A Head Scratcher

Once again, we are scratching our heads as we observe the financial markets as 1st quarter earnings roll in.  Over 75% of the companies that have reported earnings at the time of this writing have significantly beat their estimates.  ISM numbers are well above 50 (indications of economic expansion).  Housing is solid.  These are usually all good things for the stock market.  However, the year-to-date return through April for the S&P 500® Index was slightly negative.  What is driving stocks?  Is it economics? Is it policies and politics?  What are markets telling us?  This conundrum reminded us of a quote from Robert McCloskey, a writer and illustrator of children’s books from the 40’s and 50’s.  The quote goes, "I know that you believe you understand what you think I said, but I'm not sure you realize that what you heard is not what I meant."  We think that just about sums it up.

Outside of the excellent earnings reports, there seems to exist a preponderance of items that are having a negative impact on markets.  Continued concerns over employment, labor markets, inflation data, Fed rate hikes, oil prices, geopolitics, just to name a few, are definitely outweighing the earnings and global growth data that drove markets to new highs earlier this year.  Through the first few days of May, both stock and bond returns were negative, with the brunt of the decline actually being felt in the bond market.

Yes, market volatility has returned.  The combination of one of the longest bull markets on record and some “interesting” global and political developments has many investors looking for the proverbial “other shoe” to drop.  One possible “shoe” could be higher gas prices.  We are beginning to feel the effects of higher gas prices at the pump, making consumers feel a little less optimistic.  We have written in the past about the importance of consumers and their pocket books for market performance.  Oil and gasoline prices have increased on concerns of economic sanctions levied on Iran and problems in Venezuela.  But we believe that the US and Russia will increase production at these higher prices, which will help offset the effects of these geopolitical issues.  This will effectively keep prices capped. 

Is it possible for markets to experience a near term correction, similar to February?  Sure, it’s possible.  We are after all moving into the seasonal summer period when history suggests corrections are more likely to occur.  While we introduced several potential causes of concern in the second paragraph above, we think negative surprises are more likely to come out of the political arena.  While sanctions and trade talks have been in the news long enough for markets to price in some level of probability, overly aggressive or protectionist policies would have a negative impact on global growth and could ultimately hurt stocks further.  And with mid-term elections on the horizon, it is anybody’s guess as to what other “issues” may arise.

We are not trying to portray all doom and gloom or suggest that a recession is looming. Quite the contrary.  The economy appears in good shape with corporate investment in equipment in an uptrend, consumer and business confidence remaining high, and the unemployment rate (3.9%) at an 18-year low.  While such strength has caused concern about the rate of inflation and the Fed’s ability to keep it under control, measures of wage inflation suggest there is still slack in the labor market.  One measure of wage inflation suggests we still could be years away from peak employment.  This should give the Fed room to continue raising rates at a measured pace and keep any negative market surprises to a minimum.  Our own indicators have yet to give us a cautionary signal on equity markets, and long term technical indicators (think trends) are still positive, despite the recent correction. More importantly, underlying conditions in the equity markets of supply and demand have been steadily improving since this correction began in February.  All of this suggests continued support for equities moving forward.