Feeling All Right – Financial Market Update
Last September, everything felt fine. Led by technology stocks, the stock market was up over 10%. The Federal Reserve raised the fed funds rate 0.75% at this point in 2018, causing bond performance to be basically flat, but at least savers were earning something in their savings accounts and CDs. The economic news was great. Unemployment had reached 3.7%, the lowest level since 1969. Earnings were strong, as companies were reaping the benefits of the December 2017 tax cuts. The trade war had begun, but as the U.S. just reached an agreement with Mexico and Canada, the rest of the world would be sure to follow. It appeared that the markets and the economy were hitting on all cylinders and there was nothing to worry about. Everything felt great.
Scan ahead three months and everything had changed. The economy was slowing, investors were wondering if the Fed had gone too far and a recession was on the horizon. The trade war had not resulted in more agreements but instead, had escalated to a level that was destined to hurt both the U.S. and global economies. Surely this would lead to a recession. The stock market fell more than 13% in the fourth quarter. Everything felt terrible and was bound to get worse.
Fast forward to today. Things did not get worse. The economy has not fallen off a cliff. In fact, the unemployment rate stands at 3.6%. Economic growth as measured by GDP is around 2%; not gangbusters, but not the gloom and doom of a recession. The Fed provided confidence by lowering interest rates by 0.75% in three separate 0.25% cuts. This was a move designed to stimulate the economy and reduce recession fears. The trade war is still ongoing, but if one is to believe what one hears in the news, the main parties may be close to an initial agreement. The stock market must like what it hears. Through the end of October, the market is up over 23% and the bond market is up over 9%. Everything feels great again.
Now what? It seems like every time investors feel good about the economy and market, things change, and it turns around. It also seems like whenever investors feel negative about the economy and market, things change, and it turns around. The reason for this is sentiment. Sentiment is a view of or attitude toward a situation or event, in this case the economy and stock market. Sentiment is one of the most important indicators we look at when deciding to add to or decrease a position. The key takeaway from this article is “sentiment is a contrarian indicator,” especially at extremes. This means that when everyone is bullish on the stock market, the market is likely due for a pullback. When everyone is bearish on the stock market, the market is likely due for a rally.
Why is this? Let us consider the bullish example. If an investor is bullish, he or she is likely to be fully invested in the market. In other words, the investor would have all his or her cash invested in order to maximize returns. If everyone felt bullish at the same time, all investors would be fully invested and there would be no cash left to invest. It takes new capital (cash) to buy the next shares of stock and push the market higher. If there is no cash on the sidelines, who will the next buyer be? The only direction the market can go is down. In the opposite case, a bearish investor will minimize his stock exposure and take money out of the market, likely building up cash. If this is the consensus view, lots of investors will be selling and cash will be aplenty. Eventually some brave souls will reenter the market, pushing up shares, likely leading to more investors following suit. This time, there is plenty of cash ready to purchase shares and lead the market higher.
Does this mean we are ready for a pullback? Not necessarily. Sentiment is high, but it is not at the extreme levels one tends to see at market tops. Usually, something triggers a change in sentiment. Obviously, the news flow plays a big part in the day-to-day movements of the market. Positive reports on the economy and trade war will help bolster the markets, while negative stories will cause nervous investors to flee. Usually, these gyrations are just noise and lead to short-term volatility. But if the news becomes overwhelmingly negative, sentiment will begin to turn. The good news is most economists remain constructive on the economy and we believe that as long as the economy does not fall into a recession, any pullback will likely be shallow and short in duration. So, enjoy the current wave of positive sentiment while it lasts, and we will keep an eye out for signs of extreme conditions and reversals of fortune.
Tom Beilstein, CFA
Co-CIO, Bill Few Associates, Inc.
All data from Morningstar. Stock market returns are for the S&P 500, and bond market returns are for the Bloomberg Barclays US Aggregate Bond Index.