Stocks continued to grind higher in May as stock buybacks and low interest rates offset weak economic news and more financial turbulence in Greece.  Chinese stocks continued to surge forward even as economic growth weakened further.  But the economic weakness there has actually been the trigger for the stock market gains as investors believe that the central bank will have to cut interest rates further in order to get growth turned around, and those lower interest rates drive money into stocks.   The sharp gains for Chinese stocks in the past year while economy conditions there continue to worsen clearly shows how investors have become overly dependent on the largesse of the low interest rate policies of the central banks, leading once again to the anomalous situation where ‘bad (economic) news is good (stock market) news!  It is basically the ‘same game’ played by the US Federal Reserve with their three rounds of quantitative easing as well as the 2015 QE program introduced by the ECB in Europe and the ‘Abenomics’ policies in Japan.  All of these programs have contributed to the upward move in stocks.  But while stocks are trading near recent highs in many major markets, the gains have been uneven.  While U.S. stocks are near all-time highs, they are really just at the top end of the trading range they have been in since late last year.  European stocks have had a stellar year but have also stumbled a bit recently, with the German Dax Index trading down over 8% from its peak after the Euro currency stopped falling against the U.S. dollar.  Canadian stocks have been held back by the drop in the Energy sector even though the weaker Canadian dollar should give a boost to the manufacturing and exporting sectors.

Despite recent stock market strength though, our outlook remains cautious.  In our view, central banks have ‘over-applied’ the medicine of zero/low interest rates with more success inflating the value of financial assets than stimulating global economic growth.  Companies are eschewing real expansion in favour of stock buybacks and mergers, in many cases borrowing funds at low rates to do so.  Average investors are being forced into riskier investments in order to receive a normal rate of return.  Meanwhile the global economy is seeing few benefits from these low rates as consumers are still paying down excessive debt loads instead of spending.  U.S. economic growth has slowed down again due to negative impact of stronger US dollar and low export growth.  Growth was actually negative in the first quarter.  While this is being blamed primarily on the major winter storms on the east coast as well as the western port strike, economic numbers are now rebounding to any significant degree in the 2nd quarter.  Europe is growing at only 1.0-1.5% at best despite the impact of Quantitative Easing and the benefits of a weak Euro and low oil prices.  Chinese growth is also deteriorating as it over-expanded capital spending after the 2008 financial crisis and now needs to push consumer spending as an offset.

The worst news, though, is that despite weak growth, inflationary pressure could be starting to return due to rising wage growth and a lack of expansionary spending on new industrial capacity.   That means that central banks have already left low interest rates in place too long and are what we refer to as being ‘behind the curve’ and will need to raise rates.  On top of the economic issues, earnings growth is slowing down as profit margins are already at all-time highs and revenue growth is coming down.  Meanwhile, stock valuations are at levels which were higher only during the ‘tech bubble.’  While low interest rates could keep stocks rising in the short-term, we see similar warning signs to what we saw in 1999 and 2007.  Cash is not looking attractive now but will be if other financial assets start to fall.

The tougher issue for investors is that an expensive market can stay over-valued or get even more expensive once it gets that momentum, as shown by the behavior of stocks in the late 1990s.  However there is always a ‘day of reckoning’ and these trends don’t go on forever, as investors painfully discovered in 2001-02 and again in 2008.  While valuation excesses in today’s market doesn’t necessarily mean that stocks are ready to collapse, it does argue for taking a much more conservative approach to your investment strategy until these valuations are corrected.

While we continue to see many strategists, economists and even some central bankers talk about growing financial risk, investors are not really paying much attention to any of that.  We are certainly aware of what the bullish case is for stocks right now.  Those would include the following points:

  1. While stock valuations are high they are not at the record levels seen at the peak in 2001.
  2. Interest rates are at record low levels and expected to stay below normal levels for a long time thereby supporting higher overall stock valuations.
  3. Economic growth has been slow but this will keep inflationary pressures low and allow for a longer period of expansion.
  4. All of the aggressive policies of central banks throughout the world will eventually lead to better growth.
  5. Most people believe that average investors have not participated in the stock advance of the last few years so that there is still lots of ‘uninvested cash’ that could still come into the stock market.
  6. Corporate merger and buyout activity is still going strong and it generally peaks before the top in stock prices.
  7. Corporations, flush with cash and borrowing capacity, keep buying back their own shares, putting a ‘floor’ underneath the stock market.
  8. There are no really attractive alternatives to stocks at this point due to such low interest rates.

While we could refute each of those measures line-by-line, our main point is that all of those bullish arguments are reasons why stocks may not sell off in the near future (i.e. no reason to fear the dreaded ‘correction’) rather than being good reasons to buy stocks for the longer term, such as low valuations, rising earnings or improving economic conditions.  Probably the most compelling reason supporting higher stock prices for now is the 5th point, the fact that many investors have not participated in this rally.  While many bull markets have ended when the public finally steps up and buys into stocks, this has yet to occur in this cycle.   However, corporations have been such large buyers of stocks that any slowdown in their purchases would quickly put stock prices at risk.

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