor performers vs. the SP500. Given the very large decline over the past few months, it is not unusual for the markets to rally quickly from very “oversold” levels. We would like to see more evidence that an actual bottom is in place and we should begin making investments in smaller US and international stocks. The next few weeks will be interesting as both the European central bank and Fed meeting are on the calendar. How long can the gravy train of easy monetary policy last and keep stocks higher. We may have an answer by the end of March!

We are watching closely the strong rally in small US and emerging market stocks as potential areas to invest in if they are able to maintain those gains. There have been plenty of “fake-out” rallies in these asset classes that make us cautious about making the commitment just yet. The shift toward the safety of treasury bonds seems to be over for now. Our focus upon corporate bonds started slowly January and February, but is looking better of late. Short term, stocks can rally further, but long-term they remain stuck in a very broad trading range.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.